Item 1. Business.
Eaton Corporation plc (Eaton or the Company) is a power management company with 2017 net sales of $20.4 billion. The Company provides energy-efficient solutions that help its customers effectively manage electrical, hydraulic and mechanical power more efficiently, safely and sustainably. Eaton has approximately 96,000 employees in 59 countries and sells products to customers in more than 175 countries.
Eaton electronically files or furnishes reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act) to the United States Securities and Exchange Commission (SEC), including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and proxy and information statements, as well as any amendments to those reports. As soon as reasonably practicable, these reports are available free of charge through the Company's website at www.eaton.com. These filings are also accessible on the SEC's website at www.sec.gov.
Business Segment Information
Information by business segment and geographic region regarding principal products, principal markets, methods of distribution, net sales, operating profit and assets is presented in Note 15 of the Notes to the Consolidated Financial Statements. Additional information regarding Eaton's segments and business is presented below.
Electrical Products and Electrical Systems and Services
Principal methods of competition in these segments are performance of products and systems, technology, customer service and support, and price. Eaton has a strong competitive position in these segments and, with respect to many products, is considered among the market leaders. In normal economic cycles, sales of these segments are historically lower in the first quarter and higher in the third and fourth quarters of a year. In 2017, 21% of these segments' sales were made to six large distributors of electrical products and electrical systems and services.
Hydraulics
Principal methods of competition in this segment are product performance, geographic coverage, service, and price. Eaton has a strong competitive position in this segment and, with respect to many products, is considered among the market leaders. Sales of this segment are historically higher in the first and second quarters and lower in the third and fourth quarters of the year. In 2017, 9% of this segment's sales were made to three large original equipment manufacturers or distributors of agricultural, construction, and industrial equipment and parts.
Aerospace
Principal methods of competition in this segment are total cost of ownership, product and system performance, quality, design engineering capabilities, and timely delivery. Eaton has a strong competitive position in this segment and, with respect to many products and platforms, is considered among the market leaders. In 2017, 29% of this segment's sales were made to three large original equipment manufacturers of aircraft.
Vehicle
Principal methods of competition in this segment are product performance, technology, global service, and price. Eaton has a strong competitive position in this segment and, with respect to many products, is considered among the market leaders. In 2017, 69% of this segment's sales were made to nine large original equipment manufacturers of vehicles and related components.
Information Concerning Eaton's Business in General
Raw Materials
Eaton's major requirements for raw materials include iron, steel, copper, nickel, aluminum, brass, tin, silver, lead, titanium, rubber, plastic, electronic components, chemicals and fluids. Materials are purchased in various forms, such as extrusions, castings, powder metal, metal sheets and strips, forging billets, bar stock, and plastic pellets. Raw materials, as well as parts and other components, are purchased from many suppliers. Under normal circumstances, the Company has no difficulty obtaining its raw materials. In 2017, Eaton maintained appropriate levels of inventory to prevent shortages and did not experience any availability constraints.
Patents and Trademarks
Eaton considers its intellectual property, including without limitation patents, trade names, domain names, trademarks, confidential information, and trade secrets to be of significant value to its business as a whole. The Company's products are manufactured, marketed and sold under a portfolio of patents, trademarks, licenses, and other forms of intellectual property, some of which expire or are allowed to lapse at various dates in the future. Eaton develops and acquires new intellectual property on an ongoing basis and considers all of its intellectual property to be valuable. Based on the broad scope of the Company's product lines, management believes that the loss or expiration of any single intellectual property right would not have a material effect on Eaton's consolidated financial statements or its business segments. The Company's policy is to file applications and obtain patents for the majority of its novel and innovative new products including product modifications and improvements.
Order Backlog
A significant portion of open orders placed with Eaton are by original equipment manufacturers or distributors. These open orders are not considered firm as they have been historically subject to releases by customers. In measuring backlog orders, only the amount of orders to which customers are firmly committed are included. Using this criterion, total backlog at December 31, 2017 and 2016 was approximately $4.8 billion and $4.0 billion, respectively. Backlog should not be relied upon as being indicative of results of operations for future periods.
Research and Development
Research and development expenses for new products and improvement of existing products in 2017, 2016 and 2015 were $584 million, $589 million, and $625 million, respectively. Over the past five years, the Company has invested approximately $3.1 billion in research and development.
Environmental Contingencies
Operations of the Company involve the use and disposal of certain substances regulated under environmental protection laws. Eaton continues to modify processes on an ongoing, regular basis in order to reduce the impact on the environment, including the reduction or elimination of certain chemicals used in, and wastes generated from, operations. Compliance with laws that have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, are not expected to have a material adverse effect upon earnings or the competitive position of the Company. Eaton's estimated capital expenditures for environmental control facilities are not expected to be material for 2018 and 2019. Information regarding the Company's liabilities related to environmental matters is presented in Note 8 of the Notes to the Consolidated Financial Statements.
Item 1A.
Item 1A. Risk Factors.
Among the risks that could materially adversely affect Eaton's businesses, financial condition or results of operations are the following:
Volatility of end markets that Eaton serves.
Eaton's segment revenues, operating results, and profitability have varied in the past and may vary from quarter to quarter in the future. Profitability can be negatively impacted by volatility in the end markets that Eaton serves. The Company has undertaken measures to reduce the impact of this volatility through diversification of the markets it serves and expansion of the geographic regions in which it operates. Future downturns in any of the markets could adversely affect revenues, operating results, and profitability.
Eaton's operating results depend in part on continued successful research, development, and marketing of new and/or improved products and services, and there can be no assurance that Eaton will continue to successfully introduce new products and services.
The success of new and improved products and services depends on their initial and continued acceptance by Eaton's customers. The Company's businesses are affected, to varying degrees, by technological change and corresponding shifts in customer demand, which could result in unpredictable product transitions or shortened life cycles. Eaton may experience difficulties or delays in the research, development, production, or marketing of new products and services which may prevent Eaton from recouping or realizing a return on the investments required to bring new products and services to market.
Eaton's ability to attract, develop and retain executives and other qualified employees is crucial to the Company's results of operations and future growth.
Eaton depends on the continued services and performance of key executives, senior management, and skilled personnel, particularly professionals with experience in its industry and business. Eaton cannot be certain that any of these individuals will continue his or her employment with the Company. A lengthy period of time is required to hire and develop replacement personnel when skilled personnel depart. An inability to hire, develop, and retain a sufficient number of qualified employees could materially hinder the business by, for example, delaying Eaton's ability to bring new products to market or impairing the success of the Company's operations.
Eaton's operations depend on production facilities throughout the world, which subjects them to varying degrees of risk of disrupted production.
Eaton manages businesses with manufacturing facilities worldwide. The Company's manufacturing facilities and operations could be disrupted by a natural disaster, labor strike, war, political unrest, terrorist activity, economic upheaval, or public health concerns. Some of these conditions are more likely in certain geographic regions in which Eaton operates. Any such disruption could cause delays in shipments of products and the loss of sales and customers, and insurance proceeds may not adequately compensate for losses.
If Eaton is unable to protect its information technology infrastructure against service interruptions, data corruption, cyber-based attacks or network security breaches, operations could be disrupted or data confidentiality lost.
Eaton relies on information technology networks and systems, including the Internet, to process, transmit and store electronic information, and to manage or support a variety of business processes and activities, including procurement, manufacturing, distribution, invoicing and collection. These technology networks and systems may be susceptible to damage, disruptions or shutdowns due to failures during the process of upgrading or replacing software, databases or components; power outages; hardware failures; or computer viruses. In addition, security breaches could result in unauthorized disclosure of confidential information. If these information technology systems suffer severe damage, disruption, breach, or shutdown, and business continuity plans do not effectively resolve the issues in a timely manner, there could be a negative impact on operating results or the Company may suffer financial or reputational damage. Further, Cyber-based risks could also include attacks targeting the security, integrity and/or reliability of the hardware, software and information installed, stored or transmitted in our products, including after the purchase of those products and when they are incorporated into third party products, facilities or infrastructure. Such attacks could result in disruptions to third party systems, unauthorized release of confidential or otherwise protected information and corruption of data (our own or that of third parties). Further, to a significant extent, the security of our customers’ systems depends on how those systems are protected, configured, updated and monitored, all of which are typically outside our control.
Eaton's global operations subject it to economic risk as Eaton's results of operations may be adversely affected by changes in government legislation, regulations and policies and currency fluctuations.
Operating globally subjects Eaton to changes in government regulations and policies in a large number of jurisdictions around the world, including those related to tariffs and trade barriers, investments, property ownership rights, taxation, and exchange controls. Changes in the relative values of currencies occur from time to time and could affect Eaton's operating results. While the Company monitors exchange rate exposures and attempts to reduce these exposures through hedging activities, these risks could adversely affect operating results.
Further, existing free trade laws and regulations, such as the North American Free Trade Agreement, provide certain beneficial duties and tariffs for qualifying imports and exports, subject to compliance with the applicable classification and other requirements. Changes in laws or policies governing the terms of foreign trade, and in particular increased trade restrictions, tariffs or taxes on imports from countries where we manufacture products could have an impact on our business and financial results.
Eaton may be subject to risks relating to changes in its tax rates or exposure to additional income tax liabilities.
Eaton is subject to income taxes in many jurisdictions around the world. Income tax liabilities are subject to the allocation of income among various tax jurisdictions. The Company's effective tax rate could be affected by changes in the mix among earnings in countries with differing statutory tax rates, changes in the valuation allowance of deferred tax assets, or changes in tax laws. The amount of income taxes paid is subject to ongoing audits by tax authorities in the countries in which Eaton operates. If these audits result in assessments different from amounts reserved, future financial results may include unfavorable adjustments to the Company's tax liabilities.
Eaton uses a variety of raw materials and components in its businesses, and significant shortages, price increases, or supplier insolvencies could increase operating costs and adversely impact the competitive positions of Eaton's products.
Eaton's major requirements for raw materials are described above in Item 1 “Raw Materials”. Significant shortages could affect the prices Eaton's businesses are charged and the competitive position of their products and services, all of which could adversely affect operating results.
Further, Eaton's suppliers of component parts may increase their prices in response to increases in costs of raw materials that they use to manufacture component parts. The Company may not be able to increase its prices commensurately with its increased costs, adversely affecting operating results.
Eaton may be unable to adequately protect its intellectual property rights, which could affect the Company's ability to compete.
Protecting Eaton's intellectual property rights is critical to its ability to compete and succeed. The Company owns a large number of patents and patent applications worldwide, as well as trademark and copyright registrations that are necessary, and contribute significantly, to the preservation of Eaton's competitive position in various markets. Although management believes that the loss or expiration of any single intellectual property right would not have a material effect on the results of operations or financial position of Eaton or its business segments, there can be no assurance that any one, or more, of these patents and other intellectual property will not be challenged, invalidated, or circumvented by third parties. Eaton enters into confidentiality and invention assignment agreements with the Company's employees, and into non-disclosure agreements with suppliers and appropriate customers, so as to limit access to and disclosure of proprietary information. These measures may not suffice to deter misappropriation or independent third party development of similar technologies.
Eaton is subject to litigation and environmental regulations that could adversely impact Eaton's businesses.
At any given time, Eaton may be subject to litigation, the disposition of which may have a material adverse effect on the Company's businesses, financial condition or results of operations. Information regarding current legal proceedings is presented in Note 8 and Note 9 of the Notes to the Consolidated Financial Statements.
Item 1B.
Item 1B. Unresolved Staff Comments.
None.
Item 2.
Item 2. Properties.
Eaton's principal executive offices are located at Eaton House, 30 Pembroke Road, Dublin 4, Ireland D04 Y0C2. The Company maintains manufacturing facilities at approximately 327 locations in 42 countries. The Company is a lessee under a number of operating leases for certain real properties and equipment, none of which is material to its operations. Management believes that the existing manufacturing facilities are adequate for its operations and that the facilities are maintained in good condition.
Item 3.
Item 3. Legal Proceedings.
Information regarding the Company's current legal proceedings is presented in Note 8 and Note 9 of the Notes to the Consolidated Financial Statements.
Item 4.
Item 4. Mine Safety Disclosures.
Not applicable.
Executive Officers of the Registrant
Information regarding executive officers of the Company is presented in Item 10 of this Form 10-K Report.
Part II
Item 5.
Item 5. Market for the Registrant's Ordinary Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
The Company's ordinary shares are listed for trading on the New York Stock Exchange. At December 31, 2017, there were 13,089 holders of record of the Company's ordinary shares. Additionally, 20,138 current and former employees were shareholders through participation in the Eaton Savings Plan (ESP), Eaton Personal Investment Plan (EPIP), and the Eaton Puerto Rico Retirement Savings Plan.
Information regarding cash dividends paid, and the high and low market price per ordinary share, for each quarter in 2017 and 2016 is presented in “Quarterly Data” of this Form 10-K. Information regarding equity-based compensation plans required by Regulation S-K Item 201(d) is provided in Item 12 of this Form 10-K Report.
Irish Taxes Applicable to Dividends
Irish income tax may arise with respect to dividends paid on Eaton shares. Generally, shareholders who are not tax residents of Ireland and otherwise have no connection with Ireland other than his or her shareholding in Eaton, will not be subject to Irish income tax. However, in certain circumstances, Eaton will be required to deduct Irish dividend withholding tax (“IDWT”, currently at the rate of 20%) from dividends paid to its shareholders who are not Irish residents. In the majority of cases though, shareholders resident in the U.S. and certain other countries are exempt from IDWT. To establish exempt status, shareholders who qualify can complete certain Irish dividend withholding tax exemption forms or hold their shares in an account through the Depository Trust Company and have on file with their broker or qualifying agent a valid U.S. address on the record date of the dividend.
Eaton shareholders who receive their dividends subject to Irish dividend withholding tax will generally have no further liability for Irish income tax on the dividends unless they are otherwise subject to Irish income tax.
Issuer's Purchases of Equity Securities
During the fourth quarter of 2017, 0.8 million ordinary shares were repurchased in the open market at a total cost of $61 million. These shares were repurchased under the program approved by the Board on February 24, 2016. A summary of the shares repurchased in the fourth quarter of 2017 follows:
Item 6.
Item 6. Selected Financial Data.
Information regarding selected financial data is presented in the “Five-Year Consolidated Financial Summary” of this Form 10-K.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
Information required by this Item is presented in “Management's Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
Information regarding market risk is presented in “Market Risk Disclosure” of this Form 10-K.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The reports of the independent registered public accounting firm, consolidated financial statements, and notes to consolidated financial statements are presented in Item 15 of this Form 10-K.
Information regarding selected quarterly financial information for 2017 and 2016 is presented in “Quarterly Data” of this Form 10-K.
Item 9.
Item 9. Change in and Disagreements with Accountants on Accounting and Financial Disclosure.
None.
Item 9A.
Item 9A. Controls and Procedures.
Evaluation of Disclosure Controls and Procedures - Pursuant to SEC Rule 13a-15, an evaluation was performed under the supervision and with the participation of Eaton's management, including Craig Arnold - Principal Executive Officer; and Richard H. Fearon - Principal Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on that evaluation, Eaton's management concluded that the Company's disclosure controls and procedures were effective as of December 31, 2017.
Disclosure controls and procedures are designed to ensure that information required to be disclosed in Company reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in Company reports filed under the Exchange Act is accumulated and communicated to management, including the Company's Principal Executive Officer and Principal Financial Officer, to allow timely decisions regarding required disclosure.
Pursuant to Section 404 of the Sarbanes Oxley Act of 2002 and the rules and regulations adopted pursuant thereto, Eaton has included a report of management's assessment of the effectiveness of internal control over financial reporting, which is included in Item 15 of this Form 10-K.
“Report of Independent Registered Public Accounting Firm” relating to internal control over financial reporting as of December 31, 2017 is included in Item 15 of this Form 10-K.
During the fourth quarter of 2017, there was no change in Eaton's internal control over financial reporting that materially affected, or is reasonably likely to materially affect, internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
Disclosure Pursuant to Section 13(r) of the Exchange Act
Set forth below is a description of all matters reported by us pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012 and Section 13(r) of the Exchange Act. Concurrently with the filing of this Annual Report, we are filing a notice pursuant to Section 13(r) of the Exchange Act that such matters have been disclosed in this Annual Report.
During the fourth quarter, certain of our wholly-owned non-U.S. subsidiaries sold various electrical products to customers in Iran. We received total revenue of approximately 1,220,762 Euros and realized net profits of approximately 399,894 Euros from the sales (approximately $1,443,658 and $472,910 in whole U.S. dollars, respectively). One or more of our non-U.S. subsidiaries intend to continue doing business in Iran under General License H in compliance with U.S. economic sanctions and export control laws, though the Company has no assets or employees in Iran.
Part III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance.
Information required with respect to the directors of the Company is set forth under the caption “Election of Directors” in the Company's definitive Proxy Statement to be filed on or about March 16, 2018, and is incorporated by reference.
A listing of executive officers, their ages, positions and offices held over the past five years, as of February 1, 2018, follows:
There are no family relationships among the officers listed, and there are no arrangements or understandings pursuant to which any of them were elected as officers. All officers hold office for one year and until their successors are elected and qualified, unless otherwise specified by the Board of Directors; provided, however, that any officer is subject to removal with or without cause, at any time, by a vote of a majority of the Board of Directors.
Information required with respect to compliance with Section 16(a) of the Exchange Act is set forth under the caption “Section 16(a) Beneficial Ownership Reporting” in the Company's definitive Proxy Statement to be filed on or about March 16, 2018, and is incorporated by reference.
The Company has adopted a Code of Ethics, which applies to the directors, officers and employees worldwide. This document is available on the Company's website at http://www.eaton.com.
There were no changes during the fourth quarter 2017 to the procedures by which security holders may recommend nominees to the Company's Board of Directors.
Information related to the Audit Committee, and members of the Committee who are financial experts, is set forth under the caption “Board Committees - Audit Committee” in the definitive Proxy Statement to be filed on or about March 16, 2018, and is incorporated by reference.
Item 11.
Item 11. Executive Compensation.
Information required with respect to executive compensation is set forth under the caption “Compensation Discussion and Analysis” in the Company's definitive Proxy Statement to be filed on or about March 16, 2018, and is incorporated by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Information required with respect to securities authorized for issuance under equity-based compensation plans is set forth under the caption “Equity Compensation Plans” in the Company's definitive Proxy Statement to be filed on or about March 16, 2018, and is incorporated by reference.
Information required with respect to security ownership of certain beneficial owners, is set forth under the caption “Share Ownership Tables” in the Company's definitive Proxy Statement to be filed on or about March 16, 2018, and is incorporated by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence.
Information required with respect to certain relationships and related transactions is set forth under the caption “Review of Related Person Transactions” in the Company's definitive Proxy Statement to be filed on or about March 16, 2018, and is incorporated by reference.
Information required with respect to director independence is set forth under the caption “Director Independence” in the Company's definitive Proxy Statement to be filed on or about March 16, 2018, and is incorporated by reference.
Item 14.
Item 14. Principal Accounting Fees and Services.
Information required with respect to principal accountant fees and services is set forth under the caption “Audit Committee Report” in the Company's definitive Proxy Statement to be filed on or about March 16, 2018, and is incorporated by reference.
Part IV
Item 15.
Item 15. Exhibits, Financial Statement Schedules.
(a)
(1) The reports of the independent registered public accounting firm, consolidated financial statements and notes to consolidated financial statements are included in Item 8 above:
Reports of Independent Registered Public Accounting Firm
Consolidated Statements of Income - Years ended December 31, 2017, 2016 and 2015
Consolidated Statements of Comprehensive Income - Years ended December 31, 2017, 2016 and 2015
Consolidated Balance Sheets - December 31, 2017 and 2016
Consolidated Statements of Cash Flows - Years ended December 31, 2017, 2016 and 2015
Consolidated Statements of Shareholders' Equity - Years ended December 31, 2017, 2016 and 2015
Notes to Consolidated Financial Statements
(2) All other schedules for which provision is made in Regulation S-X of the SEC are not required under the related instructions or are inapplicable and, therefore, have been omitted.
(3) Exhibits incorporated by reference to or filed in conjunction with this form 10-K are listed below.
_______________________________
*
Submitted electronically herewith.
Attached as Exhibit 101 to this report are the following formatted in XBRL (Extensible Business Reporting Language): (i) Consolidated Statements of Income for the years ended December 31, 2017, 2016 and 2015, (ii) Consolidated Statements of Comprehensive Income for the years ended December 31, 2017, 2016 and 2015 (iii) Consolidated Balance Sheets at December 31, 2017 and 2016, (iv) Consolidated Statements of Cash Flows for the years ended December 31, 2017, 2016 and 2015, (v) Consolidated Statements of Shareholders' Equity for the years ended December 31, 2017, 2016 and 2015 and (vi) Notes to Consolidated Financial Statements for the year ended December 31, 2017.
Item 16. Form 10-K Summary.
Not applicable.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
EATON CORPORATION plc
Registrant
Date:
February 28, 2018
By:
/s/ Richard H. Fearon
Richard H. Fearon
(On behalf of the registrant and as Principal Financial Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
Date: February 28, 2018
Signature
Title
*
/s/ Richard H. Fearon
Craig Arnold
Chairman, Principal Executive Officer; Director
Richard H. Fearon
Principal Financial Officer, Director
/s/ Ken D. Semelsberger
*
Ken D. Semelsberger
Principal Accounting Officer
Todd M. Bluedorn
Director
*
*
Christopher M. Connor
Director
Michael J. Critelli
Director
*
*
Charles E. Golden
Director
Arthur E. Johnson
Director
*
/s/ Gregory R. Page
Deborah L. McCoy
Director
Gregory R. Page
Director
*
*
Sandra Pianalto
Director
Gerald B. Smith
Director
*
Dorothy C. Thompson
Director
*By
/s/ Richard H. Fearon
Richard H. Fearon, Attorney-in-Fact for the officers
and directors signing in the capacities indicated
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors of Eaton Corporation plc
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Eaton Corporation plc (“the Company”) as of December 31, 2017 and 2016, and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 28, 2018 expressed an unqualified opinion thereon.
Change in Accounting Principle
As discussed in Notes 1 and 14 to the consolidated financial statements, in 2017 the Company elected to change its method of accounting for certain inventories in the United States to the first-in, first-out (“FIFO”) method, while in prior years, these inventories were accounted for using the last-in, first-out (“LIFO”) method.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ Ernst & Young LLP
We have served as the Company’s auditor since 1923.
Cleveland, Ohio
February 28, 2018
MANAGEMENT'S REPORT ON FINANCIAL STATEMENTS
We have prepared the accompanying consolidated financial statements and related information of Eaton Corporation plc ("Eaton") included herein for the three years ended December 31, 2017. The primary responsibility for the integrity of the financial information included in this annual report rests with management. The financial information included in this annual report has been prepared in accordance with accounting principles generally accepted in the United States based on our best estimates and judgments and giving due consideration to materiality. The opinion of Ernst & Young LLP, Eaton's independent registered public accounting firm, on those financial statements is included herein.
Eaton has high standards of ethical business practices supported by the Eaton Code of Ethics and corporate policies. Careful attention is given to selecting, training and developing personnel, to ensure that management's objectives of establishing and maintaining adequate internal controls and unbiased, uniform reporting standards are attained. Our policies and procedures provide reasonable assurance that operations are conducted in conformity with applicable laws and with the Company's commitment to a high standard of business conduct.
The Board of Directors pursues its responsibility for the quality of Eaton's financial reporting primarily through its Audit Committee, which is composed of five independent directors. The Audit Committee meets regularly with management, the internal auditors and the independent registered public accounting firm to ensure that they are meeting their responsibilities and to discuss matters concerning accounting, control, audits and financial reporting. The internal auditors and independent registered public accounting firm have full and free access to senior management and the Audit Committee.
/s/ Craig Arnold
/s/ Richard H. Fearon
/s/ Ken D. Semelsberger
Principal Executive Officer
Principal Financial Officer
Principal Accounting Officer
February 28, 2018
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and Board of Directors of Eaton Corporation plc
Opinion on Internal Control over Financial Reporting
We have audited Eaton Corporation plc’s (“the Company”) internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2017 and 2016, and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2017 and the related notes and our report dated February 28, 2018 expressed an unqualified opinion thereon.
Basis for Opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.
Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
Definition and Limitations of Internal Control Over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/ Ernst & Young LLP
Cleveland, Ohio
February 28, 2018
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of Eaton Corporation plc ("Eaton") is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act rules 13a-15(f)).
Under the supervision and with the participation of Eaton's management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the Company's internal control over financial reporting as of December 31, 2017. In conducting this evaluation, we used the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework (2013 Framework). Based on this evaluation under the framework referred to above, management concluded that the Company's internal control over financial reporting was effective as of December 31, 2017.
The independent registered public accounting firm Ernst & Young LLP has issued an audit report on the effectiveness of the Company's internal control over financial reporting as of December 31, 2017. This report is included herein.
/s/ Craig Arnold
/s/ Richard H. Fearon
/s/ Ken D. Semelsberger
Principal Executive Officer
Principal Financial Officer
Principal Accounting Officer
February 28, 2018
EATON CORPORATION plc
CONSOLIDATED STATEMENTS OF INCOME
*Year ended December 31, 2016 and 2015 amounts have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
EATON CORPORATION plc
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
*Year ended December 31, 2016 and 2015 amounts have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
EATON CORPORATION plc
CONSOLIDATED BALANCE SHEETS
*December 31, 2016 amounts have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
EATON CORPORATION plc
CONSOLIDATED STATEMENTS OF CASH FLOWS
*Year ended December 31, 2016 and 2015 amounts have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
EATON CORPORATION plc
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
*The balances at January 1, 2015 and the year ended December 31, 2015 and 2016 amounts have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
EATON CORPORATION plc
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Amounts are in millions unless indicated otherwise (per share data assume dilution).
Note 1.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
General Information and Basis of Presentation
Eaton Corporation plc (Eaton or the Company) is a power management company with 2017 net sales of $20.4 billion. The Company provides energy-efficient solutions that help its customers effectively manage electrical, hydraulic and mechanical power more efficiently, safely and sustainably. Eaton has approximately 96,000 employees in 59 countries and sells products to customers in more than 175 countries.
The consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles in the United States. Preparation of the consolidated financial statements requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and notes. Actual results could differ from these estimates. Management has evaluated subsequent events through the date the consolidated financial statements were filed with the Securities Exchange Commission.
The consolidated financial statements include the accounts of Eaton and all subsidiaries and other entities it controls. Intercompany transactions and balances have been eliminated. The equity method of accounting is used for investments in associate companies where the Company has significant influence and generally a 20% to 50% ownership interest. Equity investments are evaluated for impairment whenever events or circumstances indicate the book value of the investment exceeds fair value. An impairment would exist if there is an other-than-temporary decline in value. Eaton does not have off-balance sheet arrangements or financings with unconsolidated entities. In the ordinary course of business, the Company leases certain real properties and equipment, as described in Note 8.
Eaton's functional currency is United States Dollars (USD). The functional currency for most subsidiaries is their local currency. Financial statements for these subsidiaries are translated at year-end exchange rates as to assets and liabilities and weighted-average exchange rates as to revenues and expenses. The resulting translation adjustments are recognized in Accumulated other comprehensive loss.
During 2017, the Company adopted Accounting Standards Update 2016-09, Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, (ASU 2016-09). Upon adoption, the Company recorded deferred tax assets of $48 for all excess tax benefits that had not been previously recognized. This was accomplished through a cumulative-effect adjustment to retained earnings. ASU 2016-09 also requires that all excess tax benefits and deficiencies generated in the current and future periods be recorded as income tax benefit or expense in the reporting period in which they occur. These excess tax benefits and deficiencies, which were previously required to be presented as financing activities on the Company’s Consolidated Statements of Cash Flows, are now classified as operating activities prospectively. The Company also reclassified $22, $18, and $38 for 2017, 2016, and 2015, respectively, from operating activities to financing activities on the Company’s Consolidated Statements of Cash Flows for withholding payments made to taxing authorities from shares withheld from employees. The Company will continue to estimate forfeitures as part of recording equity-based compensation expense.
During the fourth quarter of 2017, the Company changed its method of accounting for certain inventory in the United States from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method. All prior periods presented have been retrospectively adjusted to apply the new method of accounting. See Note 14 for more information on the change in inventory accounting method.
Certain prior year amounts have been reclassified to conform to the current year presentation.
Revenue Recognition
Sales of products are recognized when a sales agreement is in place, products have been shipped to unaffiliated customers and title has transferred in accordance with shipping terms, the selling price is fixed and determinable and collectability is reasonably assured, all significant related acts of performance have been completed, and no other significant uncertainties exist. Shipping and handling costs billed to customers are included in Net sales and the related costs in Cost of products sold. Although the majority of the sales agreements contain standard terms and conditions, there are agreements that contain multiple elements or non-standard terms and conditions. As a result, judgment is required to determine the appropriate accounting, including whether the deliverables specified in these agreements should be treated as separate units of accounting for recognition purposes, and, if so, how the sales price should be allocated among the elements and when to recognize sales for each element. For delivered elements, sales generally are recognized only when the delivered elements have standalone value and there are no uncertainties regarding customer acceptance. Sales for service contracts generally are recognized as the services are provided.
Eaton records reductions to revenue for customer and distributor incentives, primarily comprised of rebates, at the time of the initial sale. Rebates are estimated based on sales terms, historical experience, trend analysis, and projected market conditions in the various markets served. The rebate programs offered vary across businesses due to the numerous markets Eaton serves, but the most common incentives relate to amounts paid or credited to customers for achieving defined volume levels.
Goodwill and Indefinite Life Intangible Assets
Goodwill is evaluated annually for impairment as of July 1 using either a quantitative or qualitative analysis. Goodwill is tested for impairment at the reporting unit level, which is equivalent to Eaton's operating segments and based on the net assets for each segment, including goodwill and intangible assets. Goodwill is assigned to each operating segment, as this represents the lowest level that constitutes a business and is the level at which management regularly reviews the operating results. The Company performs a quantitative analysis using a discounted cash flow model and other valuation techniques, but may elect to perform a qualitative analysis. Additionally, goodwill is evaluated for impairment whenever an event occurs or circumstances change that would indicate that it is more likely than not that the fair value of an operating segment is less than its carrying amount.
Goodwill impairment testing in 2017 was performed using qualitative analysis, which is performed by assessing certain trends and factors, including projected market outlook and growth rates, forecasted and actual sales and operating profit margins, discount rates, industry data, and other relevant qualitative factors. These trends and factors are compared to, and based on, the assumptions used in the most recent quantitative assessment performed in 2016. The results of the qualitative analysis did not indicate a need to perform a quantitative analysis.
Goodwill impairment testing for 2016 was performed using a quantitative analysis under which the fair value for each reporting unit was estimated using a discounted cash flow model, which considered forecasted cash flows discounted at an estimated weighted-average cost of capital. The forecasted cash flows were based on the Company's long-term operating plan and a terminal value was used to estimate the operating segment's cash flows beyond the period covered by the operating plan. The weighted-average cost of capital is an estimate of the overall after-tax rate of return required by equity and debt market holders of a business enterprise. These analyses require the exercise of significant judgments, including judgments about appropriate discount rates, perpetual growth rates and the timing of expected future cash flows of the respective reporting unit. Sensitivity analyses were performed around these assumptions in order to assess the reasonableness of the assumptions and the resulting estimated fair values.
Based on a qualitative analysis performed in 2017 and a quantitative analysis performed in 2016, the fair value of Eaton's reporting units continue to substantially exceed their respective carrying amounts.
Indefinite life intangible assets consist of certain trademarks. They are evaluated annually for impairment as of July 1 using either a quantitative or qualitative analysis to determine whether their fair values exceed their respective carrying amounts. Indefinite life intangible asset impairment testing for 2017 and 2016 was performed using a quantitative analysis. The Company determines the fair value of these assets using a royalty relief methodology similar to that employed when the associated assets were acquired, but using updated estimates of future sales, cash flows and profitability. Additionally, indefinite life intangible assets are evaluated for impairment whenever an event occurs or circumstances change that would indicate that it is more likely than not that the asset is impaired. For 2017 and 2016, the fair value of indefinite lived intangible assets exceeded the respective carrying value.
For additional information about goodwill and other intangible assets, see Note 5.
Other Long-Lived Assets
Depreciation and amortization for property, plant and equipment, and intangible assets subject to amortization, are generally computed by the straight-line method and included in Cost of products sold, Selling and administrative expense, and Research and development expense, as appropriate. Cost of buildings are depreciated generally over 40 years and machinery and equipment over 3 to 10 years. At December 31, 2017, the weighted-average amortization period for intangible assets subject to amortization was 17 years for patents and technology, primarily as a result of the long life of aircraft platforms; 17 years for customer relationships; and 17 years for certain trademarks. Software is generally amortized up to a life of 15 years.
Other long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. Upon indications of impairment, assets and liabilities are grouped at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. The asset group would be considered impaired when the estimated future net undiscounted cash flows generated by the asset group are less than its carrying value. Determining asset groups and underlying cash flows requires the use of significant judgment.
Retirement Benefits Plans
For the principal pension plans in the United States, Canada, Puerto Rico and the United Kingdom, the Company uses a market-related value of plan assets to calculate the expected return on assets used to determine net periodic benefit costs. The market-related value of plan assets is a calculated value that recognizes changes in the fair value of plan assets over a five year period. All other plans use fair value of plan assets.
Net actuarial gains or losses are amortized to expense on a plan-by-plan basis when they exceed the accounting corridor. The Company’s corridors are set at either 8% or 10%, depending on the plan, of the greater of the plan assets or benefit obligations. Gains or losses outside of the corridor are subject to amortization over an average employee future service period that differs by plan, but is approximately 12 years on a weighted average basis. If most or all of the plan’s participants are no longer actively accruing benefits, the average life expectancy is used.
Warranty Accruals
Product warranty accruals are established at the time the related sale is recognized through a charge to Cost of products sold. Warranty accrual estimates are based primarily on historical warranty claim experience and specific customer contracts. Provisions for warranty accruals are comprised of basic warranties for products sold, as well as accruals for product recalls and other events when they are known and estimable. See Note 8 for additional information about warranty accruals.
Asset Retirement Obligations
A conditional asset retirement obligation is recognized at fair value when incurred if the fair value of the liability can be reasonably estimated. Uncertainty about the timing or method of settlement of a conditional asset retirement obligation would be considered in the measurement of the liability when sufficient information exists. Eaton believes that for substantially all of its asset retirement obligations, there is an indeterminate settlement date because the range of time over which the Company may settle the obligation is unknown or cannot be estimated. A liability for these obligations will be recognized when sufficient information is available to estimate fair value.
Income Taxes
Deferred income tax assets and liabilities are determined based on the difference between the financial statement and tax basis of the respective assets and liabilities, using enacted tax rates in effect for the year when the differences are expected to reverse. Deferred income tax assets are recognized for income tax loss carryforwards and income tax credit carryforwards. Judgment is required in determining and evaluating income tax provisions and valuation allowances for deferred income tax assets. Eaton recognizes the income tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. Eaton evaluates and adjusts these accruals based on changing facts and circumstances. Eaton recognizes interest and penalties related to unrecognized income tax benefits in the provision for income tax expense. Penalties on unrecognized income tax benefits have been accrued for jurisdictions where penalties are automatically applied to any deficiency, regardless of the merit of the position. For additional information about income taxes, see Note 9.
Equity-Based Compensation
Eaton recognizes equity-based compensation expense based on the grant date fair value of the award. Awards with service conditions or both service and market conditions are expensed over the period during which an employee is required to provide service in exchange for the award. Awards with both service and performance conditions are expensed over the period an employee is required to provide service based on the number of units for which achievement of the performance objective is probable. Participants awarded restricted stock units (RSUs) in 2015 and 2016, do not receive dividends; therefore, their fair value is determined by reducing the closing market price of the Company’s ordinary shares on the date of grant by the present value of the estimated dividends had they been paid. The fair value of RSUs awarded in 2017, restricted stock awards (RSAs) and performance stock units (PSUs) with performance conditions are determined based on the closing market price of the Company’s ordinary shares at the date of grant. The Company uses a Monte Carlo simulation to estimate the fair value of PSUs with market conditions, which incorporates assumptions regarding expected stock price volatility and the risk-free interest rate. Stock options are granted with an exercise price equal to the closing market price of Eaton ordinary shares on the date of grant. The fair value of stock options is determined using a Black-Scholes option-pricing model, which incorporates assumptions regarding the expected stock price volatility, the expected option life, the risk-free interest rate, and the expected dividend yield. See Note 11 for additional information about equity-based compensation.
Derivative Financial Instruments and Hedging Activities
Eaton uses derivative financial instruments to manage the exposure to the volatility in raw material costs, currency, and interest rates on certain debt. These instruments are marked to fair value in the accompanying Consolidated Balance Sheets. Changes in the fair value of derivative assets or liabilities (i.e., gains or losses) are recognized depending upon the type of hedging relationship and whether an instrument has been designated as a hedge. For those instruments that qualify for hedge accounting, Eaton designates the hedging instrument, based upon the exposure being hedged, as a cash flow hedge, a fair value hedge, or a hedge of a net investment in a foreign operation. Changes in fair value of these instruments that do not qualify for hedge accounting are recognized immediately in net income. See Note 13 for additional information about hedges and derivative financial instruments.
Recently Issued Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers (ASU 2014-09). This accounting standard supersedes all existing US GAAP revenue recognition guidance. Under ASU 2014-09, a company will recognize revenue when it transfers the control of promised goods or services to customers in an amount that reflects the consideration which the company expects to collect in exchange for those goods or services. ASU 2014-09 will require additional disclosures in the notes to the consolidated financial statements.
Eaton adopted the standard at the start of the first quarter of 2018 using the modified retrospective approach and recorded a cumulative effect adjustment to retained earnings based on the current terms and conditions for open contracts as of January 1, 2018. The adoption of the standard did not have a material impact on the Company’s Consolidated financial statements. While, certain revenue streams moved from point-in-time or multiple elements to over time because of the continuous transfer of control to customers, we do not expect these changes to be material. The Company implemented the appropriate changes to business processes and controls to support recognition and disclosure under the new standard, including the new qualitative and quantitative disclosures that will include information on the nature, amount, timing and significant judgments impacting revenue from contracts with customers.
In October 2016, the FASB issued Accounting Standards Update 2016-16, Intra-Entity Transfers of Assets Other Than Inventory (ASU 2016-16). This accounting standard requires companies to recognize the income tax effects of intercompany sales and transfers of assets other than inventory in the period in which the transfer occurs. The previous accounting standard required companies to defer the income tax effects of intercompany transfers of assets by recording a prepaid tax, until such assets were sold to an outside party or otherwise recognized. ASU 2016-16 is effective for annual and interim periods beginning after December 15, 2017. Upon adoption, ASU 2016-16 requires companies to write off any income tax amounts that had been deferred as prepaid taxes from past intercompany transactions, and record deferred tax balances for amounts that have not been recognized, through a cumulative-effect adjustment to retained earnings. The Company adopted ASU 2016-16 at the start of the first quarter of 2018 by recording a cumulative-effect adjustment of approximately $200 to reduce retained earnings.
In February 2016, the FASB issued Accounting Standards Update 2016-02, Leases (Topic 842), (ASU 2016-02). This accounting standard requires that a lessee recognize a lease asset and a lease liability on its balance sheet for all leases, including operating leases, with a term greater than 12 months. ASU 2016-02 will require additional disclosures in the notes to the consolidated financial statements and is effective for annual and interim reporting periods beginning after December 15, 2018. A project team has been formed to evaluate and implement the new standard. The project team is working to gather the data required to account for leases under the new standard, and validating the functionality of third-party lease accounting software. In addition, the Company is in the process of identifying and implementing the appropriate changes to business processes and controls to support recognition and disclosure under the new standard. Eaton plans to adopt the standard as of the first quarter of 2019. Eaton is evaluating the impact of ASU 2016-02 and an estimate of the impact to the consolidated financial statements cannot be made at this time.
Note 2.
SALE AND ACQUISITIONS OF BUSINESSES
Sale of heavy-duty and medium-duty commercial vehicle automated transmission business
On July 31, 2017, Eaton sold a 50% interest in its heavy-duty and medium-duty commercial vehicle automated transmission business for $600 in cash to Cummins, Inc. The new joint venture is named Eaton Cummins Automated Transmission Technologies (ECATT). The Company recognized a pre-tax gain of $1,077, of which $533 related to the pre-tax gain from the $600 proceeds from the sale and $544 related to the Company’s remaining 50% investment in the joint venture being remeasured to fair value. The after-tax gain was $843. The fair value is based on the price paid to Eaton for the 50% interest sold to Cummins, Inc. and further supported by a discounted cash flow model. Eaton accounts for its investment on the equity method of accounting.
Acquisition of Ephesus Lighting, Inc.
On October 28, 2015, Eaton acquired Ephesus Lighting, Inc. (Ephesus). Ephesus is a leader in LED lighting for stadiums and other high lumen outdoor and industrial applications. Its sales for the 12 months ended September 30, 2015 were $23. Ephesus is reported within the Electrical Products business segment.
Acquisition of UK Safety Technology Manufacturer Oxalis Group Ltd.
On January 12, 2015, Eaton acquired Oxalis Group Ltd. (Oxalis). Oxalis is a manufacturer of closed-circuit television camera stations, public address and general alarm systems and other electrical products for the hazardous area, marine and industrial communications markets. Its sales for the 12 months ended December 31, 2014 were $9. Oxalis is reported within the Electrical Systems and Services business segment.
Note 3.
ACQUISITION INTEGRATION CHARGES
Eaton incurs integration charges related to acquired businesses. A summary of these charges follows:
Business segment acquisition integration charges in 2017 related to the integration of Ephesus. The charges associated with Ephesus were included in Selling and administrative expense. Business segment acquisition integration charges in 2016 related to the integration of Ephesus and Oxalis. The charges associated with Ephesus were included in Cost of products sold and Selling and administrative expense, while the charges associated with Oxalis were included in Cost of products sold. Business segment acquisition charges in 2015 related primarily to the integration of Cooper Industries plc, which was acquired in 2012. The charges in 2015 were included in Cost of products sold or Selling and administrative expense, as appropriate. In Business Segment Information, the charges reduced Operating profit of the related business segment.
The integration of Cooper included costs related to restructuring activities Eaton undertook in an effort to gain efficiencies in selling, marketing, traditional back-office functions and manufacturing and distribution. These actions resulted in charges of $20 during 2015, comprised of severance costs and other expense totaling $1 and $19, respectively, of which $14 were incurred in the Electrical Products segment, and $6 were incurred in the Electrical Systems and Services segment.
Corporate integration charges related primarily to the acquisition of Cooper. These charges were included in Selling and administrative expense. In Business Segment Information, the charges were included in Other corporate expense - net.
See Note 15 for additional information about business segments.
Note 4.
RESTRUCTURING CHARGES
During 2015, Eaton announced its commitment to undertake actions to reduce its cost structure in all business segments and at corporate. Restructuring charges incurred under this plan were $116, $211, and $129 in 2017, 2016, and 2015, respectively. The multi-year initiative concluded at the end of 2017.
A summary of restructuring charges by type follows:
A summary of restructuring charges by segment follows:
A summary of liabilities related to workforce reductions, plant closings and other associated costs announced in 2015 follows:
These charges were included in Cost of products sold, Selling and administrative expenses or Other income-net, as appropriate. In Business Segment Information, the charges reduced Operating profit of the related business segment. See Note 15 for additional information about business segments.
Note 5.
GOODWILL AND OTHER INTANGIBLE ASSETS
Changes in the carrying amount of goodwill by segment follow:
A summary of other intangible assets follows:
Amortization expense related to intangible assets subject to amortization in 2017, and estimated amortization expense for each of the next five years, follows:
Note 6.
DEBT
A summary of long-term debt, including the current portion, follows:
Substantially all these long-term debt instruments are fully and unconditionally guaranteed on an unsubordinated, unsecured basis by Eaton and certain of its direct and indirect subsidiaries (the Senior Notes). Further, all of these long-term debt instruments except the 4.215% Japanese yen notes due 2018, the 3.875% debentures due 2020, the 3.47% notes due 2021, the 3.68% notes due 2023, and the 0.75% Euro notes due 2024 are registered by Eaton Corporation under the Securities Act of 1933, as amended (the Registered Senior Notes).
On November 17, 2017, Eaton refinanced a $500, four-year revolving credit facility with a $500, three-year revolving credit facility that will expire November 17, 2020 and also refinanced a $750, five-year revolving credit facility with a $750, five-year revolving credit facility that will expire November 17, 2022. Eaton also maintains a $750, five-year revolving credit facility that will expire October 14, 2021. These refinancings maintain long-term revolving credit facilities at a total of $2,000. The revolving credit facilities are used to support commercial paper borrowings and are fully and unconditionally guaranteed by Eaton and certain of its direct and indirect subsidiaries on an unsubordinated, unsecured basis. There were no borrowings outstanding under Eaton's revolving credit facilities at December 31, 2017 or 2016. The Company had available lines of credit of $741 from various banks primarily for the issuance of letters of credit, of which there was $297 outstanding at December 31, 2017. Borrowings outside the United States are generally denominated in local currencies.
The Company repaid the 5.30% notes on March 15, 2017 for $250, the 6.10% debentures on June 29, 2017 for $289 and the 1.50% senior notes on November 2, 2017 for $1,000. The Company repaid the 2.375% debentures on January 15, 2016, for $240.
Short-term debt was $6 all of which was outside the United States as of December 31, 2017.
On September 15, 2017, a subsidiary of Eaton issued senior notes (the 2017 Senior Notes) with a face amount of $1,000. The 2017 Senior Notes are comprised of two tranches of $700 and $300, which mature in 2027 and 2047, respectively, with interest payable semi-annually at a respective rate of 3.1% and 3.9%. The issuer received proceeds totaling $993 from the issuance, net of financing costs. The 2017 Senior Notes are fully and unconditionally guaranteed on an unsubordinated, unsecured basis by Eaton and certain of its direct and indirect subsidiaries. The 2017 Senior Notes contain customary optional redemption and par call provisions. The 2017 Senior Notes also contain a change of control provision which requires the Company to make an offer to purchase all or any part of the 2017 Senior Notes at a purchase price of 101% of the principal amount plus accrued and unpaid interest. The capitalized deferred financing fees are amortized in Interest expense-net over the respective terms of the 2017 Senior Notes. The 2017 Senior Notes are subject to customary non-financial covenants.
On September 20, 2016, a subsidiary of Eaton issued euro denominated notes (Euro Notes) with a face value of €550 ($615 based on the September 20, 2016 spot rate), in accordance with Regulation S promulgated under the Securities Act of 1933, as amended. The Euro Notes mature in 2024 with interest payable annually at a rate of 0.75%. The issuer received proceeds totaling €544 ($609 based on the September 20, 2016 spot rate) from the issuance, net of financing costs and discounts. The senior Euro Notes are fully and unconditionally guaranteed on an unsubordinated, unsecured basis by Eaton and certain of its direct and indirect subsidiaries. The Euro Notes contain an optional redemption provision by which the Company may make an offer to purchase all or any part of the Euro Notes prior to June 20, 2024 at a purchase price of the greater of (a) 100% of the principal amount of the respective Euro Notes being redeemed, or (b) the sum of the present values of the respective remaining scheduled payments of principal and interest, discounted to the redemption date on an annual basis at the benchmark Bund Rate plus 20 basis points. In each case, the redemption price will include any accrued and unpaid interest on the Euro Notes being redeemed. At any time on or after June 20, 2024, the Company may redeem the Euro Notes, in whole or in part, at a redemption price equal to 100% of the principal amount to be redeemed plus accrued and unpaid interest. The Euro Notes also contain a change of control provision which requires the Company to make an offer to purchase all or any part of the Euro Notes at a purchase price of 101% of the principal amount plus accrued and unpaid interest. The capitalized deferred financing fees and discounts are amortized in Interest expense - net over the respective terms of the Euro Notes. The Euro Notes are subject to customary non-financial covenants.
Eaton is in compliance with each of its debt covenants for all periods presented.
Maturities of long-term debt for each of the next five years follow:
Interest paid on debt follows:
Note 7.
RETIREMENT BENEFITS PLANS
Eaton has defined benefits pension plans and other postretirement benefits plans.
Obligations and Funded Status
Change in Benefit Obligations
Change in Plan Assets
The components of pension plans with an accumulated benefit obligation in excess of plan assets at December 31 follow:
Changes in pension and other postretirement benefit liabilities recognized in Accumulated other comprehensive loss follow:
Benefits Expense
The estimated pretax net amounts that will be recognized from Accumulated other comprehensive loss into net periodic benefit cost in 2018 follow:
Retirement Benefits Plans Assumptions
In 2015, 2016 and 2017, for purposes of determining liabilities related to pension plans and other postretirement benefits plans in the United States, the Company used 2014 mortality tables and generational improvement scales that are based on MP-2015, MP-2016 and MP-2017, respectively.
In 2016, the Company adopted a change in the method it uses to estimate the service and interest cost components of net periodic benefit cost for its defined benefit pension and other postretirement benefit plans. Prior to 2016, for the vast majority of its plans, the service and interest cost components were estimated using a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. Beginning in 2016, the Company used a spot rate approach by applying the specific spot rates along the yield curve to the relevant projected cash flows in the estimation of the service and interest components of benefit cost, resulting in a more precise measurement. This change does not affect the measurement of total benefit obligations. The change was accounted for as a change in estimate and, accordingly, was accounted for prospectively starting in 2016. The reductions in service cost and interest cost for 2016 associated with this change in estimate were $3 and $42, respectively.
Pension Plans
The expected long-term rate of return on pension assets was determined for each country and reflects long-term historical data taking into account each plan's target asset allocation. The expected long-term rates of return on pension assets for United States pension plans and Non-United States pension plans for 2018 are 7.52% and 6.40%, respectively. The discount rates were determined using appropriate bond data for each country.
Other Postretirement Benefits Plans
Substantially all of the obligation for other postretirement benefits plans relates to United States plans. Assumptions used to determine other postretirement benefits obligations and expense follow:
Assumed health care cost trend rates may have a significant effect on the amounts reported for the health care plans. A 1-percentage point change in the assumed health care cost trend rates would have the following effects:
Employer Contributions to Retirement Benefits Plans
Contributions to pension plans that Eaton expects to make in 2018, and made in 2017, 2016 and 2015, follow:
The following table provides the estimated pension and other postretirement benefit payments for each of the next five years, and the five years thereafter in the aggregate. For other postretirement benefits liabilities, the expected subsidy receipts related to the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 would reduce the gross payments listed below.
Pension Plan Assets
Investment policies and strategies are developed on a country specific basis. The United States plans, representing 67% of worldwide pension assets, and the United Kingdom plans representing 26% of worldwide pension assets, are invested primarily for growth, as the majority of the assets are in plans with active participants and ongoing accruals. In general, the plans have their primary allocation to diversified global equities, primarily through index funds in the form of common collective and other trusts. The United States plans' target allocation is 28% United States equities, 28% non-United States equities, 9% real estate (primarily equity of real estate investment trusts), 31% debt securities and 4% other, including hedge funds, private equity and cash equivalents. The United Kingdom plans' target asset allocations are 61% equities and the remainder in debt securities, cash equivalents and real estate investments. The equity risk for the plans is managed through broad geographic diversification and diversification across industries and levels of market capitalization. The majority of debt allocations for these plans are longer duration government and corporate debt. The United States, United Kingdom and Canada pension plans are authorized to use derivatives to achieve more economically desired market exposures and to use futures, swaps and options to gain or hedge exposures.
Other Postretirement Benefits Plan Assets
The Voluntary Employee Benefit Association trust which holds U.S. other postretirement benefits plan assets has investment guidelines that include allocations to global equities and fixed income investments. The trust's 2017 target investment allocation is 43% diversified global equities and 57% fixed income securities held in a trust that invests primarily in exchange traded funds.
Fair Value Measurements
Financial instruments included in pension and other postretirement benefits plan assets are categorized into a fair value hierarchy of three levels, based on the degree of subjectivity inherent in the valuation methodology as follows:
Level 1 -
Quoted prices (unadjusted) for identical assets in active markets.
Level 2 -
Quoted prices for similar assets in active markets, and inputs that are observable for the asset, either directly or indirectly, for substantially the full term of the financial instrument.
Level 3 -
Unobservable prices or inputs.
Certain investments that are measured at fair value using the net asset value per share practical expedient have not been categorized in the fair value hierarchy and are being presented in the tables to permit a reconciliation to total plan assets.
Pension Plans
A summary of the fair value of pension plan assets at December 31, 2017 and 2016, follows:
The fair value measurement of plan assets using significant unobservable inputs (Level 3) changed during 2016 and 2017 due to the following:
Other Postretirement Benefits Plans
A summary of the fair value of other postretirement benefits plan assets at December 31, 2017 and 2016, follows:
Valuation Methodologies
Following is a description of the valuation methodologies used for pension and other postretirement benefits plan assets measured at fair value. There have been no changes in the methodologies used at December 31, 2017 and 2016.
Common collective and other trusts - Valued at the net unit value of units held by the trust at year end. The unit value is determined by the total value of fund assets divided by the total number of units of the fund owned. The equity investments in collective trusts are predominantly in index funds for which the underlying securities are actively traded in public markets based upon readily measurable prices. The investments in other trusts are predominantly in exchange traded funds for which the underlying securities are actively traded in public markets based upon readily measurable prices. Common collective and other trusts measured at fair value using the net asset value per share practical expedient have not been categorized in the fair value hierarchy and are being presented in the tables above to permit a reconciliation of the fair value hierarchy to the total plan assets.
Fixed income securities - These securities consist of publicly traded United States and non-United States fixed interest obligations (principally corporate and government bonds and debentures). The fair value of corporate and government debt securities is determined through third-party pricing models that consider various assumptions, including time value, yield curves, credit ratings, and current market prices. The Company verifies the results of trustees or custodians and evaluates the pricing classification of these securities by performing analyses using other third-party sources.
United States treasuries - Valued at the closing price of each security.
Bank loans - These securities consist of senior secured term loans of publicly traded and privately held United States and non-United States floating rate obligations (principally corporations of non-investment grade rating). The fair value is determined through third-party pricing models that primarily utilize dealer quoted current market prices. The Company verifies the results of trustees or custodians and evaluates the pricing classification of these securities by performing analyses using other third-party sources.
Equity securities - These securities consist of direct investments in the stock of publicly traded companies. Such investments are valued based on the closing price reported in an active market on which the individual securities are traded. As such, the direct investments are classified as Level 1.
Real estate - Consists of direct investments in the stock of publicly traded companies and investments in pooled funds that invest directly in real estate. The publicly traded companies are valued based on the closing price reported in an active market on which the individual securities are traded and as such are classified as Level 1. The pooled funds rely on appraisal based valuations and as such are classified as Level 3.
Cash equivalents - Primarily certificates of deposit, commercial paper, and repurchase agreements.
Exchange traded funds - Valued at the closing price of the exchange traded fund's shares.
Hedge funds - Consists of direct investments in hedge funds through limited partnership interests. Net asset values are based on the estimated fair value of the ownership interest in the investment as determined by the General Partner. The majority of the holdings of the hedge funds are in equity securities traded on public exchanges. The investment terms of the hedge funds allow capital to be redeemed quarterly given prior notice with certain limitations. Hedge funds measured at fair value using the net asset value per share practical expedient have not been categorized in the fair value hierarchy and are being presented in the tables above to permit a reconciliation of the fair value hierarchy to the total plan assets.
Money market funds - Money market funds measured at fair value using the net asset value per share practical expedient have not been categorized in the fair value hierarchy and are being presented in the tables above to permit a reconciliation of the fair value hierarchy to the total plan assets.
Other - Primarily insurance contracts for international plans and also futures contracts and over-the-counter options. These investments are valued based on the closing prices of future contracts or indices as available on Bloomberg or similar service, and private equity investments.
For additional information regarding fair value measurements, see Note 12.
Defined Contribution Plans
The Company has various defined contribution benefit plans, primarily consisting of the plans in the United States. The total contributions related to these plans are charged to expense and were as follows:
Note 8.
COMMITMENTS AND CONTINGENCIES
Legal Contingencies
Eaton is subject to a broad range of claims, administrative and legal proceedings such as lawsuits that relate to contractual allegations, tax audits, patent infringement, personal injuries, antitrust matters and employment-related matters. Eaton is also subject to asbestos claims from historic products which may have contained asbestos. Insurance may cover some of the costs associated with these claims and proceedings. Although it is not possible to predict with certainty the outcome or cost of these matters, the Company believes they will not have a material adverse effect on the consolidated financial statements. During the fourth quarter of 2016, the Company was able to resolve several insurance matters. In total, the income from insurance matters was $68.
In December 2011, Pepsi-Cola Metropolitan Bottling Company, Inc. (“Pepsi”) filed an action against (a) Cooper Industries, LLC, Cooper Industries, Ltd., Cooper Holdings, Ltd., Cooper US, Inc., and Cooper Industries plc (collectively, “Cooper”), (b) M&F Worldwide Corp., Mafco Worldwide Corp., Mafco Consolidated Group LLC, and PCT International Holdings, Inc. (collectively, “Mafco”), and (c) the Pneumo Abex Asbestos Claims Settlement Trust (the “Trust”) in Texas state court. Pepsi alleged that it was harmed by a 2011 settlement agreement (“2011 Settlement”) among Cooper, Mafco, and Pneumo Abex, LLC (“Pneumo,” which prior to the 2011 Settlement was a Mafco subsidiary), which settlement resolved litigation that Pneumo had previously brought against Cooper involving, among other things, a guaranty related to Pneumo’s friction products business. In November 2015, after a Texas court ruled that Pepsi's claims should be heard in arbitration, Pepsi filed a demand for arbitration against Cooper, Mafco, the Trust, and Pneumo. Pepsi subsequently dropped claims against all parties except Cooper. An arbitration under the auspices of the American Arbitration Association commenced in October 2017. Pepsi’s experts have opined, among other things, that the value contributed to the Trust for a release of the guaranty was approximately $440 below reasonably equivalent value, and that an inability of Pneumo to satisfy future liabilities may result in plaintiffs suing Pepsi under various theories. Cooper submitted various expert reports and, among other things, Cooper’s experts opine that Pepsi has no basis to seek any damages and that Cooper paid reasonably equivalent value for the release of its indemnity obligations under the guaranty. The arbitration proceedings closed in December 2017. The parties are awaiting the issuance of a decision. The Company believes that the claims of Pepsi are without merit, and that the ultimate resolution of this matter will not have a material impact on the Company’s consolidated financial statements.
In December 2010, a Brazilian court held that a judgment obtained by a Brazilian company, Raysul, against another Brazilian company, Saturnia, which was sold by Eaton in 2006, could be enforced against Eaton Ltda. The judgment was based on an alleged violation of an agency agreement between Raysul and Saturnia. At March 31, 2016, the Company had a total accrual of 100 Brazilian Reais related to this matter ($31 based on June 2016 exchange rates). In June 2016, Eaton signed a settlement agreement and resolved the matter, which did not have a material impact on the consolidated financial statements.
Environmental Contingencies
Eaton has established policies to ensure that its operations are conducted in keeping with good corporate citizenship and with a positive commitment to the protection of the natural and workplace environments. The Company's manufacturing facilities are required to be certified to ISO 14001, an international standard for environmental management systems. The Company routinely reviews EHS performance at each of its facilities and continuously strives to improve pollution prevention.
Eaton is involved in remedial response and voluntary environmental remediation at a number of sites, including certain of its currently-owned or formerly-owned plants. The Company has also been named a potentially responsible party under the United States federal Superfund law, or the state equivalents thereof, at a number of disposal sites. The Company became involved in these sites as a result of government action or in connection with business acquisitions. At the end of 2017, the Company was involved with a total of 118 sites worldwide, including the Superfund sites mentioned above, with none of these sites being individually significant to the Company.
Remediation activities, generally involving soil and/or groundwater contamination, include pre-cleanup activities such as fact finding and investigation, risk assessment, feasibility study, design and action planning, performance (where actions may range from monitoring, to removal of contaminants, to installation of longer-term remediation systems), and operation and maintenance of a remediation system. The extent of expected remediation activities and costs varies by site. A number of factors affect the cost of environmental remediation, including the number of parties involved at a particular site, the determination of the extent of contamination, the length of time the remediation may require, the complexity of environmental regulations, and the continuing advancement of remediation technology. Taking these factors into account, Eaton has estimated the costs of remediation, which will be paid over a period of years. The Company accrues an amount on an undiscounted basis, consistent with the estimates of these costs, when it is probable that a liability has been incurred. Actual results may differ from these estimates. At December 31, 2017 and 2016, the Company had an accrual totaling $120 and $124, respectively, for these costs.
Based upon Eaton's analysis and subject to the difficulty in estimating these future costs, the Company expects that any sum it may be required to pay in connection with environmental matters is not reasonably possible to exceed the recorded liability by an amount that would have a material effect on its financial position, results of operations or cash flows.
Warranty Accruals
A summary of the current and long-term warranty accruals follows:
Lease Commitments
Eaton leases certain real properties and equipment. A summary of minimum rental commitments at December 31, 2017 under noncancelable operating leases, which expire at various dates and in most cases contain renewal options, for each of the next five years and thereafter in the aggregate, follow:
A summary of rental expense follows:
Note 9.
INCOME TAXES
Certain amounts below have been adjusted to reflect the retrospective application of the Company's change in inventory accounting methods, as described in Notes 1 and 14.
Eaton Corporation plc is domiciled in Ireland. Income (loss) before income taxes and income tax (benefit) expense are summarized below based on the geographic location of the operation to which such earnings and income taxes are attributable.
Reconciliations of income taxes from the Ireland national statutory rate of 25% to the consolidated effective income tax rate follow:
During 2017, income tax expense of $382 was recognized (an effective tax rate of 11.3%) compared to income tax expense of $199 for 2016 (an effective tax rate of 9.4%) and income tax expense of $159 for 2015 (an effective tax rate of 7.5%). The 2017 effective tax rate includes tax expense of $234 on the gain related to the sale of business discussed in Note 2 and a tax benefit of $62 related to the U.S. Tax Cuts and Jobs Act (TCJA) which is discussed in further detail below. Excluding the gain and related tax impact on the sale of business, and the impact of the TCJA, the effective tax rate for 2017 was expense of 9.2%. The decrease from 9.4% for 2016 compared to 9.2% for 2017 was due to the resolution of tax contingencies in various tax jurisdictions and the excess tax benefits recognized for employee share-based payments pursuant to the adoption of Accounting Standards Update 2016-09, Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. The increase from 7.5% for 2015 compared to 9.4% for 2016 is primarily due to greater levels of income earned in higher tax jurisdictions, partially offset by net decreases in worldwide tax liabilities.
The U.S. Tax Cuts and Jobs Act was enacted on December 22, 2017. The TCJA reduces the U.S. federal corporate tax rate from 35% to 21% and requires a one-time transition tax on certain unremitted earnings of non-U.S. subsidiaries owned directly or indirectly by U.S. subsidiaries of the Company. For 2017, we have recorded a provisional tax benefit amount of $62 for the impact on our deferred tax balances and the one-time transition tax.
The Company remeasured certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future, which is generally 21%. Additionally, given the significant changes included in the TCJA, the Company re-evaluated the realizability of certain deferred tax assets, including foreign tax credits and interest deferral, and determined that valuation allowances needed to be adjusted. The Company is still analyzing certain aspects of the TCJA, including interpretations by state and local tax authorities, and additional Treasury guidance may be issued which could potentially affect the measurement of these balances or give rise to new deferred tax amounts. The Company recorded a provisional $79 tax benefit for the remeasurement of deferred tax balances and related valuation allowances.
The one-time transition tax is based on post-1986 unremitted earnings and profits (E&P) of non-U.S. subsidiaries owned directly or indirectly by U.S. subsidiaries of the Company which have been previously deferred from U.S. income taxes. The amount of the transition tax also depends on the amount of E&P held in cash or other specified assets. The Company recorded a provisional tax expense of $17 for the transition tax. This amount may change when Treasury issues additional guidance and the Company finalizes the calculation of E&P, including the amounts held in cash or other specified assets, and finalizes the calculation of available foreign tax credits.
No provision has been made for income taxes on undistributed earnings of foreign subsidiaries of approximately $22.1 billion at December 31, 2017, since it is the Company's intention to indefinitely reinvest undistributed earnings of its foreign subsidiaries. It is not practicable to estimate the additional income taxes and applicable withholding taxes that would be payable on the remittance of such undistributed earnings.
The Company expects to deploy capital to those markets which offer particularly attractive growth opportunities. The cash that is permanently reinvested is typically used to expand operations either organically or through acquisitions. In addition, the Company expects that minimal to no Irish tax would apply to dividends paid to the Irish parent due to the impact of the Irish foreign tax credit system. The Company's public dividends and share repurchases are funded primarily from Non-U.S. operations.
Worldwide income tax payments, net of tax refunds, follow:
Deferred Income Tax Assets and Liabilities
Components of noncurrent deferred income taxes follow:
At December 31, 2017, Eaton Corporation plc and certain Irish subsidiaries had tax loss carryforwards that are available to reduce future taxable income and tax liabilities. These carryforwards and their respective expiration dates are summarized below:
At December 31, 2017, the Company's foreign subsidiaries, including all U.S. and non-U.S. subsidiaries, had income tax loss carryforwards and income tax credit carryforwards that are available to reduce future taxable income or tax liabilities. These carryforwards and their respective expiration dates are summarized below:
Recoverability of Deferred Income Tax Assets
Eaton is subject to the income tax laws in the jurisdictions in which it operates. In order to determine its income tax provision for financial statement purposes, Eaton must make significant estimates and judgments about its business operations in these jurisdictions. These estimates and judgments are also used in determining the deferred income tax assets and liabilities that have been recognized for differences between the financial statement and income tax basis of assets and liabilities, and income tax loss carryforwards and income tax credit carryforwards.
Management evaluates the realizability of deferred income tax assets for each of the jurisdictions in which it operates. If the Company experiences cumulative pretax income in a particular jurisdiction in the three-year period including the current and prior two years, management normally concludes that the deferred income tax assets will more likely than not be realizable and no valuation allowance is recognized, unless known or planned operating developments, or changes in tax laws, would lead management to conclude otherwise. However, if the Company experiences cumulative pretax losses in a particular jurisdiction in the three-year period including the current and prior two years, management then considers a series of factors in the determination of whether the deferred income tax assets can be realized. These factors include historical operating results, known or planned operating developments, the period of time over which certain temporary differences will reverse, consideration of the utilization of certain deferred income tax liabilities, tax law carryback capability in the particular country, prudent and feasible tax planning strategies, changes in tax laws, and estimates of future earnings and taxable income using the same assumptions as those used for the Company's goodwill and other impairment testing. After evaluation of these factors, if the deferred income tax assets are expected to be realized within the tax carryforward period allowed for that specific country, management would conclude that no valuation allowance would be required. To the extent that the deferred income tax assets exceed the amount that is expected to be realized within the tax carryforward period for a particular jurisdiction, management would establish a valuation allowance.
Applying the above methodology, valuation allowances have been established for certain deferred income tax assets to the extent they are not expected to be realized within the particular tax carryforward period.
Unrecognized Income Tax Benefits
A summary of gross unrecognized income tax benefits follows:
Eaton's long-term policy has been to enter into tax planning strategies only if it is more likely than not that the benefit would be sustained upon audit. For example, the Company does not enter into any of the United States Internal Revenue Service (IRS) Listed Transactions as set forth in Treasury Regulation 1.6011-4.
If all unrecognized tax benefits were recognized, the net impact on the provision for income tax expense would be $652.
As of December 31, 2017 and 2016, Eaton had accrued approximately $80 and $94, respectively, for the payment of worldwide interest and penalties, which are not included in the table of unrecognized income tax benefits above. Eaton recognizes interest and penalties related to unrecognized income tax benefits in the provision for income tax expense. The Company has accrued penalties in jurisdictions primarily where they are automatically applied to any deficiency, regardless of the merit of the position.
As part of Eaton’s broader efforts to streamline operations, accelerate organic growth, and increase administrative efficiencies, the Company centralized certain activities and assets, which resulted in an increase in current income taxes payable, prepaid tax, and unrecognized tax benefits for 2017. These changes did not impact the Company’s 2017 effective tax rate.
The resolution of the majority of Eaton's unrecognized income tax benefits is dependent upon uncontrollable factors such as the prospect of retroactive regulations; new case law; and the willingness of the income tax authority to settle the issue, including the timing thereof. Therefore, for the majority of unrecognized income tax benefits, it is not reasonably possible to estimate the increase or decrease in the next 12 months. For each of the unrecognized income tax benefits where it is possible to estimate the increase or decrease in the balance within the next 12 months, the Company does not anticipate any significant change.
Eaton or its subsidiaries file income tax returns in Ireland and many countries around the world. With only few exceptions, Irish and non-United States subsidiaries of Eaton are no longer subject to examinations for years before 2007.
The United States Internal Revenue Service (“IRS”) has completed its examination of Eaton Corporation and Includible Subsidiaries’ (Eaton Corp.) United States income tax returns for 2005 through 2010 and has issued Statutory Notices of Deficiency (Notices) as discussed below. The statute of limitations on these tax years remains open until the matters are resolved. The IRS is currently examining tax years 2011 through 2013. The statute of limitations for tax years 2011 through 2013 is open until August 31, 2018. Tax years 2014 through 2016 are still subject to examination by the IRS.
Eaton is also under examination for the income tax filings in various states and localities of the United States. With only a few exceptions, Eaton Corp. is no longer subject to income tax examinations from states and localities within the United States for years before 2012. Income tax returns of states and localities within the United States will be reopened to the extent of United States federal income tax adjustments, if any, going back to 2005 when those audit years are finalized. Some states and localities may not limit their assessment to the United States federal adjustments, and may require the opening of the entire tax year. In addition, with only a few exceptions, BZ Holdings Inc. and Includible Subsidiaries (the former U.S. holding company for Cooper Industries) are no longer subject to United States state and local income tax examinations for years before 2012.
In 2011, the IRS issued a Notice for Eaton Corp. for the 2005 and 2006 tax years (the 2011 Notice). The 2011 Notice proposed assessments of $75 in additional taxes plus $52 in penalties related primarily to transfer pricing adjustments for products manufactured in the Company's facilities in Puerto Rico and the Dominican Republic and sold to affiliated companies located in the U.S.. Eaton Corp. has set its transfer prices for products sold between these affiliates at the same prices that Eaton Corp. sells such products to third parties as required by two successive Advance Pricing Agreements (APAs) Eaton Corp. entered into with the IRS that governed the 2005-2010 tax years. The Company has continued to apply the arms-length transfer pricing methodology for 2011 through the current reporting period. Immediately prior to the 2011 Notice being issued, the IRS sent a letter stating that it was retrospectively canceling the APAs. Eaton Corp. contested the proposed assessments in United States Tax Court. The case involved both whether the APAs should be enforced and, if not, the appropriate transfer pricing methodology. On July 26, 2017, the United States Tax Court issued a ruling in which it agreed with Eaton Corp. that the IRS must abide by the terms of the APAs for the tax years 2005-2006. The Tax Court’s ruling on the APAs did not have a material impact on Eaton’s consolidated financial statements.
In 2014, Eaton Corp. received a Notice from the IRS for the 2007 through 2010 tax years (the 2014 Notice) proposing assessments of $190 in additional taxes plus $72 in penalties, net of agreed credits and deductions, which the company has also contested in Tax Court. The proposed assessments pertain primarily to the same transfer pricing issues and APA for which the Tax Court has issued its ruling during 2017 as noted above. The Company believes that the Tax Court’s ruling for tax years 2005-2006 will also be applicable to the 2007-2010 years. Following the issuance of the Tax Court’s ruling, Eaton and the IRS recognized that the ruling on the enforceability of the APAs did not address a secondary issue regarding the transfer pricing for a certain royalty paid from 2006-2010. Eaton Corp. reported a consistent royalty rate for 2006-2010. The IRS has agreed to the royalty rate as reported by Eaton Corp. in 2006. Although the IRS has not proposed an alternative rate, it has not agreed to apply the same royalty rate in the 2007-2010 years.
The 2014 Notice also includes a separate proposed assessment involving the recognition of income for several of Eaton Corp.’s controlled foreign corporations. The Company believes that the proposed assessment is without merit. Eaton and the IRS have both moved for partial summary judgment on this issue. The Tax Court heard oral arguments on the motions in January 2018, following which the Court ordered further briefing.
During 2010, the Company received a tax assessment of $49 (translated at the December 31, 2017 exchange rate), plus interest and penalties, in Brazil for the tax years 2005 through 2008 that relates to the amortization of certain goodwill generated from the acquisition of third-party businesses and corporate reorganizations. The Company is contesting the assessment, which is under review at the administrative appeals level. During 2013, the Brazilian tax authorities began an audit of tax years 2009 through 2012. During 2014, the Company received a tax assessment of $37 (translated at the December 31, 2017 exchange rate), plus interest and penalties, for the 2009 through 2012 tax years (primarily relating to the same issues concerning the 2005 through 2008 tax years), which the Company is also contesting and is under review at the administrative appeals level. Multiple outside advisors have stated that Brazilian tax authorities are raising the issue for most clients with similar facts and that the matter is expected to require at least 10 years to resolve. The Company continues to believe that final resolution of the assessments will not have a material impact on its consolidated financial statements.
Note 10.
EATON SHAREHOLDERS' EQUITY
There are 750 million Eaton ordinary shares authorized ($0.01 par value per share), 439.9 million and 449.4 million of which were issued and outstanding at December 31, 2017 and 2016, respectively. Eaton's Memorandum and Articles of Association authorized 40 thousand deferred ordinary shares (€1.00 par value per share) and 10 thousand preferred A shares ($1.00 par value per share), all of which were issued and outstanding at December 31, 2017 and 2016, and 10 million serial preferred shares ($0.01 par value per share), none of which is outstanding at December 31, 2017 and 2016. At December 31, 2017, there were 13,089 holders of record of Eaton ordinary shares. Additionally, 20,138 current and former employees were shareholders through participation in the Eaton Savings Plan, Eaton Personal Investment Plan, or the Eaton Puerto Rico Retirement Savings Plan.
On October 22, 2013, Eaton's Board of Directors adopted a share repurchase program (the 2013 Program). Under the 2013 Program, the ordinary shares were expected to be repurchased over time, depending on market conditions, the market price of ordinary shares, capital levels, and other considerations. During 2016 and 2015, 1.5 million and 11.3 million ordinary shares were repurchased under the 2013 Program in the open market at a total cost of $82 and $682, respectively. On February 24, 2016, the Board of Directors approved a new share repurchase program for share repurchases up to $2,500 of ordinary shares (2016 Program). Under the 2016 Program, the ordinary shares are expected to be repurchased over time, depending on market conditions, the market price of ordinary shares, capital levels, and other considerations. During 2017 and 2016, 11.5 million and 10.3 million shares, respectively, were purchased on the open market under the 2016 Program for a total cost of $850 and $648, respectively.
Eaton has deferral plans that permit certain employees and directors to defer a portion of their compensation. A trust contains $11 and $13 of ordinary shares and marketable securities at December 31, 2017 and 2016, respectively, to fund a portion of these liabilities. The marketable securities were included in Other assets and the ordinary shares were included in Shareholders' equity at historical cost.
On February 28, 2018, Eaton's Board of Directors declared a quarterly dividend of $0.66 per ordinary share, a 10% increase over the dividend paid in the fourth quarter of 2017. The dividend is payable on March 23, 2018, to shareholders of record at the close of business on March 12, 2018.
Comprehensive Income (Loss)
Comprehensive income (loss) consists primarily of net income, currency translation and related hedging instruments, changes in unrecognized costs of pension and other postretirement benefits, and changes in the effective portion of open derivative contracts designated as cash flow hedges. The following table summarizes the pre-tax and after-tax amounts recognized in Comprehensive income (loss):
The changes in Accumulated other comprehensive loss follow:
The reclassifications out of Accumulated other comprehensive loss follow:
1 These components of Accumulated other comprehensive loss are included in the computation of net periodic benefit cost. See Note 7 for additional information about defined benefit pension and other postretirement benefits items.
Net Income Per Share Attributable to Eaton Ordinary Shareholders
A summary of the calculation of net income per share attributable to Eaton ordinary shareholders follows:
*Certain amounts have been adjusted to reflect the retrospective application of the Company's change in inventory accounting method, as described in Notes 1 and 14.
In 2017, 2016, and 2015, 0.4 million, 1.7 million, and 1.6 million stock options, respectively, were excluded from the calculation of diluted net income per share attributable to Eaton ordinary shareholders because the exercise price of the options exceeded the average market price of the ordinary shares during the period and their effect, accordingly, would have been antidilutive.
Note 11.
EQUITY-BASED COMPENSATION
Restricted Stock Units and Awards
Restricted stock units (RSUs) and restricted stock awards (RSAs) have been issued to certain employees and directors. Participants awarded RSUs in 2015 and 2016 do not receive dividends; therefore, the fair value is determined by reducing the closing market price of the Company’s ordinary shares on the date of grant by the present value of the estimated dividends had they been paid. The fair value of RSUs awarded in 2017 and RSAs are determined based on the closing market price of the Company’s ordinary shares at the date of grant. The RSUs entitle the holder to receive one ordinary share for each RSU upon vesting, generally over three years. RSAs are issued and outstanding at the time of grant, but remain subject to forfeiture until vested, generally over three or four years. A summary of the RSU and RSA activity for 2017 follows:
Information related to RSUs and RSAs follows:
As of December 31, 2017, total compensation expense not yet recognized related to non-vested RSUs and RSAs was $79, and the weighted-average period in which the expense is expected to be recognized is 2.3 years. Excess tax benefit for RSUs and RSAs totaled $2 for 2017. There was no excess tax benefit for RSUs and RSAs in 2016 and 2015.
Performance Share Units
In February 2017 and 2016, the Compensation and Organization Committee of the Board of Directors approved the grant of performance share units (PSUs) to certain employees that vest based on the satisfaction of a three-year service period and total shareholder return relative to that of a group of peers. Awards earned at the end of the three-year vesting period range from 0% to 200% of the targeted number of PSUs granted based on the ranking of total shareholder return of the Company, assuming reinvestment of all dividends, relative to a defined peer group of companies. Equity-based compensation expense for these PSUs is recognized over the period during which an employee is required to provide service in exchange for the award. Upon vesting, dividends that have accumulated during the vesting period are paid on earned awards.
The Company uses a Monte Carlo simulation to estimate the fair value of PSUs with market conditions. The principal assumptions utilized in valuing these PSUs include the expected stock price volatility (based on the most recent 3-year period as of the grant date) and the risk-free interest rate (an estimate based on the yield of United States Treasury zero coupon bonds with a 3-year maturity as of the grant date). A summary of the assumptions used in determining fair value of these PSUs follows:
A summary of the 2017 activity for these PSUs follows:
1 Performance shares granted assuming the Company will perform at target relative to peers.
In February 2015 and 2016, performance share units were granted to certain employees that entitles the holder to receive one ordinary share for each PSU that vest based on the satisfaction of a three-year service period and the achievement of certain performance metrics over that same period. Upon vesting, PSU holders receive dividends that accumulate during the vesting period. The fair value of these PSUs is determined based on the closing market price of the Company's ordinary shares at the date of grant. Equity-based compensation expense is recognized over the period an employee is required to provide service based on the number of PSUs for which achievement of the performance objectives is probable. A summary of the 2017 activity for these PSUs follows:
Information related to PSUs follows:
As of December 31, 2017, total compensation expense not yet recognized related to non-vested PSUs was $30 and the weighted average period in which the expense is to be recognized is 1.6 years. There was no excess tax benefit for PSUs in 2017, 2016 and 2015.
Stock Options
Under various plans, stock options have been granted to certain employees and directors to purchase ordinary shares at prices equal to fair market value on the date of grant. Substantially all of these options vest ratably during the three-year period following the date of grant and expire 10 years from the date of grant. Compensation expense is recognized for stock options based on the fair value of the options at the date of grant and amortized on a straight-line basis over the period the employee or director is required to provide service.
The Company uses a Black-Scholes option pricing model to estimate the fair value of stock options. The principal assumptions utilized in valuing stock options include the expected stock price volatility (based on the most recent historical period equal to the expected life of the option); the expected option life (an estimate based on historical experience); the expected dividend yield; and the risk-free interest rate (an estimate based on the yield of United States Treasury zero coupon with a maturity equal to the expected life of the option). A summary of the assumptions used in determining the fair value of stock options follows:
A summary of stock option activity follows:
The aggregate intrinsic value in the table above represents the total excess of the $79.01 closing price of Eaton ordinary shares on the last trading day of 2017 over the exercise price of the stock option, multiplied by the related number of options outstanding and exercisable. The aggregate intrinsic value is not recognized for financial accounting purposes and the value changes based on the daily changes in the fair market value of the Company's ordinary shares.
Information related to stock options follows:
As of December 31, 2017, total compensation expense not yet recognized related to non-vested stock options was $8.8, and the weighted-average period in which the expense is expected to be recognized is 1.7 years.
Note 12.
FAIR VALUE MEASUREMENTS
Fair value is measured based on an exit price, representing the amount that would be received to sell an asset or paid to satisfy a liability in an orderly transaction between market participants. Fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, a fair value hierarchy is established, which categorizes the inputs used in measuring fair value as follows: (Level 1) observable inputs such as quoted prices in active markets; (Level 2) inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and (Level 3) unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.
A summary of financial instruments recognized at fair value, and the fair value measurements used, follows:
Eaton values its financial instruments using an industry standard market approach, in which prices and other relevant information is generated by market transactions involving identical or comparable assets or liabilities. No financial instruments were measured using unobservable inputs.
Other Fair Value Measurements
Long-term debt and the current portion of long-term debt had a carrying value of $7,745 and fair value of $8,048 at December 31, 2017 compared to $8,263 and $8,477, respectively, at December 31, 2016. The fair value of Eaton's debt instruments was estimated using prevailing market interest rates on debt with similar creditworthiness, terms and maturities and is considered a Level 2 fair value measurement.
As discussed in Note 2, on July 31, 2017 Eaton sold a 50% interest in its heavy-duty and medium-duty commercial vehicle automated transmission business to Cummins, Inc. Eaton's remaining 50% interest was remeasured to a fair value of $600 on July 31, 2017 using a discounted cash flow model which is considered a Level 3 fair value measurement. The model includes estimates of future cash flows, future growth rates, terminal value amounts, and the applicable weighted-average cost of capital used to discount those estimated cash flows. Eaton will account for its investment on the equity method of accounting.
Short-Term Investments
Eaton invests excess cash generated from operations in short-term marketable investments. For those investments classified as “available-for-sale”, Eaton marks these investments to fair value with the offset recognized in Accumulated other comprehensive loss. A summary of the carrying value of short-term investments follows:
Note 13.
DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES
In the normal course of business, Eaton is exposed to certain risks related to fluctuations in interest rates, currency exchange rates and commodity prices. The Company uses various derivative and non-derivative financial instruments, primarily interest rate swaps, currency forward exchange contracts, currency swaps and, to a lesser extent, commodity contracts, to manage risks from these market fluctuations. The instruments used by Eaton are straightforward, non-leveraged instruments. The counterparties to these instruments are financial institutions with strong credit ratings. Eaton maintains control over the size of positions entered into with any one counterparty and regularly monitors the credit rating of these institutions. Such instruments are not purchased and sold for trading purposes.
Derivative financial instruments are accounted for at fair value and recognized as assets or liabilities in the Consolidated Balance Sheets. Accounting for the gain or loss resulting from the change in the fair value of the derivative financial instrument depends on whether it has been designated, and is effective, as part of a hedging relationship and, if so, as to the nature of the hedging activity. Eaton formally documents all relationships between derivative financial instruments accounted for as designated hedges and the hedged item, as well as its risk-management objective and strategy for undertaking the hedge transaction. This process includes linking derivative financial instruments to a recognized asset or liability, specific firm commitment, forecasted transaction, or net investment in a foreign operation. These financial instruments can be designated as:
•
Hedges of the change in the fair value of a recognized fixed-rate asset or liability, or the firm commitment to acquire such an asset or liability (a fair value hedge); for these hedges, the gain or loss from the derivative financial instrument, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, are recognized in income during the period of change in fair value.
•
Hedges of the variable cash flows of a recognized variable-rate asset or liability, or the forecasted acquisition of such an asset or liability (a cash flow hedge); for these hedges, the effective portion of the gain or loss from the derivative financial instrument is recognized in Accumulated other comprehensive loss and reclassified to income in the same period when the gain or loss on the hedged item is included in income.
•
Hedges of the currency exposure related to a net investment in a foreign operation (a net investment hedge); for these hedges, the effective portion of the gain or loss from the derivative financial instrument is recognized in Accumulated other comprehensive loss and reclassified to income in the same period when the gain or loss related to the net investment in the foreign operation is included in income.
The gain or loss from a derivative financial instrument designated as a hedge that is effective is classified in the same line of the Consolidated Statements of Income as the offsetting loss or gain on the hedged item. The change in fair value of a derivative financial instrument that is not effective as a hedge is immediately recognized in income. The cash flows resulting from these financial instruments are classified in operating activities on the Consolidated Statements of Cash Flows.
For derivatives that are not designated as a hedge, any gain or loss is immediately recognized in income. The majority of derivatives used in this manner relate to risks resulting from assets or liabilities denominated in a foreign currency and certain commodity contracts that arise in the normal course of business. During 2017 and 2016, Eaton recognized gains of $2 and $7, respectively, associated with these commodity hedge contracts. Gains and losses associated with commodity hedge contracts are classified in Cost of products sold.
Eaton uses certain of its debt denominated in foreign currency to hedge portions of its net investments in foreign operations against foreign currency exposure (net investment hedges). Foreign currency denominated debt designated as non-derivative net investment hedging instruments on an after-tax basis was $88 and $86 at December 31, 2017 and 2016, respectively, and designated on a pre-tax basis was $652 and $572 at December 31, 2017 and 2016, respectively. See Note 6 for additional information about debt.
Interest Rate Risk
Eaton has entered into fixed-to-floating interest rate swaps to manage interest rate risk of certain long-term debt. These interest rate swaps are accounted for as fair value hedges of certain long-term debt. The maturity of the swap corresponds with the maturity of the debt instrument as noted in the table of long-term debt in Note 6. Eaton also entered into several forward starting floating-to-fixed interest rate swaps to manage interest rate risk in anticipation of debt that was refinanced in 2017.
A summary of interest rate swaps outstanding at December 31, 2017, follows:
Fixed-to-Floating Interest Rate Swaps
Derivative Financial Statement Impacts
The fair value of derivative financial instruments recognized in the Consolidated Balance Sheets follows:
The currency exchange contracts shown in the table above as derivatives not designated as hedges are primarily contracts entered into to manage currency volatility or exposure on intercompany sales and loans. While Eaton does not elect hedge accounting treatment for these derivatives, Eaton targets managing 100% of the intercompany balance sheet exposure to minimize the effect of currency volatility related to the movement of goods and services in the normal course of its operations. This activity represents the great majority of these currency exchange contracts.
The impact of derivative instruments to the Consolidated Statements of Income and Comprehensive Income follow:
Amounts recognized in net income follow:
Gains and losses described above were recognized in Interest expense - net.
Note 14.
ACCOUNTS RECEIVABLE AND INVENTORY
Accounts Receivable
Eaton performs ongoing credit evaluation of its customers and maintains sufficient allowances for potential credit losses. The Company evaluates the collectability of its accounts receivable based on the length of time the receivable is past due and any anticipated future write-off based on historic experience. Accounts receivable balances are written off against an allowance for doubtful accounts after a final determination of uncollectability has been made. Accounts receivable are net of an allowance for doubtful accounts of $57 and $50 at December 31, 2017 and 2016.
Inventory
Inventory is carried at lower of cost or net realizable value. During the fourth quarter of 2017, the Company changed its method of accounting for certain inventory in the United States from the LIFO method to the FIFO method. The FIFO method of accounting for inventory is preferable because it conforms the Company's entire inventory to a single method of accounting and improves comparability with the Company's peers. Cost components include raw materials, purchased components, direct labor, indirect labor, utilities, depreciation, inbound freight charges, purchasing and receiving costs, inspection costs, warehousing costs, and costs of the distribution network.
The components of inventory follow:
All prior periods presented in the financial statements have been retrospectively adjusted to apply the new method of FIFO accounting for certain U.S. inventory. The cumulative effect of this change on periods prior to those presented herein resulted in an increase in Retained earnings of $70 as of January 1, 2015. The Tax Cuts and Jobs Act ("TCJA"), which was signed into law on December 22, 2017, would have required $14 of additional tax expense to adjust the deferred tax asset related to the LIFO reserve to the new tax rate if inventories continued to be computed under the LIFO method. The change from the LIFO method to the FIFO method eliminated the need to record this $14 of additional tax expense.
As a result of the retrospective application of this change in accounting method, the following financial statement line items within the accompanying financial statements were adjusted, as follows:
As a result of the retrospective application of this change in accounting principle, the following financial statement line items within the unaudited interim 2017 and 2016 quarterly condensed consolidated financial statements were adjusted, as follows:
Note 15.
BUSINESS SEGMENT AND GEOGRAPHIC REGION INFORMATION
Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated on a regular basis by the chief operating decision maker, or decision making group, in deciding how to allocate resources to an individual segment and in assessing performance. Eaton’s segments are as follows:
Electrical Products and Electrical Systems and Services
The Electrical Products segment consists of electrical components, industrial components, residential products, single phase power quality, emergency lighting, fire detection, wiring devices, structural support systems, circuit protection, and lighting products. The Electrical Systems and Services segment consists of power distribution and assemblies, three phase power quality, hazardous duty electrical equipment, intrinsically safe explosion-proof instrumentation, utility power distribution, power reliability equipment, and services. The principal markets for these segments are industrial, institutional, governmental, utility, commercial, residential and information technology. These products are used wherever there is a demand for electrical power in commercial buildings, data centers, residences, apartment and office buildings, hospitals, factories, utilities, and industrial and energy facilities. The segments share several common global customers, but a large number of customers are located regionally. Sales are made directly to original equipment manufacturers, utilities, and certain other end users, as well as through distributors, resellers, and manufacturers' representatives.
Hydraulics
The Hydraulics segment is a global leader in hydraulics components, systems and services for industrial and mobile equipment. Eaton offers a wide range of power products including pumps, motors and hydraulic power units; a broad range of controls and sensing products including valves, cylinders and electronic controls; a full range of fluid conveyance products including industrial and hydraulic hose, fittings, and assemblies, thermoplastic hose and tubing, couplings, connectors, and assembly equipment; filtration systems solutions; industrial drum and disc brakes; and golf grips. The principal markets for the Hydraulics segment include renewable energy, marine, agriculture, oil and gas, construction, mining, forestry, utility, material handling, truck and bus, machine tools, molding, primary metals, and power generation. Key manufacturing customers in these markets and other customers are located globally. Products are sold and serviced through a variety of channels.
Aerospace
The Aerospace segment is a leading global supplier of aerospace fuel, hydraulics, and pneumatic systems for commercial and military use. Products include hydraulic power generation systems for aerospace applications including pumps, motors, hydraulic power units, hose and fittings, electro-hydraulic pumps; controls and sensing products including valves, cylinders, electronic controls, electromechanical actuators, sensors, aircraft flap and slat systems and nose wheel steering systems; fluid conveyance products, including hose, thermoplastic tubing, fittings, adapters, couplings, sealing and ducting; and fuel systems including fuel pumps, sensors, valves, adapters and regulators. The principal markets for the Aerospace segment are manufacturers of commercial and military aircraft and related after-market customers. These manufacturers and other customers operate globally. Products are sold and serviced through a variety of channels.
Vehicle
The Vehicle segment is a leader in the design, manufacture, marketing, and supply of: drivetrain, powertrain systems and critical components that reduce emissions and improve fuel economy, stability, performance, and safety of cars, light trucks and commercial vehicles. Products include transmissions, clutches, hybrid power systems, superchargers, engine valves and valve actuation systems, cylinder heads, locking and limited slip differentials, transmission controls, fuel vapor components, fluid connectors and conveyance products for the global vehicle industry. The principal markets for the Vehicle segment are original equipment manufacturers and aftermarket customers of heavy-, medium-, and light-duty trucks, SUVs, CUVs, passenger cars and agricultural equipment.
Other Information
No single customer represented greater than 10% of net sales in 2017, 2016 or 2015, respectively.
The accounting policies of the business segments are generally the same as the policies described in Note 1, except that operating profit only reflects the service cost component related to pensions and other postretirement benefits. Intersegment sales and transfers are accounted for at the same prices as if the sales and transfers were made to third parties. These intersegment sales are eliminated in consolidation. Operating profit includes the operating profit from intersegment sales.
For purposes of business segment performance measurement, the Company does not allocate items that are of a non-operating nature or are of a corporate or functional governance nature. Corporate expenses consist of transaction costs associated with the acquisition of certain businesses and corporate office expenses including compensation, benefits, occupancy, depreciation, and other administrative costs. Identifiable assets of the business segments exclude goodwill, other intangible assets, and general corporate assets, which principally consist of certain cash, short-term investments, deferred income taxes, certain accounts receivable, certain property, plant and equipment, and certain other assets.
Business Segment Information
*Other corporate expense - net and Income tax expense in 2016 and 2015 have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 14.
Business segment operating profit was reduced by acquisition integration charges as follows:
Corporate acquisition integration charges totaled $5 in 2015, and are included above in Other corporate expense - net. There was no corporate acquisition integration charges in 2017 and 2016. See Note 3 for additional information about acquisition integration charges.
Geographic Region Information
Net sales are measured based on the geographic destination of sales. Long-lived assets consist of property, plant and equipment - net.
Note 16.
CONDENSED CONSOLIDATING FINANCIAL STATEMENTS
The Registered Senior Notes issued by Eaton Corporation are registered under the Securities Act of 1933. Eaton and certain other of Eaton's 100% owned direct and indirect subsidiaries (the Guarantors) fully and unconditionally guaranteed (subject, in the case of the Guarantors, other than Eaton, to customary release provisions as described below), on a joint and several basis, the Registered Senior Notes. The following condensed consolidating financial statements are included so that separate financial statements of Eaton, Eaton Corporation and each of the Guarantors are not required to be filed with the Securities and Exchange Commission. The consolidating adjustments primarily relate to eliminations of investments in subsidiaries and intercompany balances and transactions. The condensed consolidating financial statements present investments in subsidiaries using the equity method of accounting. See Note 6 for additional information related to the Registered Senior Notes.
The guarantee of a Guarantor that is not a parent of the issuer will be automatically and unconditionally released and discharged in the event of any sale of the Guarantor or of all or substantially all of its assets, or in connection with the release or termination of the Guarantor as a guarantor under all other U.S. debt securities or U.S. syndicated credit facilities, subject to limitations set forth in the indenture. The guarantee of a Guarantor that is a direct or indirect parent of the issuer will only be automatically and unconditionally released and discharged in connection with the release or termination of such Guarantor as a guarantor under all other debt securities or syndicated credit facilities (in both cases, U.S. or otherwise), subject to limitations set forth in the indenture.
During 2017, 2016 and 2015, the Company undertook certain steps to restructure ownership of various subsidiaries. The transactions were entirely among wholly-owned subsidiaries under the common control of Eaton. This restructuring has been reflected as of the beginning of the earliest period presented below.
Additionally, certain amounts in 2016 and 2015 have been adjusted to reflect the change in inventory accounting method, as described in Notes 1 and 14.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Amounts are in millions of dollars or shares unless indicated otherwise (per share data assume dilution).
COMPANY OVERVIEW
Eaton Corporation plc (Eaton or the Company) is a power management company with 2017 net sales of $20.4 billion. The Company provides energy-efficient solutions that help its customers effectively manage electrical, hydraulic and mechanical power more efficiently, safely and sustainably. Eaton has approximately 96,000 employees in 59 countries and sells products to customers in more than 175 countries.
Summary of Results of Operations
During 2017, the Company's results of operations returned to solid growth as global end markets expanded, particularly in the second half of 2017. During the year, the Company completed its multi-year restructuring program that reduced its cost structure, which expanded operating margins.
On July 31, 2017, Eaton sold a 50% interest in its heavy-duty and medium-duty commercial vehicle automated transmission business for $600 in cash to Cummins, Inc. The Company recognized a pre-tax gain of $1,077, of which $533 related to the pre-tax gain from the $600 proceeds from the sale and $544 related to the Company’s remaining 50% investment in the joint venture being remeasured to fair value. The after-tax gain was $843. Eaton accounts for its investment on the equity method of accounting.
The tax rate for 2017 includes a tax benefit of $62 related to the United States Tax Cuts and Jobs Act (“TCJA”), which was signed into law on December 22, 2017. The tax benefit of $62 related to the TCJA is comprised of a tax benefit of $79 for adjusting deferred tax assets and liabilities, offset by a tax expense of $17 for the taxation of unremitted earnings of non-U.S. subsidiaries owned directly or indirectly by U.S. subsidiaries of Eaton.
During 2016, the Company's results of operations were impacted by a decline in several of the Company's end markets. Further, the results of operations were negatively impacted by the strengthening in the value of the U.S. dollar. Despite the declining market conditions and unfavorable impact of currency translation, the Company generated solid operating margins and diluted net income per share.
During 2015, Eaton announced a multi-year restructuring initiative to reduce its cost structure and gain efficiencies in all business segments and at corporate in order to respond to declining market conditions. Restructuring charges in 2017, 2016 and 2015 were $116, $211 and $129, respectively. These charges were primarily comprised of severance costs. The initiative concluded at the end of 2017 and the projected annualized savings from these restructuring actions are expected to be $518, when fully realized in 2018.
Additional information related to acquisitions and divestitures of businesses, and restructuring activities is presented in Note 2, Note 3, and Note 4, respectively, of the Notes to the Consolidated Financial Statements.
A summary of Eaton’s Net sales, Net income attributable to Eaton ordinary shareholders, and Net income per share attributable to Eaton ordinary shareholders - diluted follows:
* Years ended December 31, 2016 and 2015 amounts have been revised to reflect the change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.
RESULTS OF OPERATIONS
Non-GAAP Financial Measures
The following discussion of Consolidated Financial Results and Business Segment Results of Operations includes certain non-GAAP financial measures. These financial measures include adjusted earnings, adjusted earnings per ordinary share, and operating profit before acquisition integration charges for each business segment as well as corporate, each of which differs from the most directly comparable measure calculated in accordance with generally accepted accounting principles (GAAP). A reconciliation of adjusted earnings and adjusted earnings per ordinary share to the most directly comparable GAAP measure is included in the table below. Operating profit before acquisition integration charges is reconciled in the discussion of the operating results of each business segment, and excludes acquisition integration expense related to integration of Ephesus Lighting, Inc. in 2017 and 2016, Oxalis Group Ltd. in 2016, and primarily Cooper Industries plc in 2015. Management believes that these financial measures are useful to investors because they exclude certain transactions, allowing investors to more easily compare Eaton’s financial performance period to period. Management uses this information in monitoring and evaluating the on-going performance of Eaton and each business segment. For additional information on acquisition integration charges, see Note 3 to the Consolidated Financial Statements.
Consolidated Financial Results
* Year ended December 31, 2016 and 2015 amounts have been revised to reflect the change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.
Net Sales
Net sales in 2017 increased by 3% compared to 2016 due to an increase of 3% in organic sales. The increase in organic sales in 2017 was primarily due to higher sales volumes in the Electrical Products, Hydraulics, and Vehicle business segments. Net sales in 2016 decreased by 5% compared to 2015 due to a decrease of 4% in organic sales and decrease of 1% from the impact of negative currency translation. The decrease in organic sales in 2016 was primarily due to weakening demand in several of the Company's end markets.
Gross Profit
Gross profit margin increased from 32.1% in 2016 to 32.6% in 2017. The increase in gross profit margin in 2017 was primarily due to higher sales volumes, savings from restructuring actions, and lower restructuring charges, partially offset by commodity inflation. Gross profit increased from 31.4% in 2015 to 32.1% in 2016. The increase in gross profit margin in 2016 was primarily due to savings from restructuring actions and other cost control measures, partially offset by lower sales volumes, unfavorable product mix, and higher restructuring charges.
Income Taxes
During 2017, an income tax expense of $382 was recognized (an effective tax rate of 11.3%) compared to income tax expense of $199 in 2016 (an effective tax rate of 9.4%). The 2017 effective tax rate includes tax expense of $234 on the gain from the sale of the business discussed in Note 2, and a tax benefit of $62 related to the TCJA. Excluding the gain and related tax impact on the sale of business, and the impact of the TCJA, the tax rate for 2017 was expense of 9.2%. The decrease from 9.4% for the full year 2016 compared to 9.2% for the full year 2017 was due to the resolution of tax contingencies in various tax jurisdictions and the excess tax benefits recognized for employee share-based payments pursuant to the adoption of ASU 2016-09 as discussed in Note 1. During 2016, an income tax expense of $199 was recognized (an effective tax rate of 9.4%) compared to income tax expense of $159 in 2015 (an effective tax rate of 7.5%). The 2016 effective tax rate increased from 2015 primarily due to greater levels of income earned in higher tax jurisdictions, partially offset by net decreases in worldwide tax liabilities.
Net Income
Net income attributable to Eaton ordinary shareholders of $2,985 in 2017 increased 56% compared to $1,916 in 2016. Net income in 2017 included $843 from the gain on the sale of the business discussed in Note 2, and $62 of income from the new U.S. tax bill discussed in Note 9. Excluding these items, the increase in 2017 was primarily due to higher sales volumes, savings from restructuring actions, and lower restructuring charges, partially offset by commodity inflation. Net income attributable to Eaton ordinary shareholders of $1,916 in 2016 decreased 3% compared to Net income attributable to Eaton ordinary shareholders of $1,972 in 2015. The decrease in 2016 was primarily due to lower sales volumes, unfavorable product mix, and higher restructuring charges, partially offset by savings from restructuring actions, other cost control measures, a decrease in pension and other post benefits expense, and income from several insurance matters during 2016.
Net income per ordinary share in 2017 included $1.89 from the gain on the sale of business discussed in Note 2 and $0.14 income from the new U.S. tax bill discussed in Note 9. Net income per ordinary share increased by 59% to $6.68 in 2017 compared to $4.20 in 2016. The increase was due to higher Net income attributable to Eaton ordinary shareholders and the Company's share repurchases in 2017. Net income per ordinary share was broadly flat at $4.20 in 2016 compared to $4.22 in 2015 primarily due to a decrease in Net Income attributable to Eaton ordinary shareholders offset by the impact of the Company's share repurchases in 2016.
Adjusted Earnings
Adjusted earnings of $2,987 in 2017 increased 56% compared to Adjusted earnings of $1,919 in 2016. The increase was due to higher Net income attributable to Eaton ordinary shareholders. Adjusted earnings of $1,919 in 2016 decreased 4% compared to 2015 Adjusted earnings of $2,003. The decrease was due to lower Net income attributable to Eaton ordinary shareholders and lower acquisition integration charges.
Adjusted earnings per ordinary share increased by 59% to $6.68 in 2017 compared to $4.21 in 2016. The increase in Adjusted earnings per ordinary share in 2017 was due to higher Adjusted earnings and the Company's share repurchases in 2017. Adjusted earnings per ordinary share of $4.21 in 2016 decreased 2% from $4.29 in 2015. The decrease in Adjusted earnings per ordinary share in 2016 was due to lower Adjusted earnings, partially offset by the impact of the Company's share repurchases in 2016.
Business Segment Results of Operations
The following is a discussion of Net sales, operating profit and operating profit margin by business segment, which includes a discussion of operating profit and operating profit margin before acquisition integration charges. For additional information related to acquisition integration charges see Note 3 to the Consolidated Financial Statements.
Electrical Products
Net sales increased 3% in 2017 compared to 2016 due to an increase of 3% in organic sales. Organic sales growth in 2017 was driven by growth in the Americas and Europe. Net sales were broadly flat in 2016 compared to 2015 due to an increase of 1% in organic sales, offset by a decrease of 1% from the impact of negative currency translation. By region, organic sales grew in 2016 in the Americas and Europe, while organic sales declined in Asia Pacific.
Operating margin increased from 17.8% in 2016 to 17.9% in 2017. The increase in operating margin in 2017 was primarily due to higher sales volumes, savings from restructuring actions, and lower restructuring charges, partially offset by commodity inflation and the impact from natural disasters in 2017. Operating margin increased from 16.6% in 2015 to 17.8% in 2016. The increase in operating margin in 2016 was primarily due to savings from restructuring actions, other cost control measures, and lower acquisition integration charges, partially offset by higher restructuring charges and unfavorable product mix.
Operating margin before acquisition integration charges was flat at 17.9% for 2016 and 2017. Operating margin before acquisition integration charges increased from 16.9% in 2015 to 17.9% in 2016. The increase in operating margin before acquisition integration charges in 2016 was primarily due to an increase in operating margin, partially offset by lower acquisition integration charges.
Electrical Systems and Services
Net sales were broadly flat in 2017 compared to 2016. Net sales decreased 5% in 2016 compared to 2015 due to a decrease of 3% in organic sales and a decrease of 2% from the impact of negative currency translation. The organic sales decline in 2016 was primarily due to weakness in oil and gas markets and large industrial projects, partially offset by growth in data centers and commercial construction markets.
Operating margin increased from 12.6% in 2016 to 13.6% in 2017. Operating margin increased in 2017 primarily due to savings from restructuring actions and lower restructuring charges, partially offset by commodity inflation. Operating margin decreased from 13.1% in 2015 to 12.6% in 2016. Operating margin decreased in 2016 primarily due to lower sales volumes, unfavorable product mix, and higher restructuring charges, partially offset by savings from restructuring actions and other cost control measures.
Operating margin before acquisition integration charges increased from 12.6% in 2016 to 13.6% in 2017. The increase in operating margin before acquisition integration charges was primarily due to an increase in operating margin. Operating margin before acquisition integration charges decreased from 13.3% in 2015 to 12.6% in 2016. The decrease in operating margin was primarily due to lower operating margins and lower acquisition integration charges.
Hydraulics
Net sales in 2017 increased 11% compared to 2016 due to an increase in organic sales of 12% and a decrease of 1% from the impact of negative currency translation. The increase in organic sales in 2017 was due to strength in global mobile equipment markets. Net sales in 2016 decreased 10% compared to 2015 due to a decrease in organic sales of 9% and a decrease of 1% from the impact of negative currency translation. The decrease in organic sales was due to weakness in both the mobile equipment and industrial markets.
Operating margin increased from 8.9% in 2016 to 11.7% in 2017. The increase in operating margin in 2017 was primarily due to higher sales volumes, lower restructuring charges, and savings from restructuring actions, partially offset by commodity inflation. Operating margin decreased from 10.0% in 2015 to 8.9% in 2016. The decrease in operating margin in 2016 was primarily due to lower sales volumes and higher restructuring costs, partially offset by savings from restructuring actions and other cost control measures.
Operating margin before acquisition integration charges decreased from 10.1% in 2015 to 8.9% in 2016. The decrease in operating margin before acquisition integration charges was primarily due to lower operating margins.
Aerospace
Net sales were broadly flat in 2017 compared to 2016. Net sales in 2016 decreased 3% compared to 2015 due to a decrease of 2% from the impact of negative currency translation and a decrease in organic sales of 1%. The decrease in organic sales during 2016 was primarily due to a decrease in military OEM markets and lower cost reimbursements on certain engineering programs, partially offset by growth in commercial markets.
Operating margin decreased from 19.1% in 2016 to 19.0% in 2017. The decrease was primarily due to higher program development spending, partially offset by savings from restructuring actions. Operating margin increased from 17.2% in 2015 to 19.1% in 2016. The increase was primarily due to savings from restructuring actions, other cost control measures, and reduced program development spending.
Vehicle
Net sales increased 6% in 2017 compared to 2016 due to an increase in organic sales of 5% and an increase of 2% from the impact of positive currency translation, partially offset by a decrease of 1% from the sale of the business discussed Note 2. The increase in organic sales in 2017 was primarily due to growth in North America. Net sales decreased 14% in 2016 compared to 2015 due to a decrease in organic sales of 13% and a decrease of 1% from the impact of negative currency translation. The decrease in organic sales in 2016 was primarily due to the lower North American Class 8 truck market.
Operating margin increased from 15.0% in 2016 to 16.1% in 2017. The increase in operating margin in 2017 was primarily due to higher sales volumes, lower restructuring costs, and savings from restructuring actions, partially offset by commodity inflation and unfavorable product mix. Operating margin decreased from 17.5% in 2015 to 15.0% in 2016. The decrease in operating margin in 2016 was primarily due to lower sales volume and unfavorable product mix, partially offset by savings from restructuring actions and other cost control measures.
Corporate Expense (Income)
* Year ended December 31, 2016 and 2015 amounts have been revised to reflect the change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.
Corporate results were income of $154 in 2017 compared to expense of $840 in 2016. The change in Total corporate expense (income) in 2017 was primarily due to the gain on the sale of the business discussed in Note 2, partially offset by an increase in other corporate expense. Total corporate expense decreased 16% in 2016 to $840 from $1,000 in 2015 primarily due to a decrease in pension and other postretirement benefits expense, and income from several insurance matters of $64 during the fourth quarter of 2016. The decrease in pension and other postretirement benefits expense resulted from a change to the spot rate approach for measuring service and interest costs, higher discount rates, and updated mortality tables.
LIQUIDITY, CAPITAL RESOURCES AND CHANGES IN FINANCIAL CONDITION
Financial Condition and Liquidity
Eaton’s objective is to finance its business through operating cash flow and an appropriate mix of equity and long-term and short-term debt. By diversifying its debt maturity structure, Eaton reduces liquidity risk. The Company maintains access to the commercial paper markets through a $2,000 commercial paper program. On November 17, 2017, Eaton refinanced a $500, four-year revolving credit facility with a $500, three-year revolving credit facility that will expire November 17, 2020 and also refinanced a $750, five-year revolving credit facility with a $750, five-year revolving credit facility that will expire November 17, 2022. Eaton also maintains a $750, five-year revolving credit facility that will expire October 14, 2021. These refinancings maintain long-term revolving credit facilities at a total of $2,000. The revolving credit facilities are used to support commercial paper borrowings and are fully and unconditionally guaranteed by Eaton and certain of its direct and indirect subsidiaries on an unsubordinated, unsecured basis. There were no borrowings outstanding under Eaton's revolving credit facilities at December 31, 2017 or 2016. The Company had available lines of credit of $741 from various banks primarily for the issuance of letters of credit, of which there was $297 outstanding at December 31, 2017. Over the course of a year, cash, short-term investments and short-term debt may fluctuate in order to manage global liquidity. Eaton believes it has the operating flexibility, cash flow, cash and short-term investment balances, and access to capital markets in excess of the liquidity necessary to meet future operating needs of the business as well as scheduled payments of long-term debt.
On September 15, 2017, a subsidiary of Eaton issued senior notes (the Notes) with a face amount of $1,000. The Notes are comprised of two tranches of $700 and $300 which mature in 2027 and 2047, respectively, with interest payable semi-annually at a respective rate of 3.1% and 3.9%. The issuer received proceeds totaling $993 from the issuance, net of financing costs.
On September 20, 2016, a subsidiary of Eaton issued Euro denominated notes (Euro Notes) with a face value of €550 ($615 based on the September 20, 2016 spot rate), in accordance with Regulation S promulgated under the Securities Act of 1933, as amended. The Euro Notes mature in 2024 with interest payable annually at a rate of 0.75%. After financing costs and discounts, the issuer received proceeds totaling €544 ($609 based on the September 20, 2016 spot rate) from the issuance.
For additional information on financing transactions and debt, see Note 6 to the Consolidated Financial Statements.
Eaton’s credit facilities and indentures governing certain long-term debt contain various covenants, the violation of which would limit or preclude the use of the credit facilities for future borrowings, or might accelerate the maturity of the related outstanding borrowings covered by the indentures. At Eaton’s present credit rating level, the most restrictive financial covenant provides that the ratio of secured debt (or lease payments due under a sale and leaseback transaction) to adjusted consolidated net worth (or consolidated net tangible assets, in each case as defined in the relevant credit agreement or indenture) may not exceed 10%. Eaton's actual ratios are substantially below the required threshold. In addition, Eaton is in compliance with each of its debt covenants for all periods presented.
Sources and Uses of Cash
Operating Cash Flow
Net cash provided by operating activities was $2,666 in 2017, an increase of $96 compared to $2,570 in 2016. The increase was driven by higher net income, and lower working capital balances compared to 2016, partially offset by higher pension contributions, including $350 of voluntary contributions to Eaton's U.S. qualified pension plans.
Net cash provided by operating activities was $2,570 in 2016, an increase of $161 compared to $2,409 in 2015. The increase was driven by lower pension contributions and lower working capital balances compared to 2015.
Investing Cash Flow
Net cash used in investing activities was $217 in 2017, a decrease in the use of cash of $312 compared to $529 in 2016. The decrease in 2017 was primarily driven by proceeds of $600 from the sale of the business discussed in Note 2, partially offset by purchases of short-term investments of $298 in 2017 compared to $40 in 2016. Capital expenditures were $520 in 2017 compared to $497 in 2016. Eaton expects approximately $575 in capital expenditures in 2018.
Net cash used in investing activities was $529 in 2016, a decrease in the use of cash of $46 compared to $575 in 2015. The decrease in 2016 was primarily driven by no business acquisitions completed in 2016 and lower capital expenditures in 2016 compared to 2015, partially offset by purchases of short-term investments of $40 in 2016 compared to sales $37 in 2015. Capital expenditures were $497 in 2016 compared to $506 in 2015.
Financing Cash Flow
Net cash used in financing activities was $2,442 in 2017, an increase in the use of cash of $704 compared to $1,738 in 2016. The increase in the use of cash was primarily due to higher payments on borrowings of $1,554 in 2017 compared to $653 in 2016 and higher share repurchases of $850 in 2017 compared to $730 in 2016, partially offset by higher proceeds from borrowings of $1,000 in 2017 compared to $631 in 2016.
Net cash used in financing activities was $1,738 in 2016, a decrease in use of cash of $567 compared to $2,305 in 2015. The decrease in the use of cash was primarily due to lower payments on borrowings of $653 in 2016 compared to $1,027 in 2015 and higher proceeds from borrowings of $631 in 2016 compared to $425 in 2015, partially offset by higher share repurchases of $730 in 2016 compared to $682 in 2015.
Credit Ratings
Eaton's debt has been assigned the following credit ratings:
Defined Benefits Plans
Pension Plans
During 2017, the fair value of plan assets in the Company’s employee pension plans increased $865 to $5,312 at December 31, 2017. The increase in plan assets was primarily due to better than expected return on plan assets, the Company's contributions to the pension plans, and the impact of positive currency translation. At December 31, 2017, the net unfunded position of $1,048 in pension liabilities consisted of $279 in the U.S. qualified pension plans, $925 in plans that have no minimum funding requirements, and $62 in all other plans that require minimum funding, partially offset by $218 in plans that are overfunded.
Funding requirements are a major consideration in making contributions to Eaton’s pension plans. With respect to the Company’s pension plans worldwide, the Company intends to contribute annually not less than the minimum required by applicable law and regulations. In 2017, $473 was contributed to the pension plans. The Company anticipates making $112 of contributions to certain pension plans during 2018. The funded status of the Company’s pension plans at the end of 2018, and future contributions, will depend primarily on the actual return on assets during the year and the discount rate used to calculate certain benefits at the end of the year. Depending on these factors, and the resulting funded status of the pension plans, the level of future contributions could be materially higher or lower than in 2017.
Off-Balance Sheet Arrangements
Eaton does not have off-balance sheet arrangements or financings with unconsolidated entities or other persons. In the ordinary course of business, the Company leases certain real properties and equipment, as described in Note 8 to the Consolidated Financial Statements.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with generally accepted accounting principles (GAAP) in the United States requires management to make certain estimates and assumptions that may involve the exercise of significant judgment. For any estimate or assumption used, there may be other reasonable estimates or assumptions that could have been used. However, based on facts and circumstances inherent in developing estimates and assumptions, management believes it is unlikely that applying other such estimates and assumptions would have caused materially different amounts to have been reported. Actual results may differ from these estimates.
Revenue Recognition
Sales of products are recognized when a sales agreement is in place, products have been shipped to unaffiliated customers and title has transferred in accordance with shipping terms, the selling price is fixed and determinable and collectability is reasonably assured, all significant related acts of performance have been completed, and no other significant uncertainties exist. Shipping and handling costs billed to customers are included in Net sales and the related costs in Cost of products sold. Although the majority of the sales agreements contain standard terms and conditions, there are agreements that contain multiple elements or non-standard terms and conditions. As a result, judgment is required to determine the appropriate accounting, including whether the deliverables specified in these agreements should be treated as separate units of accounting for recognition purposes, and, if so, how the sales price should be allocated among the elements and when to recognize sales for each element. For delivered elements, sales generally are recognized only when the delivered elements have standalone value and there are no uncertainties regarding customer acceptance. Sales for service contracts generally are recognized as the services are provided.
Eaton records reductions to revenue for customer and distributor incentives, primarily comprised of rebates, at the time of the initial sale. Rebates are estimated based on sales terms, historical experience, trend analysis and projected market conditions in the various markets served. The rebate programs offered vary across businesses due to the numerous markets Eaton serves, but the most common incentives relate to amounts paid or credited to customers for achieving defined volume levels.
Impairment of Goodwill and Other Long-Lived Assets
Goodwill
Goodwill is evaluated annually for impairment as of July 1 using either a quantitative or qualitative analysis. Goodwill is tested for impairment at the reporting unit level, which is equivalent to Eaton's operating segments and based on the net assets for each segment, including goodwill and intangible assets. Goodwill is assigned to each operating segment, as this represents the lowest level that constitutes a business and is the level at which management regularly reviews the operating results. The Company performs a quantitative analysis using a discounted cash flow model and other valuation techniques, but may elect to perform a qualitative analysis.
Additionally, goodwill is evaluated for impairment whenever an event occurs or circumstances change that would indicate that it is more likely than not that the fair value of an operating segment is less than its carrying amount. Events or circumstances that may result in an impairment review include changes in macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, other relevant entity-specific events, specific events affecting the reporting unit or sustained decrease in share price.
Goodwill impairment testing for 2017 was performed using a qualitative analysis, which is performed by assessing certain trends and factors that require significant judgment, including projected market outlook and growth rates, forecasted and actual sales and operating profit margins, discount rates, industry data, and other relevant qualitative factors. These trends and factors are compared to, and based on, the assumptions used in the most recent quantitative assessment. The results of these qualitative analyses did not indicate a need to perform a quantitative analysis.
Goodwill impairment testing for 2016 was performed using a quantitative analysis under which the fair value for each reporting unit was estimated using a discounted cash flow model, which considered forecasted cash flows discounted at an estimated weighted-average cost of capital. The forecasted cash flows were based on the Company's long-term operating plan and a terminal value was used to estimate the operating segment's cash flows beyond the period covered by the operating plan. The weighted-average cost of capital is an estimate of the overall after-tax rate of return required by equity and debt market holders of a business enterprise. These analyses require the exercise of significant judgments, including judgments about appropriate discount rates, perpetual growth rates and the timing of expected future cash flows of the respective reporting unit. Sensitivity analyses were performed in order to assess the reasonableness of the assumptions and the resulting estimated fair values.
Based on the qualitative analyses performed in 2017 and quantitative analysis performed in 2016, the fair values of Eaton's reporting units continue to substantially exceed their respective carrying amounts.
Indefinite Life Intangible Assets
Indefinite life intangible assets consist of certain trademarks. They are evaluated annually for impairment as of July 1 using either a quantitative or qualitative analysis to determine whether their fair values exceed their respective carrying amounts. Indefinite life intangible asset impairment testing for 2017 and 2016 was performed using a quantitative analysis. Determining the fair value of these assets requires significant judgment and the Company uses a royalty relief methodology similar to that employed when the associated assets were acquired, but using updated estimates of future sales, cash flows and profitability.
Additionally, indefinite life intangible assets are evaluated for impairment whenever an event occurs or circumstances change that would indicate that it is more likely than not that the asset is impaired. Events or circumstances that may result in an impairment review include changes in industry and market considerations, cost factors, financial performance, and other relevant entity-specific events that could affect inputs used to determine the respective fair values of the indefinite-lived intangible assets.
For 2017 and 2016, the fair value of indefinite lived intangible assets exceeded the respective carrying value.
Other Long-Lived Assets
Other long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. Events or circumstances that may result in an impairment review include operations reporting losses, a significant adverse change in the use of an asset, the planned disposal or sale of the asset, a significant adverse change in the business climate or legal factors related to the asset, or a significant decrease in the estimated market value of an asset. Upon indications of impairment, assets and liabilities are grouped at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities. The asset group would be considered impaired when the estimated future net undiscounted cash flows generated by the asset group are less than its carrying value. In instances where the carrying amount of the asset group exceeded the undiscounted cash flows, the fair value of the asset group would be determined and an impairment loss would be recognized based on the amount by which the carrying value of the asset group exceeds its fair value. Determining asset groups and underlying cash flows requires the use of significant judgment.
For additional information about goodwill and other intangible assets, see Note 5 to the Consolidated Financial Statements.
Recoverability of Deferred Income Tax Assets
Eaton is subject to the income tax laws in the jurisdictions in which it operates. In order to determine the income tax provision for financial statement purposes, Eaton must make significant estimates and judgments about its business operations in these jurisdictions. These estimates and judgments are also used in determining the deferred income tax assets and liabilities that have been recognized for differences between the financial statement and income tax basis of assets and liabilities, and income tax loss carryforwards and income tax credit carryforwards.
Management evaluates the realizability of deferred income tax assets for each jurisdiction in which it operates. If the Company experiences cumulative pretax income in a particular jurisdiction in a three-year period including the current and prior two years, management normally concludes that the deferred income tax assets will more likely than not be realizable and no valuation allowance is recognized, unless known or planned operating developments, or changes in tax laws, would lead management to conclude otherwise. However, if the Company experiences cumulative pretax losses in a particular jurisdiction in a three-year period including the current and prior two years, management then considers a series of factors in the determination of whether the deferred income tax assets can be realized. These factors include historical operating results, known or planned operating developments, the period of time over which certain temporary differences will reverse, consideration of the utilization of certain deferred income tax liabilities, tax law carryback capability in a particular country, prudent and feasible tax planning strategies, changes in tax laws, and estimates of future earnings and taxable income using the same assumptions as the Company’s goodwill and other impairment testing. After evaluation of these factors, if the deferred income tax assets are expected to be realized within the tax carryforward period allowed for that specific country, management would conclude that no valuation allowance would be required. To the extent that the deferred income tax assets exceed the amount that is expected to be realized within the tax carryforward period for a particular jurisdiction, management would establish a valuation allowance. For additional information about income taxes, see Note 9 to the Consolidated Financial Statements.
Pension and Other Postretirement Benefits Plans
The measurement of liabilities related to pension plans and other postretirement benefits plans is based on assumptions related to future events including interest rates, return on plan assets, rate of compensation increases, and health care cost trend rates. Actual plan asset performance will either reduce or increase losses included in accumulated other comprehensive loss, which ultimately affects net income.
The discount rate for United States plans was determined by discounting the expected future benefit payments using a theoretical zero-coupon spot yield curve derived from a universe of high-quality bonds as of the measurement date and solving for the single rate that generated the same benefit obligation. Only corporate bonds with a rating of Aa or higher by either Moody’s or Standard & Poor's were included. Callable bonds that are not make-whole bonds and certain other non-comparable bonds were eliminated. Finally, a subset of bonds was selected by grouping the universe of bonds by duration and retaining 50% of the bonds that had the highest yields.
The discount rates for non-United States plans were determined by region and are based on high quality long-term corporate and government bonds. Consideration has been given to the duration of the liabilities in each plan when selecting the bonds to be used in determining the discount rate.
In 2016, the Company adopted a change in the method it uses to estimate the service and interest cost components of net periodic benefit cost for its defined benefit pension and other postretirement benefit plans. Prior to 2016, for the vast majority of its plans, the service and interest cost components were estimated using a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. Beginning in 2016, the Company used a spot rate approach by applying the specific spot rates along the yield curve to the relevant projected cash flows in the estimation of the service and interest components of benefit cost, resulting in a more precise measurement. This change does not affect the measurement of total benefit obligations. The change was accounted for as a change in estimate and, accordingly, was accounted for prospectively starting in 2016. The reductions in service cost and interest cost for 2016 associated with this change in estimate were $3 and $42, respectively.
Key assumptions used to calculate pension and other postretirement benefits expense are adjusted at each year-end. A 1-percentage point change in the assumed rate of return on pension plan assets is estimated to have approximately a $46 effect on pension expense. Likewise, a 1-percentage point change in the discount rate is estimated to have approximately a $69 effect on pension expense. A 1-percentage point change in the assumed rate of return on other postretirement benefits assets is estimated to have approximately a $1 effect on other postretirement benefits expense. A 1-percentage point change in the discount rate is estimated to have approximately a $3 effect on expense for other postretirement benefits plans.
Additional information related to changes in key assumptions used to recognize expense for other postretirement benefits plans is found in Note 7 to the Consolidated Financial Statements.
Environmental Contingencies
As a result of past operations, Eaton is involved in remedial response and voluntary environmental remediation at a number of sites, including certain of its currently-owned or formerly-owned plants. The Company has also been named a potentially responsible party under the United States federal Superfund law, or the state equivalents thereof, at a number of disposal sites.
A number of factors affect the cost of environmental remediation, including the number of parties involved at a particular site, the determination of the extent of contamination, the length of time the remediation may require, the complexity of environmental regulations, and the continuing advancement of remediation technology. Taking these factors into account, Eaton has estimated the costs of remediation, which will be paid over a period of years. The Company accrues an amount on an undiscounted basis, consistent with the estimates of these costs, when it is probable that a liability has been incurred. At December 31, 2017 and 2016, $120 and $124, respectively, was accrued for these costs.
Based upon Eaton's analysis and subject to the difficulty in estimating these future costs, the Company expects that any sum it may be required to pay in connection with environmental matters is not reasonably possible to exceed the recorded liability by an amount that would have a material effect on its financial position, results of operations or cash flows.
MARKET RISK DISCLOSURE
On a regular basis, Eaton monitors third-party depository institutions that hold its cash and short-term investments, primarily for safety of principal and secondarily for maximizing yield on those funds. The Company diversifies its cash and short-term investments among counterparties to minimize exposure to any one of these entities. Eaton also monitors the creditworthiness of its customers and suppliers to mitigate any adverse impact.
Eaton uses derivative instruments to manage exposure to volatility in raw material costs, currency, and interest rates on certain debt instruments. Derivative financial instruments used by the Company are straightforward and non-leveraged. The counterparties to these instruments are financial institutions with strong credit ratings. Eaton maintains control over the size of positions entered into with any one counterparty and regularly monitors the credit rating of these institutions. See Note 13 to the Consolidated Financial Statements for additional information about hedges and derivative financial instruments.
Eaton’s ability to access the commercial paper market, and the related cost of these borrowings, is based on the strength of its credit rating and overall market conditions. The Company has not experienced any material limitations in its ability to access these sources of liquidity. At December 31, 2017, Eaton had $2,000 of long-term revolving credit facilities with banks in support of its commercial paper program. It has no borrowings outstanding under these credit facilities.
Interest rate risk can be measured by calculating the short-term earnings impact that would result from adverse changes in interest rates. This exposure results from short-term debt, which includes commercial paper at a floating interest rate, long-term debt that has been swapped to floating rates, and money market investments that have not been swapped to fixed rates. Based upon the balances of investments and floating rate debt at year end 2017, a 100 basis-point increase in short-term interest rates would have increased the Company’s net, pretax interest expense by $30.
Eaton also measures interest rate risk by estimating the net amount by which the fair value of the Company’s financial liabilities would change as a result of movements in interest rates. Based on Eaton’s best estimate for a hypothetical, 100 basis point decrease in interest rates at December 31, 2017, the market value of the Company’s debt and interest rate swap portfolio, in aggregate, would increase by $537.
The Company is exposed to currency risk associated with translating its functional currency financial statements into its reporting currency, which is the U.S. dollar. As a result, the Company is exposed to movements in the exchange rates of various currencies against the U.S. dollar. Eaton also monitors exposure to transactions denominated in currencies other than the functional currency of each country in which the Company operates, and regularly enters into forward contracts to mitigate that exposure. In the aggregate, Eaton’s portfolio of forward contracts related to such transactions was not material to its Consolidated Financial Statements.
CONTRACTUAL OBLIGATIONS
A summary of contractual obligations as of December 31, 2017 follows:
Interest expense related to long-term debt is based on the fixed interest rate, or other applicable interest rate, related to the debt instrument. The reduction of interest expense due to interest rate swap agreements related to long-term debt is based on the difference in the fixed interest rate the Company receives from the swap, compared to the floating interest rate the Company pays on the swap. Purchase obligations are entered into with various vendors in the normal course of business. These amounts include commitments for purchases of raw materials, outstanding non-cancelable purchase orders, releases under blanket purchase orders, and commitments under ongoing service arrangements. Other long-term obligations principally include anticipated contributions of $112 to pension plans in 2018 and $45 of deferred compensation earned under various plans for which the participants have elected to receive disbursement at a later date.
The table above does not include future expected pension benefit payments or expected other postretirement benefits payments. Information related to the amounts of these future payments is described in Note 7 to the Consolidated Financial Statements. The table above also excludes the liability for unrecognized income tax benefits, since the Company cannot predict with reasonable certainty the timing of cash settlements with the respective taxing authorities. At December 31, 2017, the gross liability for unrecognized income tax benefits totaled $735 and interest and penalties were $80.
FORWARD-LOOKING STATEMENTS
This Annual Report to Shareholders contains forward-looking statements concerning litigation and regulatory developments, expected pension or other post-retirement benefit payments, and rates of return and expected future liquidity. These statements may discuss goals, intentions and expectations as to future trends, plans, events, results of operations or financial condition, or state other information relating to Eaton, based on current beliefs of management as well as assumptions made by, and information currently available to, management. Forward-looking statements generally will be accompanied by words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “forecast,” “guidance,” “intend,” “may,” “possible,” “potential,” “predict,” “project” or other similar words, phrases or expressions. These statements should be used with caution and are subject to various risks and uncertainties, many of which are outside Eaton’s control. The following factors could cause actual results to differ materially from those in the forward-looking statements: unanticipated changes in the markets for the Company’s business segments; unanticipated downturns in business relationships with customers or their purchases from us; the availability of credit to customers and suppliers; competitive pressures on sales and pricing; unanticipated changes in the cost of material and other production costs, or unexpected costs that cannot be recouped in product pricing; the introduction of competing technologies; unexpected technical or marketing difficulties; unexpected claims, charges, litigation or dispute resolutions; strikes or other labor unrest; the impact of acquisitions and divestitures; unanticipated difficulties integrating acquisitions; new laws and governmental regulations; interest rate changes; tax rate changes or exposure to additional income tax liability; stock market and currency fluctuations; war, natural disasters, civil or political unrest or terrorism; and unanticipated deterioration of economic and financial conditions in the United States and around the world. Eaton does not assume any obligation to update these forward-looking statements.
QUARTERLY DATA (unaudited)
*Certain amounts have been adjusted to reflect the retrospective application of the Company's change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.
FIVE-YEAR CONSOLIDATED FINANCIAL SUMMARY (unaudited)
*Certain amounts for the years 2013 through 2016 have been adjusted to reflect the retrospective application of the Company's change in inventory accounting method, as described in Notes 1 and 14 to the consolidated financial statements.