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MULESOFT, INC

2018-02-22

2017-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Result of Operations You should read the following discussion and analysis of our financial condition and results of operations together with the section titled “Selected Consolidated Financial and Other Data” and the consolidated financial statements and related notes that are included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including, but not limited to, those set forth in the section titled “Risk Factors” and in other parts of this Annual Report on Form 10-K. Overview We are enabling a fundamental shift in organizations’ technology operating models by equipping them to create composable, agile infrastructures. Our customers use our Anypoint Platform to connect their applications, data and devices into an application network where IT assets are pluggable instead of glued together with custom integration code. The application network enables a self-serve infrastructure through discoverable building blocks that can be used and reused to rapidly compose applications. As a result, the IT organization delivers projects faster and lines of business are able to innovate and respond more rapidly. With an application network built with Anypoint Platform, organizations can transform into composable enterprises. We generate revenue primarily from sales of software subscriptions to our platform. Our subscription pricing is based primarily on the amount of computing capacity on which our customers run our software. We offer the same capacity-based pricing model regardless of whether customers choose to deploy our platform on-premises or in the cloud. Our subscriptions are term-based, and we recognize revenue from subscriptions ratably over the subscription term. The substantial majority of our subscription and support revenue is derived from subscriptions that are one year in duration and invoiced upfront, although a growing number of our customers are entering into multi-year subscriptions that are invoiced annually. When we enter into a multi-year subscription, we typically invoice the customer on an annual basis. We also generate revenue from professional services, which consist primarily of fees associated with consulting and training services. Revenue derived from professional services is generally recognized ratably as the services are rendered. We will continue to invest in our professional services organization because we believe it plays an important role in accelerating our customers’ realization of the benefits of the platform, which helps to drive customer retention and expansion. A significant percentage of our customers purchase our professional services when they enter into new or expanded subscriptions. As of December 31, 2017, we had over 1,200 customers located in over 60 countries across every major industry. We sell to organizations worldwide primarily through our direct sales efforts. Although our platform can be adopted by organizations of nearly any size, we focus our sales efforts on the largest global organizations. Our sales efforts are targeted towards CIOs, chief IT architects, and line of business leaders, who are driving digital transformation. We also partner with SIs that enhance our sales leverage by sourcing new prospects and providing systems integration services on implementations of our platform. Historically, customers have expanded their spend with us over time as they realize the benefits of speed and innovation that come with our platform. Our customers expand the use of our platform in two ways. First, they deploy additional capacity as the usage of applications built on our platform increases. Second, as they address additional use cases with their application network, their usage of our platform further increases. The expanded use of our platform by our customers is evidenced by our high dollar-based net retention rate. We have grown rapidly in recent periods. Our revenue for the years ended December 31, 2017, 2016, and 2015 was $296.5 million, $187.7 million, and $110.3 million, respectively, representing a growth rate of 58% and 70%, respectively. We incurred net losses of $80.0 million, $49.6 million, and $65.4 million in the years ended December 31, 2017, 2016, and 2015, respectively. We have made substantial investments in developing our platform, expanding our sales, services, and marketing capabilities, and providing general and administrative resources to support our growth. Specifically, we have increased our headcount from 841 employees as of December 31, 2016 to 1,188 employees as of December 31, 2017. We intend to continue to invest heavily to grow our business to take advantage of our expansive market opportunity rather than optimizing for profitability or cash flow in the near future. Key Metrics We monitor the following key metrics to help us evaluate our business, identify trends affecting our business, formulate business plans, and make strategic decisions. We believe the following metrics are useful in evaluating our business. Customers. We believe that the number of customers is a key metric because our ability to attract new customers and grow our customer base helps drive our success and is an important contributor to the growth in our revenue. We have successfully demonstrated a history of growing both our customer base and spend per customer through increased use of our platform. As our sales force continues to focus on selling Anypoint Platform to large organizations, we expect the rate of increase in customer growth to decline, but we expect our sales model will drive higher average subscription and support revenue per customer. We define the number of customers at the end of any particular period as the number of parties or organizations that have entered into a subscription contract with us for which the term has not ended, or with which we are negotiating a renewal contract. Each party with which we have entered into a subscription contract is considered a unique customer, and in some cases, there may be more than one customer within a single organization. Although customers can elect not to renew their subscriptions by providing prior written notice to us, our subscription contracts typically have automatic renewal provisions that become effective on the expiration of a subscription contract. To the extent that we are negotiating a renewal with a customer after the expiration of the subscription contract, we continue to count such organization as a customer for a period of four months if we are actively in discussion with such organization for a new subscription contract or a contract renewal, or until such organization notifies us that it is not renewing its subscription contract, if earlier. The following table sets forth the number of customers: Average Subscription and Support Revenue per Customer. We believe that average subscription and support revenue per customer is a key metric because it is a reflection of our customers’ growing commitment to our platform and our sales force’s productivity. We define average subscription and support revenue per customer as subscription and support revenue for a trailing 12-month period divided by the number of customers as of the end of the period. The following table sets forth the average subscription and support revenue per customer: Dollar-Based Net Retention Rate. We believe that dollar-based net retention rate is a key metric to measure the long-term value of our customer relationships and is driven by our ability to retain and expand the subscription and support revenue generated from our existing customers. Our dollar-based net retention rate compares our subscription and support revenue from the same set of customers across comparable periods. We calculate our dollar-based net retention rate for all periods on a trailing four-quarter basis. To calculate our dollar-based net retention rate, we first calculate the subscription and support revenue in one quarter from a cohort of customers that were customers at the beginning of the same quarter in the prior fiscal year, or Cohort Customers. We repeat this calculation for each quarter in the trailing four-quarter period. The numerator for dollar-based net retention rate is the sum of subscription and support revenue from Cohort Customers for the four most recent quarters, or Numerator Period, and the denominator is the sum of subscription and support revenue from Cohort Customers for the four quarters preceding the Numerator Period. Dollar-based net retention rate is the quotient obtained by dividing the numerator by the denominator. Our dollar-based net retention rate may fluctuate as a result of a number of factors, including our customers’ satisfaction or dissatisfaction with our platform, the increase in the contract value of subscription and support contracts from new customers, and the other risk factors included in this Annual Report on Form 10-K. The following table sets forth the dollar-based net retention rates: Components of Results of Operations Revenue. We generate revenue from the following sources: (i) subscription and support revenue, which is comprised of subscription fees from customers accessing our cloud-hosted software and from term-based licenses of our software and support services; and (ii) professional services and other revenue, which consists primarily of fees associated with consulting and training services related to the implementation and configuration of our platform. We recognize subscription and support revenue from our cloud-hosted software ratably over the term of the arrangement. Term-based licenses are sold with support services and are recognized ratably over the life of the license or support period. Our subscriptions are typically one year in duration, although a growing number of our customers are entering into multi-year subscriptions. We generally invoice our customers in annual installments at the beginning of each year in the subscription period. Amounts that have been invoiced are initially recorded as deferred revenue and are recognized ratably over the subscription period. Professional services and other revenue is generally recognized as the services are rendered for time-and-material contracts or on a proportional performance basis for fixed-price contracts. Revenue from professional services sold exclusively with term-based licenses is recognized over the term of the subscription. We will continue to invest in our professional services because we believe that it plays an important role in enabling our customers to achieve success on our platform and accelerate their realization of its benefits, which helps to drive retention of, and expansion with, our customers. Cost of Revenue. Cost of revenue for subscription and support consists primarily of cloud-hosting costs and personnel-related costs of our customer support organization, including salaries, bonuses, benefits, stock-based compensation, commissions, and other compensation related to the equity transactions described below, as well as contractor costs to supplement our staff levels, third-party software royalties, and allocated overhead. Cost of revenue for professional services and other revenue consists primarily of personnel-related costs of our consulting and training departments, including salaries, bonuses, benefits, stock-based compensation, commissions, and other compensation related to the equity transactions described below, as well as contractor costs to supplement our staff levels, and allocated overhead. Gross Profit and Gross Margin. Gross profit, or total revenue less total cost of revenue, and gross margin, or gross profit as a percentage of total revenue, has been and will continue to be affected by various factors, including the mix among our subscription and support and professional services and other revenue, the costs associated with third-party hosting services for our cloud-based subscriptions, and the extent to which we expand our customer support and professional services organizations. Our gross margin on subscription and support revenue is significantly higher than our gross margin on professional services and other revenue. We expect our gross margin will fluctuate from period to period depending on the interplay of these various factors. Operating Expenses. Our operating expenses consist of research and development, sales and marketing, and general and administrative expenses. The most significant component of each of our operating expense categories is personnel-related costs, including salaries, bonuses, benefits, stock-based compensation, and other compensation related to the equity transactions described below, and with respect to sales and marketing, sales commissions and incentives. Research and Development Expenses. Research and development expenses consist primarily of personnel-related costs for the design and development of our platform and technologies, contractor costs to supplement our staff levels, third-party web services, consulting services, costs associated with our company-wide meeting, and allocated overhead. We expense research and development expenses as they are incurred. Historically, a significant percentage of our research and development has been conducted by our personnel in Argentina, which has provided a substantial cost-advantage in research and development expenses. We expect our research and development expenses to increase in absolute dollars and may fluctuate as a percentage of our total revenue from period to period, as we expand our research and development team to develop new products and product enhancements. Sales and Marketing Expenses. Our sales and marketing expenses consist primarily of personnel-related costs for our sales and marketing employees, marketing programs including trade shows, costs associated with our company-wide meeting, and allocated overhead. We expect that our sales and marketing expenses will increase in absolute dollars and may fluctuate as a percentage of our total revenue from period to period as we hire additional sales and marketing personnel, increase our marketing activities, grow our domestic and international operations, and build brand awareness. General and Administrative Expenses. Our general and administrative expenses consist primarily of personnel-related costs for executive, finance, legal, human resources, recruiting and administrative personnel, as well as professional fees for external legal, accounting, recruiting and other consulting services, costs associated with our company-wide meeting, and allocated overhead. We expect to continue to incur additional general and administrative expenses as a result of operating as a public company, including expenses related to compliance with the rules and regulations of the SEC and listing standards of the New York Stock Exchange, additional insurance expenses, investor relations activities and other administrative and professional services. We also expect to increase the size of our general and administrative function to support the growth of our business. As a result, we expect that our general and administrative expenses will increase in absolute dollars and may fluctuate as a percentage of our total revenue from period to period. Interest Income. Interest income consists primarily of income earned on our cash equivalents and investments in marketable securities. Other Expense, Net. Other expense, net consists primarily of foreign currency transaction gains and losses related to the impact of transactions denominated in a foreign currency other than the functional currencies of our legal entities. As we have expanded our international operations, our exposure to fluctuations in foreign currencies has increased, and we expect this to continue. Income Tax Expense. Provision for income taxes consists primarily of income taxes in certain foreign jurisdictions in which we conduct business. As we have expanded our international operations, we have incurred increased foreign tax expense, and we expect this to continue. We have a full valuation allowance for net deferred tax assets, including net operating loss carryforwards, and tax credits related primarily to research and development for our operations in the United States. We expect to maintain this full valuation allowance for the foreseeable future. We also have deferred tax assets or liabilities in certain of our foreign subsidiaries including in the United Kingdom, Argentina and Australia. Equity Transactions. In the third quarter of 2015, following our Series G convertible preferred stock financing, we repurchased shares from certain of our eligible employees and board members (the "2015 Common Stock Repurchase"). A total of 2,224,222 shares of common stock were tendered for a total purchase price of $25.0 million. The price paid up to the fair value of our common stock, totaling $15.9 million, was accounted for as a reduction to equity. The premium that we paid over the fair value of the shares, totaling $9.1 million, was recorded as other compensation expense. In the third quarter of 2016, certain of our eligible employees, board members and funds affiliated with board members sold shares to third-party investors (the "2016 Tender Offer"). A total of 4,346,203 shares of common stock were tendered for a total purchase price of $61.6 million. The premium over the fair value of the shares of common stock that was paid by third parties to eligible employees and board members, totaling $9.9 million, was recorded as other compensation expense. The excess of the sale price of the shares of convertible preferred stock sold by funds affiliated with board members over the fair value of our common stock, totaling $9.4 million, was recorded as a deemed dividend within additional paid-in capital. Results of Operations The following table sets forth our results of operations for the periods indicated: (1) Includes stock-based compensation expense as follows (in thousands): (2) Includes other compensation expense related to the 2015 Common Stock Repurchase and 2016 Tender Offer as follows (in thousands): The following table sets forth the consolidated statements of operations data for each of the periods presented as a percentage of total revenue: Comparison of the Years Ended December 31, 2017 and 2016 Revenue Subscription and support revenue increased by $85.1 million, or 56%, to $238.0 million during 2017, from $152.8 million during 2016. The increase was attributable to increased sales of subscriptions to new customers and expanded use of our platform by existing customers. Our total number of customers increased from 1,071 as of December 31, 2016 to 1,286 as of December 31, 2017. Professional services and other revenue increased by $23.6 million, or 68%, to $58.5 million during 2017, from $34.9 million during 2016. The increase was primarily attributable to the increase in consulting services to support our larger customer base. Cost of Revenue and Gross Margin Cost of revenue for subscription and support increased by $6.3 million or 46%, to $20.0 million during 2017, from $13.7 million during 2016. The increase was primarily due to an increase of $2.9 million in personnel-related expenses, which included an increase in headcount and an increase of $0.7 of related stock-based compensation expense. In addition, there was also an increase of $2.1 million in third-party cloud hosting costs, an increase of $0.8 million in facility and IT related expenses, an increase of $0.7 million for software subscriptions, an increase in direct cost of goods of $0.6 million and an increase of $0.3 million in depreciation of fixed assets and the amortization of intangibles, partially offset by a decrease of $1.1 million in contractor costs. Cost of revenue for professional services and other increased by $25.9 million, or 73%, to $61.3 million during 2017, from $35.3 million during 2016. The increase was primarily due to an increase in personnel-related costs of $12.2 million, which included an increase in headcount and an increase in stock-based compensation expense of $2.9 million, partially offset by a decrease of other compensation expense of $0.1 million related to the 2016 Tender Offer. In addition, there was also an increase of $9.1 million in contractor costs to supplement our staffing, an increase in of $2.4 million in facility and IT related expenses, an increase of $1.8 million in travel and related expenses and an increase of $0.2 million for software subscriptions. Operating Expenses Research and Development Research and development expenses increased by $31.7 million, or 97%, to $64.6 million during 2017, from $32.9 million during 2016. The increase was primarily attributable to an increase in personnel-related costs of $17.8 million, which included an increase in headcount and an increase of $5.3 million of related stock-based compensation expense, partially offset by a decrease in other compensation expense of $1.2 million related to the 2016 Tender Offer. In addition, there was also an increase of $6.3 million in contractor costs, an increase of $4.1 million in facility and IT related expenses, an increase of $2.7 million in third-party cloud-hosting costs for internal use, an increase of $0.5 million for software subscriptions and an increase of $0.3 million in costs incurred for the company-wide meeting held during the first half of 2017 and other expenses. Sales and Marketing Sales and marketing expenses increased by $62.0 million, or 51%, to $184.6 million during 2017 from $122.6 million during 2016. The increase was primarily attributable to an increase in personnel-related costs of $42.1 million, which included an increase in headcount and an increase of $9.9 million of related stock-based compensation expense, partially offset by a decrease in other compensation expense of $5.9 million related to the 2016 Tender Offer. In addition, there was also an increase of $7.8 million in facility and IT related expenses, an increase of $5.3 million in marketing programs costs, an increase of $3.5 million in travel and related expenses, an increase of $1.4 million for software subscriptions, an increase of $0.9 million in costs incurred for the company-wide meeting in the first half of 2017 and other internal meetings and an increase of $0.8 million in contractor costs. General and Administrative General and administrative expenses increased by $14.2 million, or 45%, to $45.8 million during 2017 from $31.6 million during 2016. The increase was primarily attributable to an increase in personnel-related costs of $10.7 million, which included an increase in headcount and an increase of $2.8 million of related stock-based compensation expense, partially offset by a decrease in other compensation expense of $2.7 million related to the 2016 Tender Offer. In addition, there was an increase of $2.7 million in contractor costs to supplement our staffing. Interest Income Interest income was $2.5 million in 2017 compared to $0.5 million in 2016. The increase was primarily related to the increase in interest rates beginning in December 31, 2016, resulting in increased interest income earned from our investments in U.S. Treasuries. In addition, we had more cash, cash equivalents, and investments as a result of the IPO which led to increased interest income in 2017 compared to 2016. Other Expense, Net Other expense, net was $1.0 million in 2017 compared to $0.3 million in 2016. The change was primarily related to foreign currency fluctuations. Provision for Income Taxes Provision for income taxes for each period was primarily attributable to foreign taxes incurred by certain non-U.S. subsidiaries and foreign withholding taxes. Comparison of the Years Ended December 31, 2016 and 2015 Revenue Subscription and support revenue increased by $64.7 million, or 73%, to $152.8 million during 2016, from $88.1 million during 2015. Approximately 60% of the increase was attributable to the expanded use of our platform by existing customers, and the remainder was attributable to sales of subscriptions to new customers. Our total number of customers increased from 839 as of December 31, 2015 to 1,071 as of December 31, 2016. Professional services and other revenue increased by $12.7 million, or 58%, to $34.9 million during 2016, from $22.2 million during 2015. The increase was primarily attributable to the increase in consulting services to support our larger customer base. Cost of Revenue and Gross Margin Cost of revenue for subscription and support increased by $6.2 million, or 82%, to $13.7 million during 2016, from $7.5 million during 2015. The increase was primarily due to an increase of $2.2 million in third-party cloud-hosting costs, an increase of $1.5 million in personnel-related expenses, primarily due to an increase in headcount, as well as an increase of $1.4 million in contractor costs and an increase of $0.3 million in royalty costs. Cost of revenue for professional services and other increased by $10.7 million, or 43%, to $35.3 million during 2016, from $24.6 million during 2015. The increase was primarily due to an increase in personnel-related costs of $5.8 million, primarily due to an increase in headcount, as well as an increase of $2.9 million in contractor costs to supplement our staffing and an increase in travel costs of $1.0 million. Gross margin improved during 2016, as we experienced increased leverage from our professional services organization and, to a lesser extent, an increase in subscription and support revenue, which carries a higher gross margin than professional services. Operating Expenses Research and Development Research and development expenses increased by $8.1 million, or 33%, to $32.9 million during 2016, from $24.7 million during 2015. The increase was primarily attributable to an increase in personnel-related costs of $4.7 million, primarily due to an increase in headcount. These costs included an increase of $1.1 million of stock-based compensation expense offset by a reduction of $0.8 million in other compensation expense from the equity transactions described above. In addition, there was also an increase of $1.5 million in third-party cloud-hosting costs for internal use, an increase of $0.6 million in outside contractor costs, and $0.4 million in costs incurred for the company-wide meeting held in February 2016. Sales and Marketing Sales and marketing expenses increased by $29.6 million, or 32%, to $122.6 million during 2016 from $93.1 million during 2015. The increase was primarily attributable to an increase in personnel-related costs of $22.2 million, primarily due to an increase in headcount, including an increase of $8.2 million in commissions. These costs included an increase of $2.6 million in other compensation expense from the equity transactions described above and an increase of $1.1 million in stock- based compensation expense. In addition, there was also an increase of $3.2 million in marketing costs related to advertising, and domestic and international tradeshows, $1.4 million in travel and entertainment costs, and $1.0 million in costs incurred for the company-wide meeting held in 2016. General and Administrative General and administrative expenses increased by $7.2 million, or 30%, to $31.6 million during 2016 from $24.4 million during 2015. The increase was primarily attributable to an increase in personnel-related costs of $3.2 million, primarily due to an increase in headcount. These costs included an increase of $0.5 million in stock-based compensation expense offset by a $1.0 million reduction in other compensation expense from the equity transactions described above. The increase was also attributable to an increase of $1.0 million in professional services for legal and accounting services, $0.9 million in recruiting costs as we hired additional staff to support our growth, $0.5 million in costs incurred for the company-wide meeting held in 2016, and an increase of $0.4 million in software subscription costs for our operations. Interest Income Interest income was $0.5 million in 2016 compared to $0.2 million in 2015. The increase was primarily related to an increase in our invested funds due to the proceeds from the Series G preferred stock financing completed in May 2015. Other Expense, Net Other expense, net was $0.3 million in 2016 compared to $0.7 million in 2015. The change was primarily related to foreign currency fluctuations. Provision for Income Taxes Provision for income taxes for each period was primarily attributable to foreign taxes incurred by certain non-U.S. subsidiaries and foreign withholding taxes. In 2015, we sold the non-U.S. rights to certain intellectual property to one of our non-U.S. subsidiaries. The resulting tax gain in our U.S. entity was offset by current year net operating losses and thus resulted in no current tax liability. Further, this transaction had no net impact on our 2015 deferred taxes or effective tax rate given our full valuation allowance on the net operating losses used to offset the gain. Our decision to move certain intellectual property outside of the United States is not expected to materially impact our effective tax rate for the foreseeable future as we continue to generate net operating losses in the United States and the non-U.S. subsidiary to which we sold certain intellectual property. Quarterly Results of Operations The following tables set forth our unaudited quarterly consolidated statements of operations data for each of the quarters indicated, as well as the percentage that each line item represents of our total revenue for each quarter presented. The information for each quarter has been prepared on a basis consistent with our audited consolidated financial statements included in this Annual Report on Form 10-K, and reflect, in the opinion of management, all adjustments of a normal, recurring nature that are necessary for a fair presentation of the financial information contained in those statements. Our historical results are not necessarily indicative of the results that may be expected in the future. The following quarterly financial data should be read in conjunction with our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. (1) Includes stock-based compensation expense as follows (in thousands): (2) Includes other compensation expense as follows (in thousands): (1) See the section titled “-Key Metrics” for additional information about our key metrics. Liquidity and Capital Resources To date, our principal sources of liquidity have been the net proceeds we received through the sale of our Class A common stock in our initial public offering, private sales of equity securities, as well as payments received from customers using our platform and services. As of December 31, 2017, we had cash, cash equivalents, and investments totaling $347.3 million, which we intend to use for working capital, operating expenses, and capital expenditures. We may also use a portion of these funds to acquire complementary businesses, products, services, or technologies. Our cash equivalents are comprised primarily of bank deposits and money market funds, and our investments are comprised of marketable securities such as commercial paper, corporate bonds, foreign bonds and U.S. Treasury securities. We believe that our existing cash, cash equivalents, and investments will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. We plan to continue to finance our operations from customers paying for our platform and services. However, our liquidity assumptions may prove to be incorrect, and we could utilize our available financial resources sooner than we currently expect. Our future capital requirements and the adequacy of available funds will depend on many factors, including those set forth in the section of this Annual Report on Form 10-K titled “Risk Factors.” We cannot assure you that we will be able to raise additional capital on acceptable terms or at all. In addition, if we fail to meet our operating plan during the next 12 months, our liquidity and ability to operate our business could be adversely affected. Cash Flows The following table summarizes our cash flows for the periods indicated (in thousands): Cash Flows from Operating Activities During 2017, cash provided by operating activities was $2.0 million, which consisted of a net loss of $80.0 million, adjusted by non-cash charges of $32.9 million and a net change of $49.1 million in our net operating assets and liabilities. The non-cash charges are primarily comprised of stock based-based compensation of $28.1 million, depreciation and amortization of $3.8 million and amortization of investment premiums of $0.8 million. The change in our net operating assets and liabilities was primarily due to an increase in deferred revenue of $76.0 million due to the timing of billings in advance of revenue recognition primarily for subscription and support, an increase in accrued compensation of $12.8 million due to higher commissions payable at year end, an increase in accounts payable and accrued expenses of $5.0 million due to an increase in operating expenses and timing of payments and an increase in other liabilities of $1.6 million, partially offset by an increase in accounts receivable of $39.7 million due to the timing of receipts of payments from customers and an increase in prepaid expenses and other assets of $6.7 million due to payments for software subscriptions to our cloud infrastructure provider. During 2016, cash used in operating activities was $2.4 million, which consisted of a net loss of $49.6 million, adjusted by non-cash charges of $19.6 million and a net change of $27.7 million in our net operating assets and liabilities. The non-cash charges are primarily comprised of other compensation expense related to the 2016 Tender Offer of $9.9 million, stock based-based compensation of $6.6 million, depreciation and amortization of $1.9 million, amortization of investment premiums of $0.6 million, tax benefits from employee stock plans of $0.3 million and provision for doubtful accounts of $0.2 million. The change in our net operating assets and liabilities was primarily due to an increase in deferred revenue of $51.9 million due to the timing of billings and cash received in advance of revenue recognition primarily for subscription and support services, an increase in accrued compensation of $4.7 million due to higher commissions payable at year end, an increase in accounts payable and accrued expenses of $2.2 million due to an increase in operating expenses and timing of payments and an increase in other liabilities of $1.1 million due to an increase in deferred rent, partially offset by an increase in accounts receivable of $25.1 million due to the timing of receipts of payments from customers and an increase in prepaid expenses and other current assets of $6.8 million due to payments for software subscriptions to our cloud infrastructure provider. During 2015, cash used in operating activities was $47.0 million, which consisted of a net loss of $65.4 million, adjusted by non-cash charges of $5.4 million and a change of $13.0 million in our net operating assets and liabilities. The non-cash charges were primarily comprised of stock-based compensation of $3.3 million, depreciation and amortization of $1.2 million, amortization of investment premiums of $0.6 million, tax benefits from employee stock plans of $0.2 million and a loss on disposal of property and equipment for $0.2 million. The change in our net operating assets and liabilities was primarily due to an increase in deferred revenue of $35.6 million due to the timing of billings and cash received in advance of revenue recognition primarily for subscription and support, an increase in accrued compensation and related expenses of $5.0 million due to an increase in headcount and revenue in 2015, and an increase in accrued expenses of $1.6 million, partially offset by an increase in trade receivables of $21.1 million due to an increase in the number of customers invoiced during the period, an increase in prepaid expenses and other current assets of $6.5 million, and a decrease in accounts payable of $1.3 million due to the timing of invoices from vendors and related payments. Cash Flows from Investing Activities During 2017, cash used in investing activities was $207.2 million, primarily consisting of purchases of investments of $319.7 million and payments for purchases of property and equipment of $4.8 million, consisting primarily of leasehold improvements and, to a lesser extent, the purchase of computers for personnel, partially offset by sales and maturities of investments of $117.4 million. During 2016, cash provided by investing activities was $17.5 million, primarily consisting of sales and maturities of investments of $64.2 million, partially offset by purchases of investments of $41.2 million, purchases of property and equipment of $4.5 million, consisting primarily of leasehold improvements and, to a lesser extent, the purchase of computers for personnel, and $1.0 million used for the acquisition of Express Service Gateway (ESG). During 2015, cash used in investing activities was $93.2 million, primarily consisting of purchases of investments of $106.2 million and purchases of property and equipment of $1.5 million. These outflows were partially offset by sales and maturities of investments of $14.5 million. Cash Flows from Financing Activities During 2017, cash provided by financing activities was $249.6 million which consisted of proceeds from the issuance of common stock in connection with our initial public offering of $236.4 million, proceeds from the issuance of common stock upon exercise of stock options and warrants of $8.0 million and proceeds from our 2017 Employee Stock Purchase Plan of $7.0 million, partially offset by $1.8 million of costs related to the initial public offering. During 2016, cash used in financing activities was $0.7 million consisting of $3.2 million in cash used for the repurchase of common stock and $1.7 million in payments of deferred offering costs partially offset by proceeds from the issuance of common stock upon exercise of stock options of $4.3 million. During 2015, cash provided by financing activities was $112.3 million consisting of net proceeds of $126.3 million from the issuance of Series G preferred stock and proceeds of $1.9 million from the issuance of common stock upon the exercise of stock options and warrants, partially offset by $15.9 million for the repurchase of common stock. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Contractual Obligations The following table summarizes our non-cancellable contractual obligations as of December 31, 2017 (in thousands): (1) Purchase obligations represent total future minimum payments under our contract with our cloud infrastructure provider.

<s>[INST] Overview We are enabling a fundamental shift in organizations’ technology operating models by equipping them to create composable, agile infrastructures. Our customers use our Anypoint Platform to connect their applications, data and devices into an application network where IT assets are pluggable instead of glued together with custom integration code. The application network enables a selfserve infrastructure through discoverable building blocks that can be used and reused to rapidly compose applications. As a result, the IT organization delivers projects faster and lines of business are able to innovate and respond more rapidly. With an application network built with Anypoint Platform, organizations can transform into composable enterprises. We generate revenue primarily from sales of software subscriptions to our platform. Our subscription pricing is based primarily on the amount of computing capacity on which our customers run our software. We offer the same capacitybased pricing model regardless of whether customers choose to deploy our platform onpremises or in the cloud. Our subscriptions are termbased, and we recognize revenue from subscriptions ratably over the subscription term. The substantial majority of our subscription and support revenue is derived from subscriptions that are one year in duration and invoiced upfront, although a growing number of our customers are entering into multiyear subscriptions that are invoiced annually. When we enter into a multiyear subscription, we typically invoice the customer on an annual basis. We also generate revenue from professional services, which consist primarily of fees associated with consulting and training services. Revenue derived from professional services is generally recognized ratably as the services are rendered. We will continue to invest in our professional services organization because we believe it plays an important role in accelerating our customers’ realization of the benefits of the platform, which helps to drive customer retention and expansion. A significant percentage of our customers purchase our professional services when they enter into new or expanded subscriptions. As of December 31, 2017, we had over 1,200 customers located in over 60 countries across every major industry. We sell to organizations worldwide primarily through our direct sales efforts. Although our platform can be adopted by organizations of nearly any size, we focus our sales efforts on the largest global organizations. Our sales efforts are targeted towards CIOs, chief IT architects, and line of business leaders, who are driving digital transformation. We also partner with SIs that enhance our sales leverage by sourcing new prospects and providing systems integration services on implementations of our platform. Historically, customers have expanded their spend with us over time as they realize the benefits of speed and innovation that come with our platform. Our customers expand the use of our platform in two ways. First, they deploy additional capacity as the usage of applications built on our platform increases. Second, as they address additional use cases with their application network, their usage of our platform further increases. The expanded use of our platform by our customers is evidenced by our high dollarbased net retention rate. We have grown rapidly in recent periods. Our revenue for the years ended December 31, 2017, 2016, and 2015 was $296.5 million, $187.7 million, and $110.3 million, respectively, representing a growth rate of 58% and 70%, respectively. We incurred net losses of $80.0 million, $49.6 million, and $65.4 million in the years ended December 31, 2017, 2016, and 2015, respectively. We have made substantial investments in developing our platform, expanding our sales, services, and marketing capabilities, and providing general and administrative resources to support our growth. Specifically, we have increased our headcount from 841 employees as of December 31, 2016 to 1,188 employees as of December 31, 2017. We intend to continue to invest heavily to grow our business to take advantage of our expansive market opportunity rather than optimizing for profitability or cash flow in the near future. Key Metrics We monitor the following key metrics to help us evaluate our business, identify trends affecting our business, formulate business plans, and make strategic decisions. We believe the following metrics are useful in evaluating our business. Customers. We believe that the number of customers is a key metric because our ability to attract new customers and grow our customer base helps drive our success and is an important contributor to the growth in our revenue. We have successfully demonstrated a history of growing both our customer base and spend per customer through increased use of our platform [/INST] Negative. </s>

CURO Group Holdings Corp.

2018-03-13

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ("MD&A") The following discussion of financial condition, results of operations, liquidity and capital resources, and certain factors that may affect future results, including economic and industry-wide factors, should be read in conjunction with our Consolidated Financial Statements and accompanying notes included herein. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. The matters discussed in these forward-looking statements are subject to risk, uncertainties, and other factors that could cause actual results to differ materially from those made, projected or implied in the forward-looking statements. Except as required by applicable law and regulations, we undertake no obligation to update any forward-looking statements or other statements we may make in the following discussion or elsewhere in this document even though these statements may be affected by events or circumstances occurring after the forward-looking statements or other statements were made. Please see the section titled “Risk Factors” in this Annual Report for a discussion of the uncertainties, risks and assumptions associated with these statements. Overview We are a growth-oriented, technology-enabled, highly-diversified consumer finance company serving a wide range of underbanked consumers in the United States, Canada and the United Kingdom and are a market leader in our industry based on revenues. We believe that we have the only true omni-channel customer acquisition, onboarding and servicing platform in our industry that is integrated across store, online, mobile and contact center touchpoints. Our IT platform, which we refer to as the “Curo Platform,” seamlessly integrates loan underwriting, scoring, servicing, collections, regulatory compliance and reporting activities into a single, centralized system. We use advanced risk analytics powered by proprietary algorithms and over 15 years of loan performance data to efficiently and effectively score our customers’ loan applications. Since 2010, we have extended $14.5 billion in total credit across approximately 38.1 million total loans, and our revenue of $963.6 million in 2017 represents a 24.8% compound annual growth rate, or CAGR, over the same time period. We operate in the United States under two principal brands, “Speedy Cash” and “Rapid Cash,” and launched our new brand “Avio Credit” in the United States in the second quarter of 2017. In the United Kingdom we operate online as “Wage Day Advance” and "Juo Loans" and, prior to their closure in the third quarter of 2017, our stores were branded “Speedy Cash.” In Canada, our stores are branded “Cash Money” and we offer “LendDirect” installment loans online. As of December 31, 2017, our store network consisted of 407 locations across 14 U.S. states and seven Canadian provinces. As of December 31, 2017, we offered our online services in 27 U.S. states, five Canadian provinces, and the United Kingdom. Recent Developments We completed our initial public offering ("IPO") of 6,666,667 shares of common stock on December 11, 2017, at a price of $14.00 per share, which provided net proceeds of $81.1 million. In connection with the closing, the underwriters had a 30-day option to purchase up to an additional 1,000,000 shares at the initial public offering price, less the underwriting discount to over-allotments, which they exercised on January 5, 2018, which provided additional net proceeds of $13.0 million. On February 5, 2018 CURO Financial Technologies Corp. (“CFTC”), a wholly-owned subsidiary of the Company, issued a notice of redemption for $77.5 million of its 12.00% Senior Secured Notes due 2022 (the “Notes,” and the transaction whereby the Notes are partially redeemed, the “Redemption”) that were issued by CFTC. The redemption was completed on March 7, 2018. The redemption price was equal to 112.00% of the principal amount of the Notes redeemed, plus accrued and unpaid interest paid thereon, to the date of redemption. Following the Redemption, $527.5 million of the original outstanding principal amount of the Notes remain outstanding. The Redemption was conducted pursuant to the Indenture governing the Notes (the “Indenture”), dated as of February 15, 2017, by and among CFTC, the guarantors party thereto and TMI Trust Company, as trustee and collateral agent. Consistent with the terms of the Indenture, CFTC used a portion of the cash proceeds from the Company’s initial public offering, completed on December 11, 2017, to redeem such Notes. Components of Our Results of Operations Revenue We offer a variety of loan products including Installment, Open-End and Single-Pay Loans. Revenue in our Consolidated Statements of Income includes: interest income, finance charges, CSO fees, late fees and non-sufficient funds fees as permitted by applicable laws and pursuant to the agreement with the customer. Product offerings differ by jurisdiction and are governed by the laws in each separate jurisdiction. Installment Loans are fully amortizing loans with a fixed payment amount due each period during the term of the loan. We record revenue from Installment Loans on a simple-interest basis. Accrued interest and fees are included in gross loans receivable in the Consolidated Balance Sheets. Open-End Loans are a revolving line-of-credit with no defined loan term. We record revenue from Open-End Loans on a simple-interest basis. Accrued interest and fees are included in gross loans receivable in the Consolidated Balance Sheets. Single-Pay Loans are primarily payday loans. Revenues from Single-Pay loan products are recognized each period on a constant-yield basis ratably over the term of each loan. We defer recognition of unearned fees based on the remaining term of the loan at the end of each reporting period. We also provide a number of ancillary financial products including check cashing, proprietary reloadable prepaid debit cards (Opt+), money transfer services, gold buying, credit protection insurance in the Canadian market, and retail installment sales. Provision for Losses We calculate provision for losses based on evaluation of the historical and expected cumulative net losses inherent in the underlying loan portfolios, by vintage, and several other quantitative and qualitative factors. We apply the resulting loss provision rate to our loan originations to determine the provision for losses. Accordingly, at the time we originate a loan, we recognize a loss on a portion of the loan balance based upon the applicable loss provision rate. We would then recognize any revenue in connection with that loan over the life of the loan, as described above. We may also record additional provision for losses for owned loans in connection with the periodic assessment of the adequacy of the allowance for loan losses. Q1 2017 Loss Recognition Change Effective January 1, 2017, we modified the timeframe in which Installment Loans are charged-off and made related refinements to our loss provisioning methodology. Prior to January 1, 2017, we deemed all loans uncollectible and charged-off when a customer missed a scheduled payment and the loan was considered past-due. Because of our continuing shift from Single-Pay to Installment Loan products and our analysis of payment patterns on early-stage versus late-stage delinquencies, we revised our estimates and now consider Installment Loans uncollectible when the loan has been contractually past-due for 90 consecutive days. Consequently, past-due Installment Loans and related accrued interest remain in loans receivable, with disclosure of past-due balances, for 90 days before being charged off against the allowance for loan losses. All recoveries on charged-off loans are credited to the allowance for loan losses. We evaluate the adequacy of the allowance for loan losses compared to the related gross loans receivable balances that include accrued interest. In the income statement, the provision for losses for Installment Loans is based on assessment of the cumulative net losses inherent in the underlying loan portfolios, by vintage, and several other quantitative and qualitative factors. The resulting loss provision rate is applied to loan originations to determine the provision for losses. In addition to improving estimated collectability and loss recognition for Installment Loans, we also believe these refinements result in a loss provisioning methodology that is better aligned with industry comparisons and practices. The aforementioned change was treated as a change in accounting estimate for accounting purposes and applied prospectively beginning January 1, 2017, which we refer to throughout this Annual Report as the Q1 Loss Recognition Change. The change affects comparability to prior periods as follows: • Gross Combined Loans Receivable-balances in 2017 include Installment Loans that are up to 90 days past-due with related accrued interest, while balances in prior periods do not include these loans. • Revenues-for the year ended December 31, 2017, revenues include accrued interest on past-due loan balances, while revenues in prior periods do not include these amounts. • Provision for Losses-prospectively, loans charged off on day 91 include accrued interest. Thus, provision rates in 2017 have been adjusted to include both principal and accrued interest. Additionally, because loss provision rates are applied to originations while charge-offs and recoveries are applied to the allowance for loan losses, provisioning is less affected by seasonality for the first quarter income tax refunds in the United States, which increases recoveries of delinquent balances. For a full discussion of the change, see Note 1, “Summary of Significant Accounting Policies and Nature of Operations” in this Annual Report. Hurricane Harvey Impact In a good-faith effort to help our store and online customers in the affected areas of Houston, Corpus Christi and the surrounding areas we waived loan payments that were due during the period from August 25, 2017 to September 8, 2017. This affected approximately 22,500 customers and amounted to approximately $3.0 million in total loan payments. The waived payments and losses on secured installment loans in the market increased our provision for losses by approximately $3.3 million. Property damage to our 18 stores in the affected areas was not material. Our stores in the Texas markets resumed normal operations in September. Cost of Providing Services Salaries and Benefits Salaries and benefits include personnel-related costs for our store operations, including salaries, benefits and bonuses and are driven by the number of employees. Occupancy Occupancy and equipment includes rent expense for our leased facilities, as well as depreciation, maintenance, insurance, and utility expense. Office Office includes expenses related to software, computer hardware, bank service charges, credit scoring charges and other office supplies. Other Costs of Providing Services Our other costs of providing services includes expenses related to operations such as processing fees, collections expense, security expense, taxes, repairs and professional fees. Advertising All advertising costs are expensed as incurred. Advertising includes costs associated with attracting, retaining and/or reactivating customers as well as creating awareness for the brands we promote. Creative, web and print design capabilities exist within the Company and are rarely outsourced. The use of third-party agencies is limited to mass-media production and placement. Advertising expense also includes costs for all marketing activities including paid search, advertising on social networking sites, affiliate programs, direct response television, radio air time and direct mail. Operating Expense Corporate, District and Other Expenses Corporate, district and other expenses include costs such as salaries and benefits associated with our corporate and district-level employees, as well as other corporate-related costs such as rent, insurance, professional fees, utilities, travel and entertainment expenses and depreciation expense. Interest Expense Interest expense primarily includes interest related to our Notes and our SPV Facility. Other Expenses Other (income) and expense includes the foreign currency impact to our intercompany balances, gains or losses on foreign currency exchanges and disposals of fixed assets and other miscellaneous income and expense amounts. Discussion of Revenue by Product and Segment and Related Loan Portfolio Performance Revenue by Product Unsecured and Secured Installment revenue includes interest income, CSO fees, and non-sufficient funds or returned-items fees on late or defaulted payments on past-due loans (to which we refer collectively as “late fees”). Late fees comprise less than one-half of one percent of Installment revenues. Open-End revenues include interest income on outstanding revolving balances and other usage or maintenance fees as permitted by underlying statutes. Single-Pay revenues represent deferred presentment or other fees as defined by the underlying state, provincial or national regulations. The following table summarizes revenue by product, including CSO fees, for 2017 and 2016: For full year 2017, total lending revenue (excluding revenues from ancillary products) grew $131.1 million, or 16.5%, to $923.5 million, compared to the prior year period. Growth was driven predominantly by Unsecured and Secured Installment loan revenue. Unsecured installment loan revenues rose 45.2% on related origination increase of 46.4%. Secured installment revenues increased 24.0% on related origination increase of 33.2%. Single-Pay revenues were affected primarily by regulatory changes in Canada (rate changes in Ontario and British Columbia and product changes in Alberta). U.S. and U.K. Single-Pay revenues also decreased 8.6% and 37.8%, respectively, because of continued mix shift from Single-Pay to Installment and Open-End products. Ancillary revenues increased 10.8% versus the same period a year ago primarily due to insurance revenue in Canada, partially offset by a decrease in check cashing fees. U.K. revenue increased $5.8 million, or 17.1% ($7.8 million or 23.0%, on a constant currency basis). The following table summarizes revenue by product for 2016 and 2015: Total lending revenue (excluding revenues from ancillary products) grew $18.8 million, or 2.4%, compared to the prior year, driven by growth in Installment and Open-End Loans. Unsecured Installment revenues rose 5.2% on related gross combined loan receivables growth of 29.0%, led by 7.9% growth in the United States (primarily in Texas, California and Missouri). U.K. Unsecured Installment revenues declined 41.7% because we discontinued a longer-term Installment Loan product in late 2015 due to regulatory changes. Secured Installment revenues decreased 5.6% mostly driven by competitive pressures in Nevada and Arizona. Open-End revenues grew 30.5% year-over-year primarily because in Kansas and Tennessee we replaced Single-pay products with Open-End products. Single-Pay revenues declined 2.6%. In the United States, the decline was primarily driven by the aforementioned changes in Kansas and Tennessee. Ancillary revenues were down 8.4% year-over-year primarily because secular declines in check usage continue to affect check-cashing revenues and we experienced tighter margins on foreign currency exchange. U.K. revenue comparisons are also affected meaningfully by a weaker pound. On a constant-currency basis, U.K. revenue declined $16.5 million, or 30.2%, compared to the prior year. Loan Volume and Portfolio Performance Analysis The following table summarizes Company-owned gross loans receivable, a GAAP balance sheet measure, and reconciles it to gross combined loans receivable, a non-GAAP measure including loans originated by third-party lenders through CSO programs, which are not included in the consolidated financial statements but from which we earn revenue and for which we provide a guarantee to the lender: The following table presents gross combined loans receivable by product: Gross combined loans receivable were $511.6 million and $354.2 million at December 31, 2017 and 2016, respectively. The increase was a result of Installment loan growth from higher originations and the Q1 Loss Recognition Change. For 2017, Installment loans that are up to 90 days past due are included in gross combined loans receivable. Excluding the year-over-year effect of such past-due loans, gross combined loans receivable increased $83.4 million or 23.5% from December 31, 2016 to December 31, 2017. Unsecured Installment Loans Unsecured Installment revenue and gross combined loans receivable increased from the prior year quarter due to growth in the United States, primarily in Texas and California; growth in Canada, primarily in Alberta; and growth in the United Kingdom. Gross combined Unsecured Installment loan balances (excluding past due loans) grew $49.6 million, or 30.1%, compared to December 31, 2016. Loss provision rates as a percentage of loan originations (or loss provision rates) for Company Owned loans increased sequentially from 21.1% to 22.1%, reflecting normal seasonal trends and allowance coverage evaluation. Fourth quarter 2017 provision rate was consistent with the prior year provision rate of 22.0%. The effect of of the Q1 Loss Recognition Change, which caused higher provision rates in 2017 was offset by improved underwriting and credit scoring, and seasoning. Loss provision rates for loans Guaranteed by the Company decreased sequentially from 43.3% to 40.0%. This is primarily due to the impact of Hurricane Harvey relief during the third quarter of 2017 on Texas operations. Fourth quarter 2017 provision rates increased compared to the prior year quarter of 31.1%, primarily due to the Q1 Loss Recognition Change, which caused higher provision rates in 2017, as well as loan performance. Unsecured Installment Allowance for loan losses as a percentage of Unsecured Installment gross loans receivable and Unsecured Installment CSO guarantee liability as a percentage of Unsecured Installment gross loans Guaranteed by the Company both declined from the end of the third quarter of 2017. This was a result of realization of the impacts of Hurricane Harvey, seasonal patterns in net charge-offs and evaluation of year-end allowance coverage based on underlying vintage performance. Past-due Unsecured Installment gross loans receivable and Past-due Unsecured Installment gross loans Guaranteed by the Company remained consistent quarter over quarter. Secured Installment Loans Secured Installment loan revenue and gross combined loans receivable increased from the prior year due primarily to growth in California and Arizona. Gross combined Secured Installment loan balances (excluding past due loans) increased by $8.5 million, or 12.6%, compared to December 31, 2016, on higher origination volumes. Secured Installment Allowance for loan losses as a percentage of Secured Installment gross loans receivable settled at a more normalized range in the fourth quarter and improved slightly over the same quarter a year ago on underlying vintage performance. The Past-due Secured Installment gross loans receivable rate was consistent sequentially with third quarter. Open-End Loans Open-End loan balances increased by $17.5 million, or 57.4%, compared to December 31, 2016, from year-over-year growth in Kansas and Tennessee of 21.3% and 24.2%, respectively, the 2017 launch of Open-End in Virginia ($6.2 million in balances at the end of 2017) and conversion in the fourth quarter of 2017 of LendDirect Unsecured Installment loans to Open-End in Canada ($7.2 million in balances at the end of 2017). The provision for losses and Open-End Allowance for loan losses as a percentage of Open-end gross loans receivable decreased due to improved collection trends and portfolio performance for existing markets, seasoning of the Tennessee loan book and the effect on mix of converting LendDirect to Open-End - as with our experience with other products in Canada, the LendDirect Open-End portfolio is expected to perform better relative to U.S. products. Single-Pay Single-Pay revenue, provision and combined loans receivable during the three and twelve months ended December 31, 2017 were affected primarily by regulatory changes in Canada (rate changes in Ontario and British Columbia and product shift from Single-Pay to Installment in Alberta). Single-Pay revenue in the United States also declined compared to the prior year due to the continued shift toward Installment and Open-End products. The improvement in the provision for losses in the fourth quarter of 2017 as compared to the fourth quarter of 2016 was primarily due to a lower proportion of Single-Pay loans in the U.K. where loan loss rates are higher than in the U.S. and Canada. Results of Operations - CURO Group Consolidated Operations Condensed Consolidated Statements of Income Reconciliation of Net Income and Diluted Earnings per Share to Adjusted Net Income and Adjusted Diluted Earnings per Share, non-GAAP measures Reconciliation of Net income to EBITDA and Adjusted EBITDA, non-GAAP measures Revenue and Net Revenue Revenue increased $135.0 million, or 16.3% to $963.6 million for the year ended December 31, 2017 from $828.6 million for the prior year period. U.S. revenue increased $130.9 million on volume growth, the U.K. increased $5.8 million, and Canada decreased $1.7 million due to regulatory impacts on rates and product mix. Provision for losses increased $67.9 million, or 26.3% to $326.2 million for the year ended December 31, 2017 from $258.3 million for the prior year because of higher origination volumes and higher loan balances. Cost of Providing Services The total cost of providing services increased $11.1 million, or 4.0%, to $288.2 million for the year ended December 31, 2017, compared to $277.1 million for the year ended December 31, 2016, due primarily to 18.5% higher marketing spend as well as increases in occupancy, office and other operating expenses. Operating Expenses Corporate, district and other expenses increased $30.7 million primarily due to debt extinguishment costs, share-based cash and non-cash compensation, IPO-related costs and legal settlement costs, as described above in the reconciliation of Net Income to Adjusted Net Income, as well as increases in payroll, collections, office and technology-related costs. Interest expense in the current year period increased by approximately $18.4 million which was the result of accrued interest on the retired notes through the redemption notice period and increased debt outstanding. Provision for Income Taxes The effective tax rate for the year ended December 31, 2017 was 46.4% compared to 39.4% for the prior year. As a result of the Tax Cuts and Jobs Act, the full year effective tax rate includes a net one-time charge of $3.9 million from adjustments to deferred tax assets and liabilities and recognition of tax expense related to Canadian earnings that have not been repatriated. Excluding the impact of the Tax Cuts and Jobs Act, the effective tax rate for full-year 2017 was 41.4%. The remaining change in the effective tax rate from the prior year was primarily due to U.K. operations. The 2017 U.K. results include $7.4 million of restructuring costs related to the closure of the remaining 13 U. K. stores. We recorded a 100% valuation allowance against the resulting deferred tax asset and therefore did not recognize the related tax benefit. Year Ended December 31, 2017 Compared with Year Ended December 31, 2016 - Segment Analysis We report financial results for three reportable segments: the United States, Canada and the United Kingdom. Following is a recap of results of operations for the segment and period indicated: Full year U.S. revenue grew by $130.9 million, or 21.6%, to $737.7 million. U.S. revenue growth was driven by a $49.4 million, or 18.0%, increase in gross combined loans receivable (excluding past due loans) to $323.6 million at December 31, 2017 compared to $274.2 million in the prior year period. We experienced strong volume growth in Unsecured Installment originations which increased year-over-year $131.9 million, or 27.4%. Secured Installment originations grew $45.9 million, or 33.2%, compared to the same period a year ago. The increase of $59.7 million or 28.8% in provision for losses was primarily driven by the aforementioned increase in gross combined loans receivable and related origination volumes as well as the Q1 Loss Recognition Change. U.S. cost of providing services for the year ended December 31, 2017 were $203.0 million, an increase of $8.3 million, or 4.3%, compared to $194.7 million for the year ended December 31, 2016. The increase was due primarily to $5.8 million, or 19.1% higher marketing spend, as well as increases in volume-driven expenses and increases in store security and maintenance costs. All other U.S. operating expenses were $215.8 million for the year ended December 31, 2017, an increase of $68.2 million, or 46.2%, compared to $147.6 million in the prior year period. Excluding the effects of the items discussed previously in "Reconciliation of Net Income and Diluted Earnings per Share to Adjusted Net Income and Adjusted Diluted Earnings per Share, non-GAAP measures" applicable to the U.S. as indicated in the Segment table above, Corporate, district and other operating expenses rose $13.6 million, or 15.6%, primarily due to increased technology and analytics headcount. Revenue in Canada was affected by product transition in Alberta from Single-Pay loans to Unsecured Installment loans and the impact of regulatory rate changes in Ontario and British Columbia. Non-Alberta Single-Pay revenue decreased $1.1 million, or 0.8% to $146.2 million for 2017 and was affected by lower rates from provincial regulatory changes effective January 1, 2017. The impact of the rate changes was offset by higher origination volumes resulting in a modest increase in related revenue. Single-Pay ending receivables (excluding Alberta) increased $9.1 million, or 20.9%, to $52.6 million from $43.5 million in the prior year period. Because of regulatory changes in Alberta, we converted Single-Pay customers to Unsecured Installment loans during the first week of December 2016, resulting in $22.7 million of Unsecured Installment loans outstanding at the end of 2016. As of December 31, 2017, $43.7 million of Unsecured Installment and Open-End receivables were outstanding in Alberta. The provision for losses rose $5.2 million or 12.9% to $45.1 million for full year 2017 compared to $39.9 million in the prior year period. As in the U.S., the increase was due to higher loan origination volume and the shift in Alberta from Single Pay to Unsecured Installment loans. The cost of providing services in Canada increased $3.9 million, or 5.6%, to $73.4 million for the year ended December 31, 2017, compared to $69.5 million in the prior year period due primarily to an increase in occupancy expense, based on a higher number of stores in operation during 2017 as compared to the prior year, as well as an increase in store maintenance costs and higher marketing spend. Operating expenses decreased $1.0 million, or 5.5%, to $17.2 million in the year ended December 31, 2017, from $18.2 million in the prior year period, due to the consolidation of certain back-office functions during the third quarter of 2016. U.K. revenue improved $5.8 million, or 17.1%, to $39.5 million for the year ended December 31, 2017 from $33.7 million in the prior year period. On a constant currency basis, revenue was up $7.8 million, or 23.0%. Provision for losses increased $3.0 million, or 28.6%, and increased $3.7 million, or 34.5% on a constant currency basis, due to growth in Installment Loan receivables. The cost of providing services in the United Kingdom decreased slightly from the prior year period because of third quarter 2017 store closures. On a constant currency basis the cost of providing services decreased $0.4 million, or 3.1%. Operating expenses increased $5.1 million, or 26.0%, from the prior year period, and on a constant currency basis increased $6.3 million, or 32.4%, due to restructuring costs from closure of the 13 remaining stores during the third quarter of 2017. Excluding the store closure costs, operating expenses decreased $1.3 million, or 7.2%, because of reduced headquarters and contact center headcount and lower professional fees. Results of Operations - CURO Group Consolidated Operations Condensed Consolidated Statements of Income Reconciliation of Net Income and Diluted Earnings per Share to Adjusted Net Income and Adjusted Diluted Earnings per Share, non-GAAP measures Reconciliation of Net income to EBITDA and Adjusted EBITDA , non-GAAP measures Revenue and Net Revenue Revenue increased $15.5 million, or 1.9% to $828.6 million for the year ended December 31, 2016 from $813.1 million for the prior year. Volume growth in the United States and revenue growth in Canada driven by de novo store expansion and modest same-store volume growth, were partially offset by a decline in the U.K. revenue due to currency translation impact, product mix and volume changes, as well as the closure of nearly half of the U.K. stores in December 2015. A detailed discussion of results by segment is included in the Segment Analysis below. Provision for losses decreased by $22.9 million, or 8.2% to $258.3 million for the year ended December 31, 2016 from $281.2 million for the prior year. Improved performance in the United States resulted from continuous refinements and improvements to scoring models, portfolio seasoning, and improve collection efforts. Lower relative customer acquisition spend in 2016 reduced the volume mix attributable to new customers compared to the same period a year ago. In the United Kingdom, loss provisions have improved because of tightened underwriting and seasoning. The increase in the provision for losses in Canada was due to the growth of newer bankline loan products, which have a higher provision rate as a percent of revenue than traditional Canadian single-pay products. Cost of Providing Services The total cost of providing services decreased $16.3 million, or 5.5%, to $277.1 million for the year ended December 31, 2016, compared to $293.3 million in the prior year primarily due to a decline in advertising expense of $21.7 million, or 33.1%, compared to the prior year, as we normalized customer acquisition in 2016 to maintain earning-asset levels but without the elevated levels of new customer investment of 2015. In addition, cost-per-funded loan improved significantly year-over-year so less total spend was necessary to drive similar customer volumes. Salaries and benefits also declined compared to the prior year driven by the closure of ten stores in the United Kingdom in December 2015. These declines were partially offset by an increase in other store operating expense which was attributable to higher collections costs, partially offset by a decline in store maintenance costs associated with store refurbishments that took place in the prior year. Operating Expenses Corporate, district and other expenses declined 4.8% in the year ended December 31, 2016 primarily because of U.K. store closures in 2015, a decrease in payroll costs at our U.K. corporate office, and declines in U.K. collections and office expense, as well as the impact of Canadian back-office consolidation during 2016, and the impact of certain intangible assets related to the 2011 Cash Money acquisition which became fully amortized. These declines were partially offset by an increase in U.S. corporate expense from higher payroll costs for additional headcount (primarily analytics and technology) and an increase in variable, performance based compensation, as well as an increase in professional fees and office expense. Other changes in operating expenses were affected by a pretax gain of $7.0 million related to the discount on the repurchase of $25.1 million of CFTC’s outstanding May 2011 10.75% Senior Secured Notes, as well as $3.6 million of restructuring costs related to the elimination of certain positions, primarily Finance and IT, at our Canadian headquarters, and the closure of seven underperforming The Money Box stores in Texas, and one store in Missouri that we were unable to reopen after it was damaged by a fire, and costs related to the 2015 closure of ten U.K. stores. Results in 2015 were also impacted by a $2.9 million non-cash goodwill and intangible asset impairment charges, and $4.3 million of costs related to the closure of ten U.K. stores mentioned above. These costs primarily consisted of adjustments to lease obligations associated with these locations. Provision for Income Taxes Our effective tax rate for the year ended December 31, 2016 was 39.4% compared to 50.5% for the year ended December 31, 2015. Our recorded income tax expense is affected by our mix of domestic and foreign earnings. Year Ended December 31, 2016 Compared with Year Ended December 31, 2015 - Segment Analysis We report financial results for three reportable segments: the United States, Canada and the United Kingdom. Following are a recap of results of operations for the segment and period indicated: Total revenue for our U.S. operations was $606.8 million for 2016, an increase of $33.1 million, or 5.8%, compared to the prior year. Revenue growth was driven by our online channel. Gross margin for our U.S. operations for 2016 was $204.3 million, an increase of $52.7 million, or 34.8%, compared to the prior year. Gross margin as a percent of revenue improved to 33.7%, compared to 26.4% in the prior year from improvement in the provision for losses due to relative new customer mix and growth, related portfolio seasoning, and improved credit scoring and collection trends; as well as a $12.6 million decrease in advertising expense. Operating expenses in the United States were flat with the prior year. An increase in corporate expense from higher payroll costs for additional headcount (primarily analytics and technology), an increase in variable, performance-based compensation, as well as an increase in professional fees and office expense, was more than offset by a $7.0 million gain on the extinguishment of $25.1 million of CFTC’s May 2011 10.75% Senior Secured Notes. Total revenue for our Canadian operations was $188.1 million for 2016, an increase of $3.2 million, or 1.7%, compared to the prior year. Growth in Canada was driven by our de novo store expansion and modest same-store volume growth in Ontario, Nova Scotia, British Columbia and Saskatchewan, which offset a $3.8 million, or 11.8%, decline in Alberta due to the statutory rate change. The gross margin for our Canadian operations for 2016 was $78.6 million, an increase of $1.2 million, or 1.5%, compared to the prior year. Gross margin as a percent of revenue declined slightly in the current year to 41.8% from 41.9% for the prior year. Operating expenses in Canada decreased $3.1 million, or 14.6%, from the prior year due primarily to the net impact of the elimination of 35 corporate positions in our Canadian headquarters (primarily finance and technology). Amortization expense also declined as certain intangible assets related to the 2011 Cash Money acquisition became fully amortized. Total revenue in the United Kingdom was $33.7 million for 2016, a decrease of $20.9 million, or 38.3%. The decline in the British Pound Sterling from an average exchange rate of $1.5282 for the year ended December 31, 2015 to an average exchange rate of $1.3552 for the year ended December 31, 2016, had a negative impact on our consolidated results. On a constant currency basis, revenue in the United Kingdom decreased $16.5 million, or 30.2%, compared to the prior year. Revenue declined in the United Kingdom because of product mix and volume changes, as well as the closure of nearly half of the U.K. stores in December 2015. The gross margin for our U.K. operations for 2016 was $10.3 million, an increase of $0.8 million, or 8.3%, compared to the prior year. Gross margin as a percent of revenue improved to 30.5% compared to 17.4% in the prior year. Improvement in the provision for losses, lower advertising expense, and the impact of the closure of the ten stores to occupancy and salaries and benefits expense all contributed to gross margin improvement. Store count As of December 31, 2017, we had 407 stores in 14 U.S. states and seven provinces in Canada, which included the following: • 214 U.S. locations: Texas (91), California (36), Nevada (18), Arizona (13), Tennessee (11), Kansas (10), Illinois (8), Alabama (7), Missouri (5), Louisiana (5), Colorado (3), Oregon (3), Washington (2), and Mississippi (2) • 193 Canadian locations: Ontario (124), Alberta (27), British Columbia (26), Saskatchewan (6), Nova Scotia (5), Manitoba (4), and New Brunswick (1) Online: We lend online in 27 states in the U.S., five provinces in Canada, and in England, Wales, Scotland and Northern Ireland in the United Kingdom. From January 1, 2016 through December 31, 2017 we opened 11 stores: one store in the United States and 10 in Canada. During the same period we closed 24 stores: eight stores in Texas that were primarily underperforming former Money Box stores, one store in Missouri that we were unable to reopen due to fire damage, one store in Canada due to a lease that was not renewed, and the remaining 13 store locations in the United Kingdom as part of an overall plan to reduce operating losses in the wake of ongoing regulatory and market changes in the United Kingdom. Store counts as of date are depicted below. Currency Information We operate in the United States, Canada and the U.K. and report our consolidated results in U.S. dollars. Changes in our reported revenues and net income include the effect of changes in currency exchange rates. All balance sheet accounts are translated into U.S. dollars at the currency exchange rate in effect at the end of each period. The income statement is translated at the average rates of exchange for the period. Currency translation adjustments are recorded as a component of Accumulated Other Comprehensive Income in stockholders’ equity. Constant Currency Analysis We have operations in the U.S., Canada, and the U.K. For the years ended December 31, 2017 and 2016, approximately 23.4% and 26.8%, respectively, of our revenues were originated in foreign currencies. As a result, changes in our reported results include the impacts of changes in foreign currency exchange rates for the respective currencies. Years Ended December 31, 2017 and 2016 Years Ended December 31, 2016 and 2015 As additional information, we have provided a constant currency analysis below to remove the impact of the fluctuation in foreign exchange rates and utilize constant currency results in our analysis of segment performance. All conversion rates below are based on the U.S. Dollar equivalent to one of the applicable foreign currencies. We believe that the constant currency assessment below is a useful measure in assessing the comparable growth and profitability of our operations. The revenues and gross margin below for the year ended December 31, 2017 were calculated using the actual average exchange rate for the year ended December 31, 2016. The revenues and gross margin below for the year ended December 31, 2016 were calculated using the actual average exchange rate for the year ended December 31, 2015. Liquidity and Capital Resources Our principal sources of liquidity to fund the loans we make to our customers are cash provided by operations, our Senior Revolver, funds from third party lenders under our CSO programs, and our Non-Recourse U.S. SPV Facility, which finances the originations of eligible U.S. Unsecured and Secured Installment Loans at an advance rate of 80%. In February 2017, we issued 12.00% Senior Secured Notes to refinance similar notes that were nearing maturity and whose proceeds had been used primarily for acquisitions and general corporate purposes. As of December 31, 2017, we were in compliance with all financial ratios, covenants and other requirements set forth in our debt agreements. We anticipate that our primary use of cash will be to fund growth in our working capital, finance capital expenditures and meet our debt obligations. Our level of cash flow provided by operating activities typically experiences some seasonal fluctuation related to our levels of net income and changes in working capital levels, particularly loans receivable. Unexpected changes in our financial condition or other unforeseen factors may result in our inability to obtain third-party financing or could increase our borrowing costs in the future. We have the ability to adjust our volume of lending to consumers which would reduce cash outflow requirements while increasing cash inflows through loan repayments to the extent we experience any short-term or long-term funding shortfalls. We may also sell or securitize our assets, draw on our available revolving credit facility or line of credit, enter into additional refinancing agreements and reduce our capital spending in order to generate additional liquidity. We believe our cash on hand and available borrowings provide us with sufficient liquidity for at least the next twelve months. Borrowings Our long-term debt consisted of the following as of December 31, 2017 and 2016 (net of deferred financing costs): Available Credit Facilities and Other Resources 12.00% Senior Secured Notes On February 15, 2017 CURO issued $470.0 million 12.00% Senior Secured Notes due March 1, 2022 ("12.00% Senior Secured Notes"). Interest on the notes is payable semiannually, in arrears, on March 1 and September 1 of each year, beginning on September 1, 2017. The proceeds from the 12.00% Senior Secured Notes were used, together with available cash, to (i) redeem the outstanding 10.75% Senior Secured Notes due 2018 of our wholly-owned subsidiary, CURO Intermediate, (ii) redeem our outstanding 12.00% Senior Cash Pay Notes due 2017, or the Senior Cash Pay Notes and (iii) pay fees, expenses, premiums and accrued interest in connection with the offering. The extinguishment of all of the 10.75% Senior Secured Notes due 2018 and the Senior Cash Pay Notes resulted in a pretax loss of $12.5 million in 2017. In connection with this debt issuance we capitalized financing costs of approximately $14.0 million, the balance of which are included in the Consolidated Balance Sheets as a component of “Long-Term Debt,” and are being amortized over the term of the 12.00% Senior Secured Notes and included as a component of interest expense. On November 2, 2017, CFTC issued $135.0 million principal amount of additional 12.00% Senior Secured Notes in a private offering exempt from the registration requirements of the Securities Act, or the Additional Notes Offering. The proceeds from the Additional Notes Offering were used, together with available cash, to (i) pay a cash dividend in an amount of $140.0 million to us, CFTC's sole stockholder, and ultimately our stockholders and (ii) pay fees, expenses, premiums and accrued interest in connection with the Additional Notes Offering. CFTC received the consent of holders holding a majority in the outstanding principal amount outstanding of the current 12.00% Senior Secured Notes to a one-time waiver with respect to the restrictions contained in Section 5.07(a) of the indenture governing the 12.00% Senior Secured Notes to permit the dividend. The 12.00% Senior Secured Notes rank senior in right of payment to all of our and our guarantor entities’ existing and future subordinated indebtedness and equal in right of payment with all our and our guarantor entities’ existing and future senior indebtedness, including borrowings under our revolving credit facilities. The 12.00% Senior Secured Notes and the guarantees are effectively subordinated to our credit facilities and certain other indebtedness to the extent of the value of the assets securing such indebtedness and to liabilities of our subsidiaries that are not guarantors. The 12.00% Senior Secured Notes are secured by liens on substantially all of our and the guarantors’ assets, subject to certain exceptions. On or after March 1, 2019, we may redeem some or all of the Notes at a premium that will decrease over time, plus accrued and unpaid interest, if any to the applicable date of redemption. Prior to March 1, 2019, we will be able to redeem up to 40% of the Notes at a redemption price of 112% of the principal amount of the Notes redeemed, plus accrued and unpaid interest to the redemption date with the net cash proceeds of certain equity offerings. Prior to March 1, 2019, subject to certain terms and conditions, we may redeem the Notes, in whole or in part, by paying a “make-whole” premium plus accrued and unpaid interest to the redemption date. On March 7, 2018, we used a portion of the net proceeds from the IPO to redeem $77.5 million of the 12.00% Senior Secured Notes due 2022 and to pay related fees, expenses, premiums and accrued interest. See Note 25 - Subsequent Events of this Annual Report on Form 10-K for additional information about this transaction. Non-Recourse U.S. SPV Facility and ABL Facility On November 17, 2016, CURO Receivables Finance I, LLC, a Delaware limited liability company (the “SPV Borrower”) and a wholly-owned subsidiary, entered into a five-year revolving credit facility with Victory Park Management, LLC and certain other lenders that provides for an $80.0 million term loan and $45.0 million of initial revolving borrowing capacity, with the ability to expand such revolving borrowing capacity over time and an automatic expansion to $70.0 million on the six-month anniversary of the closing date May 17, 2017 (our “Non-Recourse U.S. SPV Facility”). On November 17, 2016, Intermediate entered into a six-month recourse credit facility with Victory Park Management, LLC and certain other lenders (the "ABL Facility") which provided for $25.0 million of borrowing capacity. This facility matured in May 2017 and was repaid through the sale of the underlying collateral to the Non-Recourse U.S. SPV Facility. See Note 11 - "Long-Term Debt" of our notes to the Consolidated Financial Statements for further detail. Senior Revolver On September 1, 2017, we closed a $25 million Senior Secured Revolving Loan Facility (the "Senior Revolver"). The negative covenants of the Senior Revolver generally conform to the related provisions in the Indenture for our 12.00% Senior Secured Notes. We believe this facility complements our other financing sources, while providing seasonal short-term liquidity. Under the Senior Revolver, there is $25.0 million maximum availability, including up to $5.0 million of standby letters of credit, for a one-year term, renewable for successive terms following annual review. The Senior Revolver accrues interest at the one-month LIBOR (which may not be negative) plus 5.00% per annum and is repayable on demand. The terms of the Senior Revolver require that the outstanding balance be reduced to $0 for at least 30 consecutive days in each calendar year. The Senior Revolver is guaranteed by all subsidiaries of CURO that guarantee our 12.00% Senior Secured Notes and is secured by a lien on substantially all assets of CURO and the guarantor subsidiaries that is senior to the lien securing our 12.00% Senior Secured Notes. The Senior Revolver was undrawn at December 31, 2017. In February 2018, the Senior Revolver capacity was increased to $29.0 million as permitted by the Indenture to the Senior Secured Notes based upon consolidated tangible assets. The Senior Revolver is now syndicated with participation by a second bank. In connection with this facility we capitalized financing costs of approximately $0.1 million, the balance of which are included in the Consolidated Balance Sheets as a component of “Other assets,” and are being amortized over the term of the facility and included as a component of interest expense. Cash Money Revolving Credit Facility Cash Money Cheque Cashing, Inc., one of our Canadian subsidiaries, maintains a C$7.3 million revolving credit facility with Royal Bank of Canada. The Cash Money Revolving Credit Facility provides short-term liquidity required to meet the working capital needs of our Canadian operations. Aggregate draws under the revolving credit facility are limited to the lesser of: (i) the borrowing base, which is defined as a percentage of cash, deposits in transit and accounts receivable, and (ii) C$7.3 million. As of December 31, 2017, the borrowing capacity under our revolving credit facility was reduced by C$0.3 million in stand-by-letters of credit. The Cash Money Revolving Credit Facility is collateralized by substantially all of Cash Money’s assets and contains various covenants that include, among other things, that the aggregate borrowings outstanding under the facility not exceed the borrowing base, restrictions on the encumbrance of assets and the creation of indebtedness. Borrowings under the Cash Money Revolving Credit Facility bear interest (per annum) at the prime rate of a Canadian chartered bank plus 1.95%. The Cash Money Revolving Credit Facility was undrawn at December 31, 2017 and December 31, 2016. Balance Sheet Changes - December 31, 2017 compared to December 31, 2016 Cash - Cash decreased from 2016 primarily because of cash used in the redemption and refinancing of the Company's 12.00% Senior Cash Pay Notes due 2017 and CURO Intermediate’s 10.75% Senior Secured Notes due 2018 ("Former Senior Secured Notes"). On February 15, 2017, CFTC issued $470.0 million of 12.00% Senior Secured Notes due 2022. The proceeds, along with $122.5 million of company cash, were used to redeem the $539.9 million outstanding Former Senior Secured Notes (including accrued interest, prepayment penalties, transaction costs and the original-issue discount). The decrease in cash from this refinancing was offset partially by cash generated by operations during 2017 and net proceeds after transaction costs of $81.1 million from our initial public offering of 6,666,667 shares of common stock at a price of $14.00 per share. On November 2, 2017, CFTC issued $135.0 million of additional 12.00% Senior Secured Notes due 2022. The proceeds of the notes offering and related issuance premium were used to pay a $140.0 million cash dividend to the Company and, ultimately, the Company's stockholders. Restricted Cash - Restricted cash increased from 2016 year end because of increased cash in our consolidated wholly-owned, bankruptcy remote special purpose subsidiaries, or VIEs, from underlying installment loan volume growth. Gross Loans Receivable and Allowance for Loan Losses - We originated $780.7 million and $184.3 million of Unsecured and Secured Installment Loans, respectively, during 2017 as compared to $533.4 million and $138.4 million in the prior year. As explained in the Loan Volume and Portfolio Performance Analysis section above, changes in Gross Loans Receivable and related Allowance for Loan Losses were due to high customer demand and loan origination volumes during 2017 that were concentrated in Installment Loans. Other Assets - Other assets increased primarily because of the equity investment in Cognical Holdings, Inc. We made a $5.0 million investment on April 20, 2017 and an additional $0.6 million investment in October 2017 that increased the Company's equity ownership from 8.9% to 9.4%. Cognical Holdings, Inc. operates as a business under an online website, www.zibby.com, that facilitates the purchase of household items by underbanked consumers. Long-term debt (including current maturities) and Accrued Interest - Changes from year-end 2016 are due to the refinancing of the Former Senior Secured Notes, the conversion of the ABL Facility to the Non-Recourse U.S. SPV Facility and the issuance of additional 12.00% Senior Secured Notes due 2022 in November 2017. See Note 11 Long-Term Debt of the Notes to the Consolidated Financial Statements for a detailed discussion of changes in debt balances. Cash Flows The following highlights our cash flow activity and the sources and uses of funding during the periods indicated: Years Ended December 31, 2017 and 2016 Cash flows from operating activities During the year ended December 31, 2017 our operating activities provided net cash of $17.4 million. Contributing to current year net cash provided by operating activities were net income of $49.2 million, and non-cash expenses, such as depreciation and amortization, the provision for loan losses, and a loss on debt extinguishment for a total of $376.5 million, partially offset by changes in our operating assets and liabilities of $408.3 million. The most significant change within operating assets and liabilities was a $435.5 million increase in loans receivable. Loans receivable will fluctuate from period to period depending on the timing of loan issuances and collections. A seasonal decline in consumer loans receivable typically takes place during the first quarter of the year and is driven by income tax refunds in the United States. Customers receiving income tax refunds will use the proceeds to pay outstanding loan balances, resulting in an increase of our net cash balances and a decrease of our consumer loans receivable balances. Consumer loans receivable balances typically reflect growth during the remainder of the year. Cash flows from investing activities During the year ended December 31, 2017, we used cash of $19.3 million to increase our restricted cash balances by approximately $4.0 million, to purchase approximately $9.8 million of property and equipment, including software licenses, and to purchase $5.6 million of Cognical Holdings preferred shares. The increase in restricted cash was primarily attributable to our Non-Recourse U.S. SPV Facility. Cash flows from financing activities Net cash used for the year ended December 31, 2017 was $36.7 million. We extinguished our 10.75% Senior Secured Notes for $426.0 million (which included $8.9 million of call premium) and extinguished our Senior Cash Pay Notes for $130.1 million. These payments were partially financed by proceeds of $447.6 million (net of $14.0 million of debt issuance costs and $8.5 million of discount on notes issued) from the issuance of the 12.00% Senior Secured Notes due 2022. On November 2, 2017, CFTC issued $135.0 million of additional 12.00% Senior Secured Notes due 2022. The proceeds of this notes offering and related issuance premium were used to pay a $140.0 million dividend to the Company and, ultimately, the Company's stockholders. We paid total dividends of $182.0 million to our stockholders during 2017. Our initial public offering of 6,666,667 shares of common stock at a price of $14.00 per share provided net proceeds after transaction costs of $81.1 million. We also had net borrowings of $32.9 million from our U.S. SPV Facility and our ABL Facility. Years Ended December 31, 2016 and 2015 Cash flows from operating activities During the year ended December 31, 2016 our operating activities provided net cash of $47.7 million, compared to $17.1 million in net cash used in operating activities during the year ended December 31, 2015. Contributing to net cash provided by operating activities in 2016 were net income of $65.4 million, and non-cash expenses, such as depreciation and amortization, the provision for loan losses, and a benefit related to deferred income taxes, of $278.7 million; non-cash restructuring costs of $0.5 million, partially offset by a $7.0 million non-cash benefit from a gain on debt extinguishment and a $290.0 million net decrease in cash resulting from changes in operating assets and liabilities. The most significant change within operating assets and liabilities was a $287.8 million increase in loans receivable, net of provision for losses. Loans receivable will fluctuate from period to period depending on the timing of loan issuances and collections. A seasonal decline in consumer loans receivable typically takes place during the first quarter of the year and is driven by income tax refunds in the United States. Customers receiving income tax refunds will use the proceeds to pay outstanding loan balances, resulting in an increase of our net cash balances and a decrease of our consumer loans receivable balances. Consumer loans receivable balances typically reflect growth during the remainder of the year. Cash flows from investing activities During the year ended December 31, 2016, we used net cash of $16.0 million for the purchase of property and equipment, including software licenses, partially offset by a $3.1 million decrease in our restricted cash balance. This compared to $26.3 million in net cash used in investing activities during the year ended December 31, 2015. The growth in property and equipment was driven primarily by capital expenditures associated with new store openings in Canada, store refreshes in the United States, and expenditures for software licenses. For the year ended December 31, 2016, we also received £1.4 million ($1.9 million) of funds previously placed in a collateral account with a U.K. banking institution, and received $4.0 million of funds previously placed in a collateral account with a U.S. banking institution. As a result of the borrowings from the Non-Recourse U.S. SPV Facility, approximately $2.8 million of cash was restricted. Cash flows from financing activities During the year ended December 31, 2016, net cash provided by financing activities was $59.4 million, compared to $12.3 million in net cash used in financing activities during the year ended December 31, 2015. The change was primarily due to $91.7 million of proceeds received from new borrowings from our newly created Non-Recourse U.S. SPV Facility and ABL Facility. In addition, we incurred additional deferred financing costs associated with this debt. During the year ended December 31, 2016, CURO Intermediate used cash of $18.9 million to purchase $25.1 million of outstanding May 2011 10.75% Senior Secured Notes at 71.25% of the principal, plus accrued and unpaid interest of $1.0 million via an open-market purchase. During the year, we also received proceeds from draws on our credit facilities of $30.0 million, and repaid $38.1 million of the outstanding balance of borrowings on our credit facilities. Borrowings under our credit facilities provided us with short-term liquidity and were used for working capital requirements and to fund capital expenditures. Contractual Obligations Contractual obligations include agreements that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum, or variable price provisions; and the approximate timing of the transaction. For obligations with cancellation provisions, the amounts included in the following table were limited to the non-cancelable portion of the agreement terms or the minimum cancellation fee. The expected timing of payments of the obligations below is estimated based on current information. Timing of payments and actual amounts paid may be different, depending on the timing of receipt of goods or services, or changes to agreed-upon amounts for some obligations. The following table summarizes our significant contractual obligations and commitments as of December 31, 2017: On February 15, 2017, CFTC issued $470.0 million of 12.00% Senior Secured Notes. Interest on the notes is payable semiannually, in arrears, on March 1 and September 1 of each year, beginning on September 1, 2017. The proceeds from the notes and available cash were used to (i) redeem 10.75% Senior Secured Notes due 2018 of our subsidiary, CURO Intermediate, (ii) redeem our 12.00% Senior Cash Pay Notes due 2017, and (iii) pay fees, expenses, premiums and accrued interest in connection with the offering. On September 1, 2017, we closed a $25.0 million Senior Secured Revolving Loan Facility, or the Senior Revolver. The negative covenants of the Senior Revolver generally conform to the related provision of the Indenture dated February 15, 2017 for our 12.00% Senior Secured Notes and complements our other financing sources, while providing seasonal short-term liquidity. The Senior Revolver was undrawn at December 31, 2017. On November 2, 2017, CFTC issued $135.0 million principal amount of additional 12.00% Senior Secured Notes in a private offering exempt from the registration requirements of the Securities Act, or the Additional Notes Offering. We used the proceeds from the Additional Notes Offering, together with available cash, to (i) pay a cash dividend, in an amount of $140.0 million, and (ii) pay fees and expenses, in connection therewith. CFTC received the consent of the holders holding a majority in the outstanding principal amount outstanding of the current 12.00% Senior Secured Notes to a one-time waiver with respect to the restrictions contained in Section 5.07(a) of the indenture governing the 12.00% Senior Secured Notes to permit the dividend. We entered into operating lease agreements for the buildings in which we operate that expire at various times through 2030. The majority of the leases have an original term of five years with two 5-year renewal options. Most of the leases have escalation clauses and several also require payment of certain period costs including maintenance, insurance and property taxes. For additional information concerning our operating leases, see Note 19, "Operating Leases" of the Notes to Consolidated Financial Statements in this Annual Report on Form 10-K. Off-Balance Sheet Arrangements We originate loans in all of our store locations and online, except for our operations in Texas and Ohio. In these states, we operate as a Credit Services Organization, or CSO, through three of our operating subsidiaries. Our CSO program in Texas is licensed as a Credit Access Business, or CAB, under Texas Finance Code Chapter 393 and regulated by the Texas Office of the Consumer Credit Commissioner. Our CSO program in Ohio is registered under the Credit Services Organization Act, Ohio Revised Code Sections 4712.01 to 4712.99, and regulated by the Ohio Department of Commerce Division of Financial Institutions. As a CAB, we charge our customers a CSO fee for arranging an unrelated third-party to make a loan to that customer. When a customer executes an agreement with us under our CSO programs, we agree, for a CSO fee payable to us by the customer, to provide certain services to the customer, one of which is to guarantee the customer’s obligation to repay the loan the customer receives from the third-party lender if the customer fails to do so. For CSO loans, each lender is responsible for providing the criteria by which the customer’s application is underwritten and, if approved, determining the amount of the customer loan. We in turn are responsible for assessing whether or not we will guarantee the loan. This guarantee represents an obligation to purchase specific loans, if they go in to default. Since the loans are made by a third-party lender, they are not included in our Consolidated Balance Sheets as loans receivable. As of December 31, 2017, the maximum amount payable under all such guarantees was $65.2 million, compared to $59.6 million at December 31, 2016. Should we be required to pay any portion of the total amount of the loans we have guaranteed, we will attempt to recover some or the entire amount from the customers. We hold no collateral in respect of the guarantees. The initial measurement of this guarantee liability is recorded at fair value and reported in the Credit services organization guarantee liability line in our Consolidated Balance Sheets. The fair value of the guarantee is measured by assessing the nature of the loan products, the creditworthiness of the borrowers in the customer base, our historical loan default history for similar loans, industry loan default history, and historical collection rates on similar products, current default trends, past-due account roll rates, changes to underwriting criteria or lending policies, new store development or entrance into new markets, changes in jurisdictional regulations or laws, recent credit trends and general economic conditions. The guarantee liability was $17.8 million at December 31, 2017 and $17.1 million at December 31, 2016, respectively. Additionally, we enter into operating leases in the normal course of business. Our operating lease obligations are discussed in Note 19 - "Operating Leases" of our Notes to Consolidated Financial Statements. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We consider the following accounting policies to be critical in understanding our historical and future performance and require management's most subjective and complex judgments. Current and Past-Due Loans Receivable We classify our loans receivable as either current or past-due. Single-Pay and Open-End Loans are considered past-due when a customer misses a scheduled payment, and it is charged-off to the allowance for loan losses. The charge-off of Unsecured Installment and Secured Installment Loans was impacted by a change in accounting estimate in 2017. Effective January 1, 2017, we modified the timeframe in which Installment Loans are charged-off and made related refinements to our loss provisioning methodology. Prior to January 1, 2017, we deemed all loans uncollectible and charged-off when a customer missed a scheduled payment and the loan was considered past-due. Because of our continuing shift from Single-Pay to Installment Loan products and analysis of the timing and quantity of payments on early-stage versus late-stage delinquencies, we revised our estimates and now consider Installment Loans uncollectible when the loan has been past-due for 90 consecutive days. Consequently, past-due Installment Loans remain in loans receivable, with disclosure of past-due balances, for 90 days before being charged-off against the allowance for loan losses. Subsequently, all recoveries on charged-off loans are credited to the allowance for loan losses. In the income statement, the provision for losses for Installment Loans is based on an assessment of the cumulative net losses inherent in the underlying loan portfolios, by vintage, and other quantitative and qualitative factors. The resulting loss provision rate is applied to loan originations to determine the provision for losses. In addition to improving estimated collectability and loss recognition for Installment Loans, we also believe these refinements are better aligned with industry comparisons and practices. The aforementioned change was treated as a change in accounting estimate and is being applied prospectively, effective January 1, 2017. As a result, some credit quality metrics for 2017 may not be comparable to historical periods. Throughout the remainder of this report, we refer to the change as the Q1 Loss Recognition Change. Installment Loans generally are considered past-due when a customer misses a scheduled payment. Loans zero to 90 days past-due are included in gross loans receivable. We accrue interest on past-due loans until charged off. The amount of the resulting charge-off includes unpaid principal, accrued interest and any uncollected fees, if applicable. Consequently, net loss rates that include accrued interest will be higher than under the methodology applied prior to January 1, 2017. In addition to the revised loss provision rates to accommodate the change in estimate, $61.0 million of past-due Installment Loans were included in gross loans receivable as of December 31, 2017. Before the Q1 Loss Recognition Change, no past-due loans were included in gross loans receivable. Allowance for Loan Losses The allowance for loan losses is primarily based on back-testing of subsequent collections history by product and cumulative aggregate net losses by product and by vintage. We do not specifically reserve for any individual loan but rather segregate loans into separate pools based upon loan portfolios containing similar risk characteristics. Additional quantitative factors, such as current default trends, past-due account roll rates (expected future cash collections by past-due aging category based on current trends) and changes to underwriting and portfolio mix are also considered in evaluating the adequacy of the allowance and current provision rates. Qualitative factors such as the impact of new loan products, changes to underwriting criteria or lending policies, new store development or entrance into new markets, changes in jurisdictional regulations or laws, recent credit trends and general economic conditions impact management’s judgment on the overall adequacy of the allowance for loan losses. In addition to the effect on Installment provision rates and loan balances, the Q1 Loss Recognition Change affected comparability of activity in the related allowance for loan losses. Specifically, no Unsecured Installment or Secured Installment Loans were charged-off to the allowance for loan losses in the three months ended March 31, 2017 because charge-off effectively occurs on day 91 under the revised methodology and no affected loans originated during the period reached day 91 until April 2017. Actual charge-offs and recoveries on defaulted/charged-off loans from the three months ended March 31, 2017 affected the allowance for loan losses in prospective periods. But, as discussed previously, the related net losses were recognized in the Consolidated Statement of Income during the year ended December 31, 2017 by applying expected net loss provision rates to the related loan originations. Credit Services Organization Through our CSO programs, we act as a credit services organization/credit access business on behalf of customers in accordance with applicable state laws. We currently offer loans through CSO programs in stores and online in the state of Texas and online in the state of Ohio. In Texas we offer Unsecured Installment Loans and Secured Installment Loans with a maximum term of 180 days. In Ohio we offer an Unsecured Installment Loan product with a maximum term of 18 months. As a CSO we earn revenue by charging the customer a fee, or the CSO fee, for arranging an unrelated third-party to make a loan to that customer. When a customer executes an agreement with us under our CSO programs, we agree, for a CSO fee payable to us by the customer, to provide certain services to the customer, one of which is to guarantee the customer’s obligation to repay the loan the customer receives from the third-party lender if the customer fails to do so. CSO fees are calculated based on the amount of the customer’s outstanding loan. For CSO loans, each lender is responsible for providing the criteria by which the customer’s application is underwritten and, if approved, determining the amount of the customer loan. We in turn are responsible for assessing whether or not we will guarantee the loan. This guarantee represents an obligation to purchase specific loans, if they go in to default. These guarantees are performance guarantees as defined in ASC Topic 460. Performance guarantees are initially accounted for pursuant to ASC Topic 460 and recognized at fair value, and subsequently pursuant to ASC Topic 450 as contingent liabilities when we incur losses as the guarantor. The initial measurement of the guarantee liability is recorded at fair value and reported in the Credit services organization guarantee liability line in our Consolidated Balance Sheets. The initial fair value of the guarantee is the price we would pay to a third party market participant to assume the guarantee liability. There is no active market for transferring the guarantee liability. Accordingly, we determine the initial fair value of the guarantee by estimating the expected losses on the guaranteed loans. The expected losses on the guaranteed loans are estimated by assessing the nature of the loan products, the credit worthiness of the borrowers in the customer base, our historical loan default history for similar loans, industry loan default history, and historical collection rates on similar products, current default trends, past-due account roll rates, changes to underwriting criteria or lending policies, new store development or entrance into new markets, changes in jurisdictional regulations or laws, recent credit trends and general economic conditions. We review the factors that support estimates of expected losses and the guarantee liability monthly. In addition, because the majority of the underlying loan customers make bi-weekly payments, loan-pool payment performance is evaluated more frequently than monthly. Our guarantee liability represents the unamortized portion of the guarantee obligation required to be recognized at inception of the performance guarantee in accordance with ASC Topic 460 and a contingent liability for those performance guarantees where it is probable that we will be required to purchase the guaranteed loan from the lender in accordance with ASC Topic 450. CSO fees are calculated based on the amount of the customer’s outstanding loan. We comply with the applicable jurisdiction’s Credit Services Organization Act or a similar statute. These laws generally define the services that we can provide to consumers and require us to provide a contract to the customer outlining our services and the cost of those services to the customer. For services we provide under our CSO programs, we receive payments from customers on their scheduled loan repayment due dates. The CSO fee is earned ratably over the term of the loan as the customers make payments. If a loan is paid off early, no additional CSO fees are due or collected. The maximum CSO loan term is 180 days and 18 months in Texas and Ohio, respectively. During the year ended December 31, 2017 and 2016, approximately 53.6% and 53.2%, respectively, of Unsecured Installment Loans, and 53.6% and 62.5%, respectively, of Secured Installment Loans originated under CSO programs were paid off prior to the original maturity date. Since CSO loans are made by a third-party lender, we do not include them in our Consolidated Balance Sheets as loans receivable. CSO fees receivable are included in “Prepaid expense and other” in our Consolidated Balance Sheets. We receive payments from customers for these fees on their scheduled loan repayment due dates. Recently Issued Accounting Pronouncements See Note 1 Summary of Significant Accounting Policies and Nature of Operations of our Notes to Consolidated Financial Statements for a discussion of recent accounting pronouncements.

<s>[INST] Overview We are a growthoriented, technologyenabled, highlydiversified consumer finance company serving a wide range of underbanked consumers in the United States, Canada and the United Kingdom and are a market leader in our industry based on revenues. We believe that we have the only true omnichannel customer acquisition, onboarding and servicing platform in our industry that is integrated across store, online, mobile and contact center touchpoints. Our IT platform, which we refer to as the “Curo Platform,” seamlessly integrates loan underwriting, scoring, servicing, collections, regulatory compliance and reporting activities into a single, centralized system. We use advanced risk analytics powered by proprietary algorithms and over 15 years of loan performance data to efficiently and effectively score our customers’ loan applications. Since 2010, we have extended $14.5 billion in total credit across approximately 38.1 million total loans, and our revenue of $963.6 million in 2017 represents a 24.8% compound annual growth rate, or CAGR, over the same time period. We operate in the United States under two principal brands, “Speedy Cash” and “Rapid Cash,” and launched our new brand “Avio Credit” in the United States in the second quarter of 2017. In the United Kingdom we operate online as “Wage Day Advance” and "Juo Loans" and, prior to their closure in the third quarter of 2017, our stores were branded “Speedy Cash.” In Canada, our stores are branded “Cash Money” and we offer “LendDirect” installment loans online. As of December 31, 2017, our store network consisted of 407 locations across 14 U.S. states and seven Canadian provinces. As of December 31, 2017, we offered our online services in 27 U.S. states, five Canadian provinces, and the United Kingdom. Recent Developments We completed our initial public offering ("IPO") of 6,666,667 shares of common stock on December 11, 2017, at a price of $14.00 per share, which provided net proceeds of $81.1 million. In connection with the closing, the underwriters had a 30day option to purchase up to an additional 1,000,000 shares at the initial public offering price, less the underwriting discount to overallotments, which they exercised on January 5, 2018, which provided additional net proceeds of $13.0 million. On February 5, 2018 CURO Financial Technologies Corp. (“CFTC”), a whollyowned subsidiary of the Company, issued a notice of redemption for $77.5 million of its 12.00% Senior Secured Notes due 2022 (the “Notes,” and the transaction whereby the Notes are partially redeemed, the “Redemption”) that were issued by CFTC. The redemption was completed on March 7, 2018. The redemption price was equal to 112.00% of the principal amount of the Notes redeemed, plus accrued and unpaid interest paid thereon, to the date of redemption. Following the Redemption, $527.5 million of the original outstanding principal amount of the Notes remain outstanding. The Redemption was conducted pursuant to the Indenture governing the Notes (the “Indenture”), dated as of February 15, 2017, by and among CFTC, the guarantors party thereto and TMI Trust Company, as trustee and collateral agent. Consistent with the terms of the Indenture, CFTC used a portion of the cash proceeds from the Company’s initial public offering, completed on December 11, 2017, to redeem such Notes. Components of Our Results of Operations Revenue We offer a variety of loan products including Installment, OpenEnd and SinglePay Loans. Revenue in our Consolidated Statements of Income includes: interest income, finance charges, CSO fees, late fees and nonsufficient funds fees as permitted by applicable laws and pursuant to the agreement with the customer. Product [/INST] Positive. </s>

CURO Group Holdings Corp.

2019-03-18

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ("MD&A") The following discussion of financial condition, results of operations, liquidity and capital resources and certain factors that may affect future results, including economic and industry-wide factors, should be read in conjunction with our Consolidated Financial Statements and accompanying notes included herein. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. The matters discussed in these forward-looking statements are subject to risk, uncertainties and other factors that could cause actual results to differ materially from those made, projected or implied in the forward-looking statements. Except as required by applicable law and regulations, we undertake no obligation to update any forward-looking statements or other statements we may make in the following discussion or elsewhere in this document even though these statements may be affected by events or circumstances occurring after the forward-looking statements or other statements were made. Please see the section titled “Risk Factors” in this Annual Report for a discussion of the uncertainties, risks and assumptions associated with these statements. Overview We are a growth-oriented, technology-enabled, highly-diversified, multi-channel and multi-product consumer finance company serving a wide range of underbanked consumers in the United States ("U.S."), Canada and, through February 25, 2019, the United Kingdom ("U.K") and are a market leader in our industry based on revenues. We believe that we have the only true omni-channel customer acquisition, onboarding and servicing platform that is integrated across store, online, mobile and contact center touchpoints. Our IT platform, which we refer to as the “Curo Platform,” seamlessly integrates customer acquisition loan underwriting, scoring, servicing, collections, regulatory compliance and reporting activities into a single, centralized system. We use advanced risk analytics powered by proprietary algorithms and over 15 years of loan performance data to efficiently and effectively score our customers’ loan applications. From 2010 through December 31, 2018, we have extended $17.1 billion in total credit across approximately 43.8 million total loans. We operate in the U.S. under two principal brands, “Speedy Cash” and “Rapid Cash,” and we launched our online brand “Avio Credit” in the U.S. in the second quarter of 2017. In Canada, our stores are branded “Cash Money” and we offer “LendDirect” Installment loans online and at certain stores. In the U.K., through February 25, 2019, we operated online as “Wage Day Advance” and "Juo Loans" and, prior to their closure in the third quarter of 2017, our stores were branded “Speedy Cash.” As of December 31, 2018, our store network consisted of 413 locations across 14 U.S. states and seven Canadian provinces and we offered our online services in 27 U.S. states, five Canadian provinces and the U.K. Recent Developments Metabank. In April 2018, we announced that we expect to begin offering U.S. consumers a new line of credit product through a relationship with MetaBank® ("Meta"), a wholly-owned subsidiary of Meta Financial Group, Inc. CURO and Meta are currently developing the pilot launch. We do not expect the Meta relationship to contribute to our financial results until 2020. Secondary Offering and Underwriter Option. On May 21, 2018, certain of our stockholders sold shares of our common stock pursuant to an underwritten public offering, at a price to the public of $23.00 per share. The underwriters subsequently partially exercised their option to purchase additional shares of our common stock from certain of these selling stockholders, which together with the May offering, totaled more than 5.5 million shares. We did not sell any shares in the offering and did not receive any proceeds from the sale of the shares offered by the selling stockholders in the offering. Credit facilities: For recent developments related to our Senior Secured Notes, SPV facilities and other resources, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources.” U.K. Developments. On February 25, 2019, we announced that a proposed Scheme of Arrangement ("SOA"), as described in our Form 8-K dated January 31, 2019, related to CTL, will not be implemented. We also announced that effective February 25, 2019, in accordance with the provisions of the U.K. Insolvency Act 1986 and as approved by the boards of directors of our U.K. Subsidiaries, insolvency practitioners from KPMG were appointed as Administrators in respect of both of the U.K. Subsidiaries. The effect of the U.K. Subsidiaries’ entry into administration was to place the management, affairs, business and property of the U.K. Subsidiaries under the direct control of the Administrators. Accordingly, we will deconsolidate the U.K. Subsidiaries as of February 25, 2019 and will present the U.K. Subsidiaries as Discontinued Operations in the first quarter of 2019. In our Form 8-K dated January 31, 2019, our results of operations included a $30.3 million expense comprised of (i) a proposed $23.6 million fund to settle historical redress claims and (ii) $6.7 million in advisory and other costs that would be required to execute the SOA. We subsequently concluded that pursuant to ASC 450, Contingencies, the SOA did not represent an estimate of loss for the redress loss contingency but instead was offered in ongoing negotiation of a potential compromised settlement with creditors. Therefore, the settlement offered through the SOA did not meet the recognition threshold pursuant to ASC 450 and should not have been accrued as a contingent liability for customer redress claims as of December 31, 2018. Our Form 8-K filed March 1, 2019 appropriately included $4.6 million of fourth quarter 2018 redress costs and related charges which represents known claims as of December 31, 2018. See Item 9A., "Controls and Procedures" for further discussion of the material weakness in internal controls over improper or incomplete application of technical GAAP standards and related interpretations of complex or non-routine matters. Components of Our Results of Operations Effects of Inflation The impact of inflation has not had a material effect on our annual consolidated results of operations over the past three years. However, prolonged periods of deflation could adversely affect the degree to which we are able to increase sales through price increases. Revenue We offer a variety of loan products including Unsecured Installment, Secured Installment, Open-End and Single-Pay loans. Revenue in our Consolidated Statements of Operations includes: interest income, finance charges, CSO fees, late fees and non-sufficient funds fees as permitted by applicable laws and pursuant to the agreement with the customer. Product offerings differ by jurisdiction and are governed by the laws in each separate jurisdiction. Installment loans are fully amortizing loans with a fixed payment amount due each period during the term of the loan. We record revenue from Installment loans on a simple-interest basis. Unsecured and Secured Installment revenue includes interest income, CSO fees, and non-sufficient funds or returned-items fees on late or defaulted payments on past-due loans (to which we refer collectively as “late fees”). Late fees comprise less than 1% of Installment revenues. Accrued interest and fees are included in "Gross loans receivable" in the Consolidated Balance Sheets. Open-End loans are a revolving line-of-credit with no defined loan term. We record revenue from Open-End loans on a simple-interest basis. Open-End revenues include interest income on outstanding revolving balances and other usage or maintenance fees as permitted by underlying statutes. Accrued interest and fees are included in "Gross loans receivable" in the Consolidated Balance Sheets. Single-Pay loans are primarily payday loans. We recognize revenues from Single-Pay loan products each period on a constant-yield basis ratably over the term of each loan. We defer recognition of unearned fees based on the remaining term of the loan at the end of each reporting period. Single-Pay revenues represent deferred presentment or other fees as defined by the underlying state, provincial or national regulations. We also provide a number of ancillary financial products including check cashing, proprietary reloadable prepaid debit cards (Opt+), money transfer services, gold buying, credit protection insurance in the Canadian market, and retail installment sales. Provision for Losses Credit losses are an inherent part of outstanding loans receivable. We maintain an allowance for loan losses for loans and interest receivable at a level estimated to be adequate to absorb such losses based primarily on our analysis of historical loss rates by products containing similar risk characteristics. The allowance for losses on our Company-owned gross loans receivables reduces the outstanding gross loans receivables balance in the consolidated balance sheets. The liability for estimated incurred losses related to Loans Guaranteed by the Company under CSO programs is reported in "Liability for losses on CSO lender-owned consumer loans" in the consolidated balance sheets. Increases in either the allowance or the liability, net of charge-offs and recoveries, are recorded as “Provision for losses” in the Consolidated Statements of Operations. Q1 2017 Loss Recognition Change Effective January 1, 2017, we modified the timeframe in which Installment loans are charged-off and made related refinements to our loss provisioning methodology. Prior to January 1, 2017, we deemed all loans uncollectible and charged-off when a customer missed a scheduled payment and the loan was considered past-due. Because of our continuing shift from Single-Pay to Installment loan products and our analysis of payment patterns on early-stage versus late-stage delinquencies, we revised our estimates and now consider Installment loans uncollectible when the loan has been contractually past-due for 90 consecutive days. Consequently, past-due Installment loans and related accrued interest remain in loans receivable, with disclosure of past-due balances, for 90 days before being charged off against the allowance for loan losses. All recoveries on charged-off loans are credited to the allowance for loan losses. We evaluate the adequacy of the allowance for loan losses compared to the related gross loans receivable balances that include accrued interest. The aforementioned change was treated as a change in accounting estimate for accounting purposes and applied prospectively beginning January 1, 2017, which we refer to throughout this Annual Report as the Q1 2017 Loss Recognition Change. The change affected comparability to prior periods as follows: • Gross Combined Loans Receivable-balances in 2017 included Installment loans that were up to 90 days past-due with related accrued interest, while balances in prior periods did not include these loans. • Revenues-for the year ended December 31, 2017, revenues included accrued interest on past-due loan balances, while revenues in prior periods did not include these amounts. • Provision for Losses-prospectively, loans charged off on day 91 included accrued interest. Thus, we adjusted allowance coverage rates in 2017 to include both principal and accrued interest. For a full discussion of the change, see Note 1, “Summary of Significant Accounting Policies and Nature of Operations” of the Notes to Consolidated Financial Statements. Hurricane Harvey Impact In an effort to help our store and online customers in the affected areas of Houston, Corpus Christi and the surrounding areas, we waived loan payments that were due during the period from August 25, 2017 to September 8, 2017. This affected approximately 22,500 customers and amounted to approximately $3.0 million in total loan payments. The waived payments and losses on secured installment loans in the market increased our provision for losses by approximately $3.3 million. Property damage to our 18 stores in the affected areas was not material. Our stores in the Texas markets resumed normal operations in September 2017. Cost of Providing Services Salaries and Benefits Salaries and benefits include personnel-related costs for our store operations, including salaries, benefits and bonuses and are driven by the number of employees. Occupancy Occupancy and equipment includes rent expense for our leased facilities, as well as depreciation, maintenance, insurance and utility expense. Office Office includes expenses related to software, computer hardware, bank service charges, credit scoring charges and other office supplies. Other Costs of Providing Services Our other costs of providing services includes expenses related to operations such as processing fees, collections expense, security expense, taxes, repairs and professional fees. Advertising All advertising costs are expensed as incurred. Advertising includes costs associated with attracting, retaining and/or reactivating customers as well as creating awareness for the brands we promote. We have internal creative, web and print design capabilities and we rarely outsource those services. The use of third parties is limited to mass-media production and placement. Advertising expense also includes costs for all marketing activities including paid search, advertising on social networking sites, affiliate programs, direct response television, radio air time and direct mail. Operating Expense Corporate, District and Other Expenses Corporate and district expenses include costs such as salaries and benefits associated with our corporate and district-level employees, as well as other corporate-related costs such as rent, insurance, professional fees, utilities, travel and entertainment expenses and depreciation expense. Other (income) and expense includes the foreign currency impact to our intercompany balances, gains or losses on foreign currency exchanges and disposals of fixed assets and other miscellaneous income and expense amounts. Interest Expense Interest expense primarily includes interest related to our Senior Secured Notes, our Non-Recourse SPV facilities and our Senior Revolver. Discussion of Revenue by Product and Segment and Related Loan Portfolio Performance Revenue by Product The following table summarizes revenue by product, including CSO fees, for 2018 and 2017: During the year ended December 31, 2018, total lending revenue (excluding revenues from ancillary products) grew $120.6 million, or 13.1%, to $1,044.2 million, compared to the prior year, predominantly driven by growth in Installment loans in the U.S. and U.K. and Open-End loans in the U.S. and Canada. Geographically, revenue in the U.S., Canada and U.K. grew 15.6%, 3.0% and 24.7%, respectively, with Canada being affected negatively by product mix shift away from Single-Pay loans. From a product perspective, Unsecured Installment revenues rose 17.0% and Secured Installment revenues rose 9.6% because of loan growth. Single-Pay revenues were affected by regulatory changes in Canada (rate changes in Ontario and British Columbia) leading to a shift to Open-End loans as well as a continued general product shift away from Single-Pay. Open-End revenues rose 93.2% on the introduction of Open-End products in Canada and Virginia and on organic growth in the U.S. Open-End loan balances in Canada, where we began offering the product in the fourth quarter of 2017, grew $150.9 million year-over-year. Ancillary revenues increased 25.0% versus the prior year primarily due to non-lending revenue in Canada. The following table summarizes revenue by product for 2017 and 2016: Total lending revenue (excluding revenues from ancillary products) grew $131.1 million, or 16.5%, to $923.5 million, compared to the prior year period. Growth was driven predominantly by Unsecured and Secured Installment loan revenue. Unsecured installment loan revenues rose 45.2% on related origination increase of 46.4%. Secured Installment revenues increased 24.0% on related origination increase of 33.2%. Single-Pay revenues were affected primarily by regulatory changes in Canada (rate changes in Ontario and British Columbia and product changes in Alberta). U.S. and U.K. Single-Pay revenues also decreased 8.6% and 37.8%, respectively, because of continued mix shift from Single-Pay to Installment and Open-End products. Ancillary revenues increased 10.8% versus the same period a year ago primarily due to insurance revenue in Canada, partially offset by a decrease in check cashing fees. U.K. revenue increased $5.8 million, or 17.1% ($7.8 million, or 23.0%, on a constant currency basis). Loan Volume and Portfolio Performance Analysis The following table summarizes Company-Owned gross loans receivable, a GAAP balance sheet measure, and reconciles it to gross combined loans receivable, a non-GAAP measure(1) including loans originated by third-party lenders through CSO programs, which are not included in the consolidated financial statements but from which we earn revenue and for which we provide a guarantee to the lender: (1) See a description of non-GAAP Financial Measures in "Supplemental Non-GAAP Financial Information" above. The following table presents gross combined loans receivable by product: Gross combined loans receivable increased $165.6 million, or 32.4%, to $677.2 million as of December 31, 2018 compared to $511.6 million at December 31, 2017. Geographically, gross combined loans receivable grew 14.0%, 100.9% and 28.9%, respectively, in the U.S., Canada and U.K., explained further by product in the following sections. Unsecured Installment Loans Unsecured Installment revenue and gross combined loans receivable during the quarter ended December 31, 2018 increased from the prior year quarter due to growth in the U.S., primarily in California and our CSO programs, as well as growth in the U.K. Gross combined Unsecured Installment loan balances grew $20.1 million, or 7.4%, compared to December 31, 2017, despite a decline in Canada of $29.3 million due to mix shift to Open-End. Excluding Canada, gross combined Unsecured Installment loan balances increased 21.8% year-over-year. Canada was negatively impacted by the growth and customer preference of Open-End during 2018, as further discussed below. In Canada, total Unsecured Installment loan originations declined $22.4 million, or 72.3%, from the fourth quarter of 2017 also due to mix shift; U.S. originations were up $19.4 million, or 11.0%, versus the prior-year quarter. The net charge-off ("NCO") rate for Company Owned Unsecured Installment loans in the fourth quarter of 2018 increased approximately 350 bps from the fourth quarter of 2017, primarily due to geographic mix shift from Canada to the U.S. and U.K. Canada Unsecured Installment balances were down $29.3 million compared to the prior year due to shifting customer preference from that product to Open-End, while U.S. Company Owned balances grew $38.1 million due to customer demand and greater advertising spend. As a result, the U.S. percentage mix of total Company Owned Unsecured Installment loan balances rose from 69.7% to 81.7% year-over-year. The level of NCO rates in the U.S. and U.K. is higher than Canada, so the relative growth in the U.S. balances resulted in an overall increase in the consolidated NCO rate. The NCO rate for the U.S. also increased (approximately 160 bps) year-over-year due to broader qualifications for credit limit increases ("CLI"). While CLIs generally result in modestly higher NCO rates in the related loan vintages, the growth in net revenue over the life of such vintages more than covers the higher NCO rates. In addition, NCO rates in the fourth quarter of 2017 were lowered by the pattern of monthly growth in that quarter. The required Unsecured Installment Allowance for loan losses as a percentage of Gross Company Owned Unsecured Installment loans receivable ("Allowance Coverage") remained consistent sequentially on a consolidated basis. Although NCO rates increased sequentially, consistent with normal seasonal trends, the past-due rate was flat and evaluation of collection experience required Allowance Coverage at a level similar to the level in the third quarter 2018. NCO rates for Unsecured Installment loans Guaranteed by the Company increased 400 bps compared to the same quarter in 2017. Approximately half of the increase was due to broader qualification for CLIs. As described above, NCO rates increase as a result of CLIs but growth in net revenue more than covers the increased NCO rates. The remainder of the increase was due to the timing of loan growth in the fourth quarter of 2017, which occurred sequentially from November to December and distorted the relationship between NCO dollars and quarterly average loan balances. NCO rates and past-due rates for Unsecured Installment loans Guaranteed by the Company improved sequentially by 320 bps and 90 bps, respectively, resulting in the required CSO liability for losses coverage to decrease from 16.8% to 15.0% in the fourth quarter of 2018. Secured Installment Loans Secured Installment gross combined loans receivable balances as of December 31, 2018 increased by $3.1 million, or 3.3%, compared to December 31, 2017, primarily due to organic growth in Arizona, while related Secured Installment revenue grew 6.3% because of the related loan growth. Allowance for loan losses and CSO liability for losses as a percentage of Secured Installment gross loans receivable increased sequentially from 12.4% to 13.2%, primarily driven by an increase in NCO rates during the fourth quarter of 2018 because Arizona's loans tend to have relatively higher yields and loss rates than our average secured installment loans. Open-End Loans Open-End loan balances as of December 31, 2018 increased by $159.4 million, or 332.4%, compared to December 31, 2017, primarily due to the aforementioned launch of Open-End products in Canada, which amounted to $150.9 million of the total loan growth. Open-End balances in Canada grew $19.4 million sequentially from the third quarter of 2018 ($28.2 million on a constant currency basis), to $158.1 million in the fourth quarter of 2018. Remaining year-over-year loan growth was driven by the introduction of Open-End loans in Virginia in the third quarter of 2017 and growth in seasoned markets, such as Tennessee and Kansas. The Open-End Allowance for loan losses as a percentage of Open-End gross loans receivable was flat sequentially and declined year-over-year primarily due to geographic mix shift, Open-End loans in Canada require lower allowance coverage than Open-End loans in the U.S. At December 31, 2018, Canadian Open-End gross loans receivable comprised 76.2% of the total Open- End product, compared to 15.0% at December 31, 2017. In addition, the allowance for loan losses as a percentage of Open-End gross loans receivable declined modestly in the U.S. because of a 330 bps sequential improvement in NCO rates from continued seasoning of the U.S. portfolio, particularly in Virginia and Tennessee. Additionally, in Canada run-rate growth is stabilizing after the Ontario launch and net charge-offs as a percentage of gross loans receivable improved sequentially in the fourth quarter of 2018 by nearly 280 bps. Single-Pay Single-Pay revenue and related loans receivable during the three months ended December 31, 2018 declined year-over-year compared to the prior year period, primarily due to regulatory changes in Canada (rate changes in Ontario and British Columbia) that accelerated the shift to Open-End loans, as well as a continued general product shift away from Single-Pay to Installment and Open-End loans in all three countries. The aforementioned Open-End growth in Canada ($150.9 million year-over-year) in part came at the expense of Single-Pay loan balances, which shrank year-over-year by $16.0 million. The Single-Pay Allowance for loan losses as a percentage of gross loans receivable increased from 4.7% to 5.4%, sequentially, primarily as a result of new rules in certain provinces in Canada requiring an extended payment plan structure for customers taking multiple loans within a condensed period of time. Results of Operations - CURO Group Consolidated Operations Condensed Consolidated Statements of Operations Reconciliation of Net Income and Diluted Earnings per Share to Adjusted Net Income and Adjusted Diluted Earnings per Share, non-GAAP measures Reconciliation of Net income to EBITDA and Adjusted EBITDA, non-GAAP measures Revenue and Net Revenue Revenue increased $130.7 million, or 13.6%, to $1,094.3 million for the year ended December 31, 2018 from $963.6 million for the year ended December 31, 2017. On a year-over-year basis, U.S. revenue increased 15.6% driven by volume growth. Canada revenue increased 3.0%, as volume growth offset yield compression from regulatory impacts on Single-Pay loan rates and a significant product mix-shift to Open-End loans. U.K. revenue increased 24.7%. The provision for losses increased $117.0 million, or 35.9%, to $443.2 million for the year ended December 31, 2018 from $326.2 million for the year ended December 31, 2017. As further described in the "Segment Analysis" below, the increase in the provision was greater than the revenue growth, primarily as a result of loan growth, upfront provisioning on Open-End loan volumes and mix shift away from Single-Pay loans. Cost of Providing Services The total cost of providing services increased $22.0 million, or 7.6%, to $310.2 million for the year ended December 31, 2018, as compared to $288.2 million for the year ended December 31, 2017, primarily because of higher advertising costs associated with the revenue growth of 13.6%. Operating Expenses Corporate, district and other expenses increased $31.6 million, or 20.4%, primarily due to $22.5 million of goodwill impairment charges, $5.1 million of asset impairment charges and $11.5 million of U.K. customer redress costs, offset by lower year-over-year share-based cash and non-cash compensation, transaction costs and legal settlements as described above. See Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations-U.K. Segment Results" below for further explanations on the customer redress costs. Provision for Income Taxes The effective income tax benefit rate for the year ended December 31, 2018 was (7.2)% compared to an effective income tax expense rate of 46.4% for the year ended December 31, 2017. As a result of the 2017 Tax Act, the statutory U.S. federal corporate income tax rate decreased from 35% in 2017 to 21%, effective in 2018. The provision for income tax as of December 31, 2018 includes a net accrual reduction of $1.6 million for adjustments to estimates of the tax on prior years' foreign repatriation as the result of additional interpretative guidance from the IRS issued in 2018. Excluding this benefit from tax expense and excluding the U.K. redress and related costs described above, the effective income tax rate for full year 2018 would have been 23.5%. Year Ended December 31, 2018 Compared with Year Ended December 31, 2017 - Segment Analysis We report financial results for three reportable segments: the U.S., Canada and the U.K. Following is a summary of results of operations for the segment and period indicated: U.S. revenues increased by $115.4 million, or 15.6%, to $853.1 million for the year ended December 31, 2018. U.S. revenue growth was driven by a $54.4 million, or 14.0%, increase in gross combined loans receivable, to $441.9 million at December 31, 2018, from $387.5 million at December 31, 2017. Unsecured Installment receivables increased year-over-year $40.4 million, or 19.1%. Open-End receivables increased $8.5 million, or 20.9%, compared to the prior year period, primarily driven by the 2017 third quarter introduction of Open-End loans in Virginia and organic growth in Tennessee and Kansas. Secured Installment loan receivables increased from the prior year period by $3.1 million, or 3.3%, while CSO and Single-Pay receivables grew 3.1% and 5.6%, respectively. The increase of $81.1 million, or 30.3%, in provision for losses was driven in part by the 14.0% increase in gross combined loans receivable of $54.4 million and higher NCOs as a percentage of average gross loans receivable. The provision for loan losses and related loan portfolio performance is further analyzed under “Discussion of Revenue by Product and Segment and Related Loan Portfolio Performance--Loan Volume and Portfolio Performance Analysis” above. The U.S. cost of providing services was $219.7 million, an increase of $16.7 million, or 8.2%, compared to $203.0 million for the year ended December 31, 2017. The increase was primarily due to $12.7 million, or 35.1%, higher advertising costs. Advertising costs were elevated in 2018 compared to 2017 primarily because of the expansion of Avio loans and the mix shift to online. The $8.0 million decrease in corporate, district and other operating expenses was primarily due to $2.1 million lower share-based compensation expense, lower variable compensation costs for financial performance and lower professional fees, offset by increased investment in technology, analytical and professional talent and incremental costs of being a public company. Canada revenue rose $5.5 million, or 3.0%, to $191.9 million, for the year ended December 31, 2018, from $186.4 million in the prior year. Revenue growth in Canada benefited from the significant asset growth and accelerated product transition from Single-Pay and Unsecured Installment loans to Open-End loans. Single-Pay yields were affected adversely by regulatory rate changes in Alberta, Ontario and British Columbia. Currency translation for the period did not have a significant impact on net revenue compared to the prior year. Single-Pay revenue decreased $36.2 million, or 24.5%, to $111.4 million for the year ended December 31, 2018, and Single-Pay ending receivables decreased $16.0 million, or 30.5%, to $36.6 million from $52.6 million in the prior year. The decreases in Single-Pay revenue and receivables were due to the product mix shift in Canada from Single-Pay loans to Open-End loans and by regulatory changes that lowered pricing year-over-year. Canadian non-Single-Pay revenue increased $41.7 million, or 107.5%, to $80.5 million compared to $38.8 million in the same period a year ago on $121.5 million, or 234.0%, growth in related loan balances. The increase was primarily related to the launch of Open-End products in Alberta and Ontario in the fourth quarter of 2017 and significant expansion of the Open-End product in Ontario in the third and fourth quarters of 2018. The provision for losses increased $27.9 million, or 61.9%, to $73.0 million for the year ended December 31, 2018 compared to $45.1 million in the prior-year period, primarily because of loan volumes and mix shift from Single-Pay loans to Unsecured Installment and Open-End loans. The cost of providing services in Canada increased $4.9 million, or 6.7%, to $78.3 million for the year ended December 31, 2018, compared to $73.4 million in the prior year. The increase was due primarily to $4.8 million, or 7.6%, higher non-advertising costs of providing services compared to the prior year, reflecting $2.2 million of loan servicing costs associated with Canada's increased loan portfolio and $1.1 million of additional compensation expense related to an increase in headcount from LendDirect store openings. The remaining increase is primarily related to occupancy expenses from higher store counts, as we opened seven LendDirect stores during 2018. Operating expenses increased $6.5 million, or 37.8%, to $23.6 million in the year ended December 31, 2018, from $17.2 million in the prior year. Corporate, district and other expenses increased $2.7 million, due to increased collections and customer support payroll expenses, increased volumes, expansion of the LendDirect business and product shifts from Single-Pay and Unsecured Installment to Open-End loans. Additionally, interest expense increased $3.8 million, due to the Non-Recourse Canada SPV Facility commenced in August 2018. U.K. revenue improved $9.7 million, or 24.7%, to $49.2 million for the year ended December 31, 2018 compared to $39.5 million in the prior year. On a constant currency basis, revenue rose $8.2 million, or 20.7%. Provision for losses increased $8.0 million, and, on a constant currency basis, increased $7.3 million, or 53.3%, due to volume growth. The cost of providing services in the U.K. increased $0.4 million, or 3.5%, for the year ended December 31, 2018, compared to the prior year period. On a constant currency basis, the cost of providing services remained flat year-over-year. Corporate, district and other expenses increased $36.9 million, or 214.4%, to $54.1 million for the year ended December 31, 2018, as compared to the prior year period, which includes (i) $22.5 million of goodwill impairment, (ii) $5.1 million of intangible asset and property and equipment impairment charges as a result of the U.K. Subsidiaries placement into administration on February 25, 2019 and (iii) $11.5 million of customer redress costs. Results of Operations - CURO Group Consolidated Operations Condensed Consolidated Statements of Operations Reconciliation of Net Income and Diluted Earnings per Share to Adjusted Net Income and Adjusted Diluted Earnings per Share, non-GAAP measures Reconciliation of Net income to EBITDA and Adjusted EBITDA, non-GAAP measures Revenue and Net Revenue Revenue increased $135.0 million, or 16.3%, to $963.6 million for the year ended December 31, 2017 from $828.6 million for the prior year period. U.S. revenue increased $130.9 million on volume growth, the U.K. increased $5.8 million and Canada decreased $1.7 million due to regulatory impacts on rates and product mix. Provision for losses increased by $67.9 million, or 26.3%, to $326.2 million for the year ended December 31, 2017 from $258.3 million for the prior year because of higher origination volumes and higher loan balances. Cost of Providing Services The total cost of providing services increased $11.1 million, or 4.0%, to $288.2 million for the year ended December 31, 2017, compared to $277.1 million for the year ended December 31, 2016, due primarily to 18.5% higher marketing spend as well as increases in occupancy, office and other operating expenses. Operating Expenses Corporate, district and other expenses increased $30.7 million primarily due to debt extinguishment costs, share-based cash and non-cash compensation, IPO-related costs and legal settlement costs, as described above in the reconciliation of Net income to Adjusted net income, as well as increases in payroll, collections, office and technology-related costs. Interest expense in 2017 increased by approximately $18.4 million which was the result of accrued interest on the retired notes through the redemption notice period and increased debt outstanding. Provision for Income Taxes The effective tax rate for the year ended December 31, 2017 was 46.4% compared to 39.4% for the prior year. As a result of the 2017 Tax Act, the full year effective tax rate includes a net one-time charge of $3.9 million from adjustments to deferred tax assets and liabilities and recognition of tax expense related to Canadian earnings that have not been repatriated. Excluding the impact of the 2017 Tax Act, the effective tax rate for full-year 2017 was 41.4%. The remaining change in the effective tax rate from the prior year was primarily due to U.K. operations. The 2017 U.K. results included $7.4 million of restructuring costs related to the closure of the remaining 13 U.K. stores. We recorded a 100% valuation allowance against the resulting deferred tax asset and therefore did not recognize the related tax benefit. Year Ended December 31, 2017 Compared with Year Ended December 31, 2016 - Segment Analysis We report financial results for three reportable segments: the U.S., Canada and the U.K. Following are a recap of results of operations for the segment and period indicated: Full year U.S. revenue grew by $130.9 million, or 21.6%, to $737.7 million. U.S. revenue growth was driven by a $49.4 million, or 18.0%, increase in gross combined loans receivable (excluding past-due loans) to $323.6 million at December 31, 2017 compared to $274.2 million in the prior year period. We experienced strong volume growth in Unsecured Installment originations which increased year-over-year $131.9 million, or 27.4%. Secured Installment originations grew $45.9 million, or 33.2%, compared to the same period a year ago. The increase of $59.7 million, or 28.8%, in provision for losses was primarily driven by the previously-mentioned increase in gross combined loans receivable and related origination volumes as well as the Q1 2017 Loss Recognition Change. U.S. cost of providing services for the year ended December 31, 2017 were $203.0 million, an increase of $8.3 million, or 4.3%, compared to $194.7 million for the year ended December 31, 2016. The increase was due primarily to $5.8 million, or 19.1%, higher marketing spend, as well as increases in volume-driven expenses and store security and maintenance costs. All other U.S. operating expenses were $215.8 million for the year ended December 31, 2017, an increase of $68.2 million, or 46.2%, compared to $147.6 million in the prior year period. Excluding the effects of the items discussed previously in "Reconciliation of Net Income and Diluted Earnings per Share to Adjusted Net Income and Adjusted Diluted Earnings per Share, non-GAAP measures" applicable to the U.S. as indicated in the Segment table above, Corporate, district and other operating expenses rose $13.6 million, or 15.6%, primarily due to increased technology and analytics headcount. Revenue in Canada was affected by product transition in Alberta from Single-Pay loans to Unsecured Installment loans and the impact of regulatory rate changes in Ontario and British Columbia. Non-Alberta Single-Pay revenue decreased $1.1 million, or 0.8%, to $146.2 million for 2017 and was affected by lower rates from provincial regulatory changes effective January 1, 2017. The impact of the rate changes was offset by higher origination volumes resulting in a modest increase in related revenue. Single-Pay ending receivables (excluding Alberta) increased $9.1 million, or 20.9%, to $52.6 million from $43.5 million in the prior year period. Because of regulatory changes in Alberta, we converted Single-Pay customers to Unsecured Installment loans during December 2016, resulting in $22.7 million of Unsecured Installment loans outstanding at the end of 2016. As of December 31, 2017, $43.7 million of Unsecured Installment and Open-End receivables were outstanding in Alberta. The provision for losses rose $5.2 million, or 12.9%, to $45.1 million for full year 2017 compared to $39.9 million in the prior year period. As in the U.S., the increase was due to higher loan origination volume and the shift in Alberta from Single-Pay to Unsecured Installment loans. The cost of providing services in Canada increased $3.9 million, or 5.6%, to $73.4 million for the year ended December 31, 2017, compared to $69.5 million in the prior year period due primarily to an increase in occupancy expense, based on a higher number of stores in operation during 2017 as compared to the prior year, as well as an increase in store maintenance costs and higher marketing spend. Operating expenses decreased $1.0 million, or 5.5%, to $17.2 million in the year ended December 31, 2017, from $18.2 million in the prior year period, due to the consolidation of certain back-office functions during the third quarter of 2016. U.K. revenue improved $5.8 million, or 17.1%, to $39.5 million for the year ended December 31, 2017 from $33.7 million in the prior year period. On a constant currency basis, revenue was up $7.8 million, or 23.0%. Provision for losses increased $3.0 million, or 28.6%, and increased $3.7 million, or 34.5%, on a constant currency basis, due to growth in Installment loan receivables. The cost of providing services in the U.K. decreased slightly from the prior year period because of third quarter 2017 store closures. On a constant currency basis the cost of providing services decreased $0.4 million, or 3.1%. Operating expenses increased $5.1 million, or 26.0%, from the prior year period, and on a constant currency basis increased $6.3 million, or 32.4%, due to restructuring costs from closing the 13 remaining stores during the third quarter of 2017. Excluding the store closure costs, operating expenses decreased $1.3 million, or 7.2%, because of reduced headquarters and contact center headcount and lower professional fees. Store count As of December 31, 2018, we had 413 stores in 14 U.S. states and seven provinces in Canada, which included the following: • 213 U.S. locations: Texas (90), California (36), Nevada (18), Arizona (13), Tennessee (11), Kansas (10), Illinois (8), Alabama (7), Missouri (5), Louisiana (5), Colorado (3), Oregon (3), Washington (2), and Mississippi (2) • 200 Canadian locations: Ontario (131), Alberta (27), British Columbia (26), Saskatchewan (6), Nova Scotia (5), Manitoba (4), and New Brunswick (1) Online: We lend online in 27 states in the U.S., five provinces in Canada, and, through February 25, 2019, in England, Wales, Scotland and Northern Ireland in the U.K. From January 1, 2017 through December 31, 2018 we opened 10 LendDirect stores in Canada. During the same period we closed 17 stores: three stores in Texas that primarily were underperforming former Money Box stores, one store in Canada due to a lease that was not renewed and the remaining 13 store locations in the U.K. as part of an overall plan to reduce operating losses in light of ongoing regulatory and market changes in the U.K. Store counts as of date are depicted below. Currency Information We operate in the U.S., Canada and, through February 25, 2019, the U.K. and report our consolidated results in U.S. dollars. Changes in our reported revenues and net income include the effect of changes in currency exchange rates. We translate all balance sheet accounts into U.S. dollars at the currency exchange rate in effect at the end of each period. We translate the statement of operations at the average rates of exchange for the period. We record currency translation adjustments as a component of Accumulated Other Comprehensive Income in stockholders’ equity. Constant Currency Analysis We have operations in the U.S., Canada, and, through February 25, 2019, the U.K. For the years ended December 31, 2018 and 2017, approximately 22.0% and 23.4%, respectively, of our revenues were originated in foreign currencies. As a result, changes in our reported results include the impacts of changes in foreign currency exchange rates for the respective currencies. Years Ended December 31, 2018 and 2017 Years Ended December 31, 2017 and 2016 As additional information, we have provided a constant currency analysis below to remove the impact of the fluctuation in foreign exchange rates and utilize constant currency results in our analysis of segment performance. All conversion rates below are based on the U.S. Dollar equivalent to one of the applicable foreign currencies. We believe that the constant currency assessment below is a useful measure in assessing the comparable growth and profitability of our operations. We calculated the revenues and gross margin below for the year ended December 31, 2018 using the actual average exchange rate for the year ended December 31, 2017. We calculated the revenues and gross margin below for the year ended December 31, 2017 using the actual average exchange rate for the year ended December 31, 2016. Liquidity and Capital Resources Our principal sources of liquidity to fund the loans we make to our customers are cash provided by operations, our Senior Revolver, funds from third party lenders under our CSO programs, our Non-Recourse U.S. SPV Facility and our Non-Recourse Canada SPV Facility (defined below). During August 2018, we issued $690.0 million 8.25% Senior Secured Notes due September 2025 ("8.25% Senior Secured Notes") to (i) redeem the outstanding 12.00% Senior Secured Notes due 2022 of CURO Financial Technologies Corp., the Company's wholly-owned subsidiary ("CFTC"), (ii) to repay the outstanding indebtedness under the five-year revolving credit facility of CURO Receivables Finance I, LLC, our wholly-owned subsidiary, which consists of a term loan and revolving borrowing capacity, (iii) for general corporate purposes and (iv) to pay fees, expenses, premiums and accrued interest in connection with the foregoing. As of December 31, 2018, we were in compliance with all financial ratios, covenants and other requirements set forth in our debt agreements. We anticipate that our primary use of cash will be to fund growth in our working capital, finance capital expenditures and meet our debt obligations. Our level of cash flow provided by operating activities typically experiences some seasonal fluctuation related to our levels of net income and changes in working capital levels, particularly loans receivable. Unexpected changes in our financial condition or other unforeseen factors may result in our inability to obtain third-party financing or could increase our borrowing costs in the future. We have the ability to adjust our volume of lending to consumers which would reduce cash outflow requirements while increasing cash inflows through loan repayments to the extent we experience any short-term or long-term funding shortfalls. We may also sell or securitize our assets, draw on our available revolving credit facility or line of credit, enter into additional refinancing agreements and reduce our capital spending in order to generate additional liquidity. We believe our cash on hand and available borrowings provide us with sufficient liquidity for at least the next 12 months. Borrowings Our long-term debt consisted of the following as of December 31, 2018 and 2017 (net of deferred financing costs): Available Credit Facilities and Other Resources 8.25% Senior Secured Notes As noted above, we issued our 8.25% Senior Secured Notes in August 2018. Interest on the notes is payable semiannually, in arrears, on March 1 and September 1 of each year. In connection with the 8.25% Senior Secured Notes, we capitalized financing costs of approximately $13.3 million, the balance of which is included in the Consolidated Balance Sheets as a component of Long-term debt, and is being amortized over the term of the 8.25% Senior Secured Notes and included as a component of interest expense. The extinguishment of the 12.00% Senior Secured Notes due 2022 resulted in a pretax loss of $69.2 million during the year ended December 31, 2018. 12.00% Senior Secured Notes In February and November 2017, CFTC issued $470.0 million and $135.0 million, respectively, of 12.00% Senior Secured Notes ("12.00% Senior Secured Notes"). Interest on the 12.00% Senior Secured Notes is payable semiannually, in arrears, on March 1 and September 1 of each year, beginning on September 1, 2017. The February issuance refinanced similar notes that were nearing maturity. The extinguishment of the existing notes resulted in a pretax loss of $12.5 million during the nine months ended September 30, 2017. In connection with these 2017 debt issuances, we capitalized financing costs of approximately $18.3 million, the balance of which is included in the Consolidated Balance Sheets as a component of Long-term debt as of December 31, 2017. On March 7, 2018, CFTC redeemed $77.5 million of its 12.00% Senior Secured Notes using a portion of the proceeds from our IPO as required by the underlying indentures (the transaction whereby the 12.00% Senior Secured Notes were partially redeemed, the “Redemption”) at a price equal to 112.00% of the principal amount of the 12.00% Senior Secured Notes redeemed, plus accrued and unpaid interest paid thereon to the date of Redemption. Following the Redemption, $527.5 million of the original outstanding principal amount of the 12.00% Senior Secured Notes remain outstanding. The Redemption was conducted pursuant to the Indenture governing the 12.00% Senior Secured Notes (the “Indenture”), dated as of February 15, 2017, by and among CFTC, the guarantors party thereto and TMI Trust Company, as trustee and collateral agent. The remainder of the 12.00% Senior Secured Notes were extinguished effective September 7, 2018 as a result of the issuance of the 8.25% Senior Secured Notes as described above. Non-Recourse U.S. SPV Facility and ABL Facility In November 2016, CURO Receivables Finance I, LLC, a Delaware limited liability company (the “SPV Borrower”) and a wholly-owned subsidiary, entered into a five-year revolving credit facility with Victory Park Management, LLC and certain other lenders that provided for an $80.0 million term loan and $70.0 million of revolving borrowing capacity that can expand over time (“Non-Recourse U.S. SPV Facility”). The loans bear interest at an annual rate of up to 12.00% plus the greater of (x) 1.0% per annum and (y) the three-month LIBOR. The SPV Borrower also pays a 0.50% per annum commitment fee on the unused portion of the commitments. During the three months ended September 30, 2018, a portion of the proceeds from the 8.25% Senior Secured Notes were used to extinguish the revolver's balance of $42.4 million. In October 2018, we extinguished the remaining term loan balance of $80.0 million. We made the final termination payment of $2.7 million on October 26, 2018, resulting in a loss on the extinguishment of debt of $9.7 million during the fourth quarter of 2018. Non-Recourse Canada SPV Facility In August 2018, CURO Canada Receivables Limited Partnership, a newly created, bankruptcy-remote special purpose vehicle (the “Canada SPV Borrower”) and a wholly-owned subsidiary, entered into a four-year revolving credit facility with Waterfall Asset Management, LLC that provides for C$175.0 million of initial borrowing capacity and the ability to expand such capacity up to C$250.0 million (“Non-Recourse Canada SPV Facility”). The Non-Recourse Canada SPV Facility is secured by a first lien against all assets of the Canada SPV Borrower, which is a special purpose vehicle into which certain eligible receivables originated by our operating entities in Canada are sold. The loans bear interest at an annual rate of 6.75% plus the three-month CDOR. As of December 31, 2018, the carrying amount of outstanding borrowings from the Non-Recourse Canada SPV Facility was $107.5 million. Senior Revolver On September 1, 2017, we closed a $25.0 million Senior Secured Revolving Loan Facility (the "Senior Revolver"). In February 2018, the Senior Revolver capacity was increased to $29.0 million. In November 2018, the Senior Revolver capacity was increased to $50.0 million as permitted by the Indenture to the Senior Secured Notes. The Senior Revolver is now syndicated with participation by four banks. The negative covenants of the Senior Revolver generally conform to the related provisions in the Indenture for our 8.25% Senior Secured Notes. We believe this facility complements our other financing sources, while providing seasonal short-term liquidity. Under the Senior Revolver, there is $50.0 million maximum availability, including up to $5.0 million of standby letters of credit, for a one-year term, renewable for successive terms following annual review. The Senior Revolver accrues interest at the one-month LIBOR (which may not be negative) plus 5.00% per annum and is repayable on demand. The terms of the Senior Revolver require that the outstanding balance be reduced to $0 for at least 30 consecutive days in each calendar year. The Senior Revolver is guaranteed by all subsidiaries of CURO that guarantee our 8.25% Senior Secured Notes and is secured by a lien on substantially all assets of CURO and the guarantor subsidiaries that is senior to the lien securing our 8.25% Senior Secured Notes. The outstanding balance for the Senior Revolver was $20.0 million at December 31, 2018. In connection with this facility we capitalized financing costs of approximately $0.1 million, the balance of which are included in the Consolidated Balance Sheets as a component of “Other assets,” and are being amortized over the term of the facility and included as a component of interest expense. Cash Money Revolving Credit Facility Cash Money Cheque Cashing, Inc., one of our Canadian subsidiaries, maintains a C$10 million revolving credit facility with Royal Bank of Canada. The Cash Money Revolving Credit Facility provides short-term liquidity required to meet the working capital needs of our Canadian operations. Aggregate draws under the revolving credit facility are limited to the lesser of: (i) the borrowing base, which is defined as a percentage of cash, deposits in transit and accounts receivable, and (ii) C$10 million. As of December 31, 2018 and December 31, 2017, the borrowing capacity under our revolving credit facility was reduced by C$0.3 million in stand-by-letters of credit. The Cash Money Revolving Credit Facility is collateralized by substantially all of Cash Money’s assets and contains various covenants that include, among other things, that the aggregate borrowings outstanding under the facility not exceed the borrowing base, restrictions on the encumbrance of assets and the creation of indebtedness. Borrowings under the Cash Money Revolving Credit Facility bear interest (per annum) at the prime rate of a Canadian chartered bank plus 1.95%. The Cash Money Revolving Credit Facility was undrawn at December 31, 2018 and December 31, 2017. Balance Sheet Changes - December 31, 2018 compared to December 31, 2017 Cash. During the year ended December 31, 2018, we fully redeemed the 12.00% Senior Secured Notes held by CFTC, our wholly-owned subsidiary. CFTC redeemed $77.5 million of the 12.00% Senior Secured Notes in the first quarter of 2018 and the remaining $527.5 million of the original outstanding principal in the third quarter of 2018. The redemptions were conducted pursuant to the Indenture at a price equal to 112.00% of the principal amount plus accrued and unpaid interest to the date of redemption. During the fourth quarter of 2018, CFTC also extinguished the outstanding indebtedness under the CURO Receivables Finance I, LLC, our wholly-owned subsidiary, five-year revolving credit facility consisting of a term loan and revolving borrowing capacity. The resulting decrease in cash was offset by (i) 1.0 million shares exercised by the underwriters on January 5, 2018 at $14 per share in connection with our IPO in December 2017 providing additional net proceeds to us of $13.1 million; (ii) issuance of $690.0 million aggregate principal amount of 8.25% Senior Secured Notes due 2025; (iii) net outstanding balance of $20.0 million on our credit facility (the facility was drawn $29.0 million at the end of the third quarter of 2018, $9.0 million of which was repaid during the fourth quarter); and (iv) $111.3 million proceeds from the Canada SPV Facility. Restricted Cash. Restricted cash increased in 2018 due to increased cash in our consolidated wholly-owned, bankruptcy remote special purpose subsidiaries ("VIEs") from underlying loan volume growth. Gross Loans Receivable and Allowance for Loan Losses. As explained in "Discussion of Revenue by Product and Segment and Related Loan Portfolio Performance--Loan Volume and Portfolio Performance Analysis" above, changes in Gross Loans Receivable and related Allowance for Loan Losses were due to organic growth in Installment loans and product mix shift to Installment and Open-End loans (primarily in Canada). Other Assets. Other assets increased because of a $2.6 million increase in the cash surrender value of life insurance used to fund our non-qualified deferred compensation plan and an additional $1.0 million investment we made in Cognical Holdings, Inc. ("Cognical Holdings") in March 2018 that increased our equity ownership from 9.4% to 10.4%. Cognical Holdings operates as a business under an online website, www.zibby.com, that facilitates the purchase of household items by underbanked consumers. Long-term debt (including current maturities) and Accrued Interest. Changes from year-end 2017 were primarily due to the issuance of the 8.25% Senior Secured Notes due 2025 and the redemption of the 12.00% Senior Secured Notes due 2022, as previously discussed. During the third quarter of 2018, we entered into the Canadian SPV Facility and, on October 11, 2018 we used a portion of the proceeds from the 8.25% Senior Secured Notes due 2025 to pay, in full, the U.S. SPV Facility. Additionally, the Canada SPV Facilities had $111.3 million outstanding as of December 31, 2018. Cash Flows The following highlights our cash flow activity and the sources and uses of funding during the periods indicated. Net cash outflows for loan originations and receipts on collections of principal of $417.5 million and $278.5 million have been reclassified from "Net cash provided by operating activities" to "Net cash used in investing activities" for the years ended December 31, 2017 and 2016, respectively, to conform to current year presentation. We determined such reclassification is required by ASC 230-10-45-12 and 13, Statement of Cash Flows. This change in classification did not impact cash flows. See Item 9A. Controls and Procedures for discussion of the material weakness in internal controls over improper or incomplete application of technical GAAP standards and related interpretations to complex or non-routine matters. Years Ended December 31, 2018 and 2017 Cash Flows from Operating Activities During the year ended December 31, 2018, our net cash provided by operating activities was $534.5 million. Contributing to current year net cash provided by operating activities were net loss of $22.1 million and expenses, primarily non-cash, of $592.5 million. Major components of non-cash expenses include depreciation and amortization of $18.8 million, provision for loan losses of $443.2 million, loss on debt extinguishment of $90.6 million, goodwill impairment charge of $22.5 million related to our U.K. reporting unit placed into administration on February 25, 2019, and share-based compensation expense of $8.2 million. Contributions from net loss and non-cash expenses were offset by changes in our operating assets and liabilities of $36.0 million. Fees and service charges on our loans receivable change represented $12.0 million of the total change in operating assets and liabilities. Cash Flows from Investing Activities During the year ended December 31, 2018, our net cash used in investing activities was $620.8 million, primarily reflecting the net origination of loans of $605.6 million. In addition, we used cash to purchase approximately $14.3 million of property and equipment, including software licenses, and to purchase $1.0 million of Cognical Holdings preferred shares. Origination of loans will fluctuate from period-to-period, depending on the timing of loan issuances and collections. A seasonal decline in consumer loans receivable typically occurs during the first quarter of the year and is driven by income tax refunds in the U.S. Typically, customers will use the proceeds from income tax refunds to pay outstanding loan balances, resulting in an increase in our net cash balances and a decrease in our consumer loans receivable balances. Consumer loans receivable balances typically reflect growth during the remainder of the year. Cash Flows from Financing Activities Net cash used for the year ended December 31, 2018 was $19.1 million. During 2018, we redeemed $77.5 million of our 12.00% Senior Secured Notes in the first quarter of 2018 and the remaining $527.5 million of the original outstanding principal in the third quarter of 2018 resulting from the issuance of $690.0 million aggregate principal amount of 8.25% Senior Secured Notes due 2025. During the fourth quarter of 2018, we extinguished the outstanding indebtedness under the Canada SPV Borrower, resulting in net payments of $124.6 million for the year ended December 31, 2018. As part of these extinguishments, we paid $69.7 million in call premiums. During the third quarter of 2018, we entered into a Non-Recourse Canada SPV facility which provided $117.2 million of proceeds. We also had net borrowings of $20.0 million on our Senior Revolver during 2018. Net proceeds from the issuance of common stock and proceeds from the exercise of stock options were $11.7 million as of December 31, 2018. Years Ended December 31, 2017 and 2016 Cash Flows from Operating Activities During the year ended December 31, 2017, our operating activities provided net cash of $434.9 million. Contributing to 2017 net cash provided by operating activities were net income of $49.2 million and non-cash expenses of $376.5 million, including depreciation and amortization, the provision for loan losses and a loss on debt extinguishment. The net contribution from changes in our operating assets and liabilities was $9.2 million. Cash Flows from Investing Activities During the year ended December 31, 2017, we used cash of $432.9 million primarily as a result of the increase in loans receivable, which represented $417.5 million of the total change in investing activities. In addition, we used cash to increase our restricted cash balances by approximately $4.0 million, to purchase approximately $9.8 million of property and equipment, including software licenses, and to purchase $5.6 million of Cognical Holdings preferred shares. The increase in restricted cash was primarily attributable to our Non-Recourse U.S. SPV Facility. Loans receivable will fluctuate from period-to-period depending on the timing of loan issuances and collections. A seasonal decline in consumer loans receivable typically takes place during the first quarter of the year and is driven by income tax refunds in the U.S. Customers receiving income tax refunds will use the proceeds to pay outstanding loan balances, resulting in an increase in our net cash balances and a decrease in our consumer loans receivable balances. Consumer loans receivable balances typically reflect growth during the remainder of the year. Cash Flows from Financing Activities Net cash used for the year ended December 31, 2017 was $36.7 million. We extinguished our 10.75% Senior Secured Notes for $426.0 million (which included $8.9 million of call premium) and extinguished our Senior Cash Pay Notes for $130.1 million. These payments were partially financed by proceeds of $447.6 million (net of $14.0 million of debt issuance costs and $8.5 million of discount on notes issued) from the issuance of the 12.00% Senior Secured Notes due 2022. On November 2, 2017, CFTC issued $135.0 million of additional 12.00% Senior Secured Notes due 2022. CFTC used the proceeds of this notes offering and related issuance premium to pay a $140.0 million dividend to us and, ultimately, our stockholders. We paid total dividends of $182.0 million to our stockholders during 2017. Our IPO of 6,666,667 shares of common stock at a price of $14.00 per share provided net proceeds after transaction costs of $81.1 million. We also had net borrowings of $32.9 million from our U.S. SPV Facility and our ABL Facility. Contractual Obligations Contractual obligations include agreements that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. For obligations with cancellation provisions, the amounts included in the following table were limited to the non-cancelable portion of the agreement or the minimum cancellation fee. The expected timing of payments of the obligations below is estimated based on current information. Timing of payments and actual amounts paid may be different, depending on the timing of receipt of goods or services, or changes to agreed-upon amounts for some obligations. The following table summarizes our significant contractual obligations and commitments as of December 31, 2018: In August 2018, we issued our 8.25% Senior Secured notes due 2025. The proceeds of this issuance were used to (i) redeem the outstanding 12.00% Senior Secured Notes due 2022 of the Company's wholly-owned subsidiary, CURO Financial Technologies Corp., (ii) to repay the outstanding indebtedness under the CURO Receivables Finance I, LLC, our wholly-owned subsidiary, five-year revolving credit facility consisting of a term loan and revolving borrowing capacity, (iii) for general corporate purposes and (iv) to pay fees, expenses, premiums and accrued interest in connection therewith. In August 2018, CURO Canada Receivables Limited Partnership, a newly created, bankruptcy-remote special purpose vehicle (the "Canada SPV Borrower") and wholly-owned subsidiary, entered into a four-year revolving credit facility with Waterfall Asset Management, LLC that provides for C$175.0 million of initial borrowing capacity and the ability to expand such capacity up to C$250.0 million ("Non-Recourse Canada SPV Facility"). This facility matures in 2022. We entered into operating leases for the buildings in which we operate that expire at various times through 2030. The majority of the leases have an original term of five years with two, five-year renewal options. Most of the leases have escalation clauses and several also require payment of certain period costs including maintenance, insurance and property taxes. For additional information concerning our operating leases, see Note 18, "Operating Leases" of the Notes to Consolidated Financial Statements. Off-Balance Sheet Arrangements We originate loans in all of our store locations and online, except for our operations in Texas and Ohio. In these states, we operate as a Credit Services Organization ("CSO"), through three of our operating subsidiaries. Our CSO program in Texas is licensed as a Credit Access Business ("CAB") under Texas Finance Code Chapter 393 and regulated by the Texas Office of the Consumer Credit Commissioner. Our CSO program in Ohio is registered under the Credit Services Organization Act, Ohio Revised Code Sections 4712.01 to 4712.99, and regulated by the Ohio Department of Commerce Division of Financial Institutions. Refer to "Critical Accounting Practices and Estimates--Credit Services Organization" below for further information on our CSO/CAB relationships. As of December 31, 2018, the maximum amount payable under all such guarantees was $66.9 million, compared to $65.2 million at December 31, 2017. This liability is not included in our Consolidated Balance Sheets. Should we be required to pay any portion of the total amount of the loans we have guaranteed, we will attempt to recover some or the entire amount from the customers. We hold no collateral in respect of the guarantees. We estimate a liability for losses associated with the guaranty provided to the CSO lenders using assumptions and methodologies similar to the allowance for loan losses, which we recognize for our consumer loans. The liability for incurred losses on CSO lender-owned consumer loans was $12.0 million at December 31, 2018 and $17.8 million at December 31, 2017. Additionally, we enter into operating leases in the normal course of business. Our operating lease obligations are discussed in Note 18, "Operating Leases" of our Notes to Consolidated Financial Statements. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We consider the following accounting policies to be critical in understanding our historical and future performance and require management's most subjective and complex judgments. Current and Past-Due Loans Receivable We classify our loans receivable as either current or past-due. Single-Pay and Open-End loans are considered past-due when a customer misses a scheduled payment, and it is charged-off to the allowance for loan losses. The charge-off of Unsecured Installment and Secured Installment loans was impacted by a change in accounting estimate in 2017. Effective January 1, 2017, we modified the timeframe in which Installment loans are charged-off and made related refinements to our loss provisioning methodology. Prior to January 1, 2017, we deemed all loans uncollectible and charged-off when a customer missed a scheduled payment and the loan was considered past-due. Because of our continuing shift from Single-Pay to Installment loan products and analysis of the timing and quantity of payments on early-stage versus late-stage delinquencies, we revised our estimates and now consider Installment loans uncollectible when the loan has been past-due for 90 consecutive days. Consequently, past-due Installment loans remain in loans receivable, with disclosure of past-due balances, for 90 days before being charged-off against the allowance for loan losses. Subsequently, all recoveries on charged-off loans are credited to the allowance for loan losses. The aforementioned change was treated as a change in accounting estimate and is being applied prospectively, effective January 1, 2017. As a result, some credit quality metrics for 2017 may not be comparable to historical periods. Throughout the remainder of this Annual Report, we refer to the change as the Q1 2017 Loss Recognition Change. Installment loans generally are considered past-due when a customer misses a scheduled payment. Loans zero to 90 days past-due are included in gross loans receivable. We accrue interest on past-due loans until charged off. The amount of the resulting charge-off includes unpaid principal, accrued interest and any uncollected fees, if applicable. Consequently, net loss rates that include accrued interest will be higher than under the methodology applied prior to January 1, 2017. In addition to the revised loss provision rates to accommodate the change in estimate, $61.0 million of past-due Installment loans were included in gross loans receivable as of December 31, 2017. Before the Q1 2017 Loss Recognition Change, no past-due loans were included in gross loans receivable. Allowance for Loan Losses Credit losses are an inherent part of outstanding loans receivable. We maintain an allowance for loan losses for loans and interest receivable at a level estimated to be adequate to absorb incurred losses based primarily on our analysis of historical loss or charge-off rates by products containing similar risk characteristics. The allowance for losses on our Company-owned gross loans receivables reduces the outstanding gross loans receivables balance in the Consolidated Balance Sheets. The liability for incurred losses related to Loans Guaranteed by the Company under CSO programs is reported in “Liability for losses on CSO lender-owned consumer loans” in the Consolidated Balance Sheets. Increases in either the allowance or the liability, net of charge-offs and recoveries, are recorded as “Provision for losses” in the Consolidated Statements of Operations. We also consider delinquency trends as well as any macro-economic conditions that we believe may affect portfolio losses. If a loan is deemed to be uncollectible before it is fully reserved based on information we become aware of (e.g., receipt of customer bankruptcy notice or death), we charge off such loan at that time. Qualitative factors such as the impact of new loan products, changes to underwriting criteria or lending policies, new store development or entrance into new markets, changes in jurisdictional regulations or laws, recent credit trends and general economic conditions impact management’s judgment on the overall adequacy of the allowance for loan losses. Any recoveries on loans previously charged to the allowance are credited to the allowance when collected. During the year ended December 31, 2018, the Company changed its estimated allowance for loan losses for its Unsecured Installment and Secured Installment gross loans receivable and for Loans Guaranteed by the Company under CSO programs. Prior to the change in the estimate, the Company utilized historic collection experience by AR aging grouping for these products to assess losses inherent in the portfolio and incurred as of the balance sheet date. Upon further consideration, as the company now has history on performance subsequent to the Q1 2017 Loss Recognition Change, it was determined that the estimation process should be refined to utilize charge off and recovery rates and estimated loss development periods to comply with the provisions of ASC 310-10-35-41 and ASC 450-20. See Item 9A. Controls and Procedures for further discussion of the material weakness in internal controls over improper or incomplete application of technical GAAP standards and related interpretations to complex or non-routine matters. In addition to the effect on Unsecured and Secured Installment provision rates and loan balances, the Q1 2017 Loss Recognition Change affected comparability of activity in the related allowance for loan losses. Specifically, no Unsecured or Secured Installment loans were charged-off against the allowance for loan losses in the three months ended March 31, 2017 because charge-off effectively occurs on day 91 under the revised methodology and no affected loans originated during the period reached day 91 until April 2017. Actual charge-offs and recoveries on defaulted/charged-off loans from the three months ended March 31, 2017 affected the allowance for loan losses in prospective periods. However, as discussed previously, the related net losses were recognized in the Consolidated Statements of Operations during the year ended December 31, 2017 by applying expected net loss provision rates to the related loan originations. Credit Services Organization Through our CSO programs, we act as a CSO/CAB on behalf of customers in accordance with applicable state laws. We currently offer loans through CSO programs in stores and online in the state of Texas and online in the state of Ohio. In Texas we offer Unsecured Installment Loans and Secured Installment Loans with a maximum term of 180 days. In Ohio we offer an Unsecured Installment Loan product with a maximum term of 18 months. As a CSO, we earn revenue by charging the customer a fee ("CSO fee") for arranging an unrelated third-party to make a loan to that customer. When a customer executes an agreement with us under our CSO programs, we agree, for a CSO fee payable to us by the customer, to provide certain services to the customer, one of which is to guarantee the customer’s obligation to repay the loan to the third-party lender if the customer fails to do so. CSO fees are calculated based on the amount of the customer’s outstanding loan. For CSO loans, each lender is responsible for providing the criteria by which the customer’s application is underwritten and, if approved, determining the amount of the customer loan. We in turn are responsible for assessing whether or not we will guarantee the loan. This guarantee represents an obligation to purchase specific loans, if they go in to default. We estimate a liability for losses associated with the guaranty provided to the CSO lenders using assumptions and methodologies similar to the allowance for loan losses, which we recognize for our consumer loans. Our liability for incurred losses on CSO loans guaranteed by the Company was $12.0 million and $17.8 million at December 31, 2018 and 2017, respectively. CSO fees are calculated based on the amount of the customer’s outstanding loan. We comply with the applicable jurisdiction’s Credit Services Organization Act or a similar statute. These laws generally define the services that we can provide to consumers and require us to provide a contract to the customer outlining our services and related costs. For services we provide under our CSO programs, we receive payments from customers on their scheduled loan repayment due dates. The CSO fee is earned ratably over the term of the loan as the customers make payments. If a loan is paid off early, no additional CSO fees are due or collected. The maximum CSO loan term is 180 days and 18 months in Texas and Ohio, respectively. During the year ended December 31, 2018 and 2017, approximately 57.3% and 53.6%, respectively, of Unsecured Installment loans, and 54.5% and 53.6%, respectively, of Secured Installment loans originated under CSO programs were paid off prior to the original maturity date. Since CSO loans are made by a third-party lender, we do not include them in our Consolidated Balance Sheets as loans receivable. CSO fees receivable are included in “Prepaid expense and other” in our Consolidated Balance Sheets. We receive payments from customers for these fees on their scheduled loan repayment due dates. Recently Issued Accounting Pronouncements See Note 1, "Summary of Significant Accounting Policies and Nature of Operations" of our Notes to Consolidated Financial Statements for a discussion of recent accounting pronouncements.

<s>[INST] Overview We are a growthoriented, technologyenabled, highlydiversified, multichannel and multiproduct consumer finance company serving a wide range of underbanked consumers in the United States ("U.S."), Canada and, through February 25, 2019, the United Kingdom ("U.K") and are a market leader in our industry based on revenues. We believe that we have the only true omnichannel customer acquisition, onboarding and servicing platform that is integrated across store, online, mobile and contact center touchpoints. Our IT platform, which we refer to as the “Curo Platform,” seamlessly integrates customer acquisition loan underwriting, scoring, servicing, collections, regulatory compliance and reporting activities into a single, centralized system. We use advanced risk analytics powered by proprietary algorithms and over 15 years of loan performance data to efficiently and effectively score our customers’ loan applications. From 2010 through December 31, 2018, we have extended $17.1 billion in total credit across approximately 43.8 million total loans. We operate in the U.S. under two principal brands, “Speedy Cash” and “Rapid Cash,” and we launched our online brand “Avio Credit” in the U.S. in the second quarter of 2017. In Canada, our stores are branded “Cash Money” and we offer “LendDirect” Installment loans online and at certain stores. In the U.K., through February 25, 2019, we operated online as “Wage Day Advance” and "Juo Loans" and, prior to their closure in the third quarter of 2017, our stores were branded “Speedy Cash.” As of December 31, 2018, our store network consisted of 413 locations across 14 U.S. states and seven Canadian provinces and we offered our online services in 27 U.S. states, five Canadian provinces and the U.K. Recent Developments Metabank. In April 2018, we announced that we expect to begin offering U.S. consumers a new line of credit product through a relationship with MetaBank® ("Meta"), a whollyowned subsidiary of Meta Financial Group, Inc. CURO and Meta are currently developing the pilot launch. We do not expect the Meta relationship to contribute to our financial results until 2020. Secondary Offering and Underwriter Option. On May 21, 2018, certain of our stockholders sold shares of our common stock pursuant to an underwritten public offering, at a price to the public of $23.00 per share. The underwriters subsequently partially exercised their option to purchase additional shares of our common stock from certain of these selling stockholders, which together with the May offering, totaled more than 5.5 million shares. We did not sell any shares in the offering and did not receive any proceeds from the sale of the shares offered by the selling stockholders in the offering. Credit facilities: For recent developments related to our Senior Secured Notes, SPV facilities and other resources, see “Management’s Discussion and Analysis of Financial Condition and Results of OperationsLiquidity and Capital Resources.” U.K. Developments. On February 25, 2019, we announced that a proposed Scheme of Arrangement ("SOA"), as described in our Form 8K dated January 31, 2019, related to CTL, will not be implemented. We also announced that effective February 25, 2019, in accordance with the provisions of the U.K. Insolvency Act 1986 and as approved by the boards of directors of our U.K. Subsidiaries, insolvency practitioners from KPMG were appointed as Administrators in respect of both of the U.K. Subsidiaries. The effect of the U.K. Subsidiaries’ entry into administration was to place the management, affairs, business and property of the U.K. Subsidiaries under the direct control of the Administrators. Accordingly, we will deconsolidate the U.K. Subsidiaries as of February 25, 2019 and will present the U.K. Subsidiaries as Discontinued Operations in the first quarter [/INST] Negative. </s>

CURO Group Holdings Corp.

2020-03-09

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ("MD&A") The following discussion of financial condition, results of operations, liquidity and capital resources and certain factors that may affect future results, including economic and industry-wide factors, should be read in conjunction with our Consolidated Financial Statements and accompanying notes included herein. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. The matters discussed in these forward-looking statements are subject to risk, uncertainties and other factors that could cause actual results to differ materially from those made, projected or implied in the forward-looking statements. Except as required by applicable law and regulations, we undertake no obligation to update any forward-looking statements or other statements we may make in the following discussion or elsewhere in this document even though these statements may be affected by events or circumstances occurring after the forward-looking statements or other statements were made. Please see the section titled “Risk Factors” in this Annual Report for a discussion of the uncertainties, risks and assumptions associated with these statements. Overview We are a growth-oriented, technology-enabled, highly-diversified, multi-channel and multi-product consumer finance company serving a wide range of underbanked consumers in the U.S. and Canada. We believe that we have the only true omni-channel customer acquisition, onboarding and servicing platform that is integrated across store, online, mobile and contact center touchpoints. Our IT platform, which we refer to as “Curo,” seamlessly integrates customer acquisition loan underwriting, scoring, servicing, collections, regulatory compliance and reporting activities into a single, centralized system. We use advanced risk analytics powered by proprietary algorithms and nearly 20 years of loan performance data to efficiently and effectively score our customers’ loan applications. From 2010 through December 31, 2019, we extended $18.5 billion in credit across approximately 46.7 million loans. In the U.S., our stores operate under “Speedy Cash” and “Rapid Cash.” In the second quarter of 2017, we launched “Avio Credit,” an online Installment and Open-End brand. In February 2019, we launched Revolve Finance, as discussed below. In Canada, our stores are branded “Cash Money” and we offer “LendDirect” Installment and Open-End loans online and at certain stores. As of December 31, 2019, our store network consisted of 416 locations across 14 U.S. states and seven Canadian provinces and we offered our online services in 27 U.S. states and five Canadian provinces. Recent Developments Share Repurchase Program. Our Board of Directors authorized a share repurchase program in April 2019 providing for the repurchase of up to $50.0 million of our common stock. The repurchase program, which commenced June 2019, was fully expended as of February 5, 2020. In February 2020, our Board of Directors authorized a new share repurchase program up to $25.0 million of our common stock. See Note 23, "Share Repurchase Program" of the Notes to Consolidated Financial Statements for additional details. Dividend Program. In February 2020, we initiated a dividend program and declared our first quarterly cash dividend of $0.055 per share ($0.22 per share annualized). See Note 24, "Subsequent Events" of the Notes to Consolidated Financial Statements for additional details. Ad Astra Acquisition. In January 2020, we acquired Ad Astra, our exclusive provider of third-party collection services for the U.S. business. See Note 24, "Subsequent Events" of the Notes to Consolidated Financial Statements for additional details. FFL Repurchase. In August 2019, we entered into a Share Repurchase Agreement (the “Share Repurchase Agreement”) with FFL, a related party. Pursuant to the Share Repurchase Agreement, we repurchased 2,000,000 shares of its common stock, par value $0.001 per share, owned by FFL, in a private transaction at a purchase price equal to $13.55 per share of common stock. This transaction occurred outside of the share repurchase program authorized in April 2019. Revolve Finance. In February 2019, we launched Revolve Finance, sponsored by Republic Bank of Chicago, which is being introduced across our U.S. stores. This product provides customers a checking account solution, with FDIC-insured deposits, that combines a Visa-branded debit card, a number of technology-enabled tools and optional overdraft protection. Bank Relationships. In September 2019, we terminated the previously disclosed marketing and servicing agreement with MetaBank, a wholly-owned subsidiary of Meta Financial Group, Inc. In the fourth quarter of 2019, we signed with Stride Bank to launch an Unsecured Installment loan originated by Stride Bank. We market and service loans on behalf of the bank and Stride licenses our proprietary credit decisioning for Stride Bank's scoring and approval. This product is offered in two U.S. states currently, and we expect to expand it geographically throughout 2020. California Assembly Bill 539: In September 2019, the California legislature passed Assembly Bill 539 which imposes an interest rate cap of 36%, plus Federal Funds Rate, on all consumer loans between $2,500 and $10,000. It became effective on January 1, 2020. Revenue from California Unsecured and Secured Installment loans amounted to 12.2% of total revenue from continuing operations for the year ended December 31, 2019. See "Business-Regulatory Environment and Compliance" for additional details. Credit Facilities. In February 2020, we executed a non-binding letter of intent for an additional $200 million Non-Recourse Revolving Credit Facility to fund our growing U.S. portfolios. For recent developments related to our Senior Secured Notes, SPV facilities and other resources, see -Liquidity and Capital Resources.” U.K. Developments. In February 2019, we announced that a proposed Scheme of Arrangement ("SOA"), as described in our Current Report on Form 8-K filed with the SEC on January 31, 2019, related to Curo Transatlantic Limited and SRC Transatlantic Limited (collectively the "U.K. Subsidiaries"), would not be implemented. We also announced that effective February 25, 2019, in accordance with the provisions of the U.K. Insolvency Act 1986 and as approved by the Boards of Directors of our U.K. Subsidiaries, insolvency practitioners from KPMG were appointed as administrators ("Administrators") for the U.K. Subsidiaries. The effect of the U.K. Subsidiaries’ entry into administration was to place the management, affairs, business and property of the U.K. Subsidiaries under the direct control of the Administrators. As a result, we deconsolidated the U.K. Subsidiaries as of February 25, 2019 and present the U.K. Subsidiaries as Discontinued Operations in this Annual Report. In our Current Report on Form 8-K filed with the SEC on January 31, 2019, our results of operations included a $30.3 million expense comprised of (i) a proposed $23.6 million fund to settle historical redress claims and (ii) $6.7 million in advisory and other costs that would be required to execute the SOA. We subsequently concluded that pursuant to ASC 450, Contingencies, the SOA did not represent an estimate of loss for the redress loss contingency but instead was offered in ongoing negotiation of a potential compromised settlement with creditors. Therefore, the settlement offered through the SOA did not meet the recognition threshold pursuant to ASC 450 and should not have been accrued as a contingent liability for customer redress claims as of December 31, 2018. Our Current Report on Form 8-K filed with the SEC on March 1, 2019 appropriately included $4.6 million of fourth quarter 2018 redress costs and related charges which represented known claims as of December 31, 2018. See "Controls and Procedures" in this Annual Report for further discussion. Refer to "Business-Regulatory Environment and Compliance” in this Annual Report for additional information regarding recent regulatory developments that may impact our business. Components of Our Results of Operations Effects of Inflation The impact of inflation has not had a material effect on our annual consolidated results of operations over the past three years. However, prolonged periods of deflation could adversely affect the degree to which we are able to increase sales through price increases. Revenue We offer a variety of loan products, including Unsecured Installment, Secured Installment, Open-End and Single-Pay loans. Revenue in our Consolidated Statements of Operations includes: interest income, finance charges, CSO fees, late fees and non-sufficient funds fees as permitted by applicable laws and pursuant to the agreement with the customer. Product offerings differ by jurisdiction and are governed by the laws in each jurisdiction. Installment loans are fully amortizing loans with a fixed payment amount due each period during the term of the loan. We record revenue from Installment loans on a simple-interest basis. Unsecured and Secured Installment revenue includes interest income, CSO fees and non-sufficient funds or returned-items fees on late or defaulted payments on past-due loans (to which we refer collectively as “late fees”). Late fees comprise less than 1% of Installment revenues. Accrued interest and fees are included in "Gross loans receivable" in the Consolidated Balance Sheets. Open-End loans are a revolving line-of-credit with no defined loan term. We record revenue from Open-End loans on a simple-interest basis. Open-End revenues include interest income on outstanding revolving balances and other usage or maintenance fees as permitted by underlying statutes. Accrued interest and fees are included in "Gross loans receivable" in the Consolidated Balance Sheets. Single-Pay loans are primarily payday loans. We recognize revenues from Single-Pay loan products each period on a constant-yield basis ratably over the term of each loan. We defer recognition of unearned fees based on the remaining term of the loan at the end of each reporting period. Single-Pay revenues represent deferred presentment or other fees as defined by the underlying state, provincial or national regulations. We also provide a number of ancillary financial products including check cashing, proprietary reloadable prepaid debit cards (Opt+), demand deposit accounts (Revolve Credit), money transfer services, credit protection insurance in the Canadian market and retail installment sales. Provision for Losses Credit losses are an inherent part of outstanding loans receivable. We maintain an allowance for loan losses for loans and interest receivable at a level estimated to be adequate to absorb such losses based primarily on our analysis of historical loss rates by products containing similar risk characteristics. The allowance for losses on our Company-Owned gross loans receivables reduces the outstanding gross loans receivables balance in the Consolidated Balance Sheets. The liability for estimated incurred losses related to loans Guaranteed by the Company under CSO programs is reported in "Liability for losses on CSO lender-owned consumer loans" in the Consolidated Balance Sheets. Increases in either the allowance or the liability, net of charge-offs and recoveries, are recorded as “Provision for losses” in the Consolidated Statements of Operations. Q1 2019 Open-End Loss Recognition Change Effective January 1, 2019, we modified the timeframe in which we charge-off Open-End loans and made related refinements to our loss provisioning methodology. Prior to January 1, 2019, we deemed Open-End loans uncollectible and charged-off when a customer missed a scheduled payment and the loan was considered past-due. Because of our continuing shift to Open-End loans in Canada and our analysis of payment patterns on early-stage versus late-stage delinquencies, we revised our estimates and now consider Open-End loans uncollectible when the loan has been contractually past-due for 90 consecutive days. Consequently, past-due Open-End loans and related accrued interest now remain in loans receivable for 90 days before being charged off against the allowance for loan losses. All recoveries on charged-off loans are credited to the allowance for loan losses. We evaluate the adequacy of the allowance for loan losses compared to the related gross loans receivable balances that include accrued interest. The aforementioned change was treated as a change in accounting estimate for accounting purposes and applied prospectively beginning January 1, 2019. For a full discussion of the change, see Note 1, “Summary of Significant Accounting Policies and Nature of Operations” of the Notes to Consolidated Financial Statements. Q1 2017 Installment Loss Recognition Change Effective January 1, 2017, we modified the timeframe in which Installment loans are charged-off and made related refinements to its loss provisioning methodology. Prior to January 1, 2017, we deemed all loans uncollectible and charged-off when a customer missed a scheduled payment and the loan was considered past-due. Because of the continued shift from Single-Pay to Installment loan products and analysis of payment patterns on early-stage versus late-stage delinquencies, we revised its estimates and now consider Installment loans uncollectible when the loan has been contractually past-due for 90 consecutive days. Consequently, past-due Installment loans and related accrued interest remain in loans receivable, with disclosure of past-due balances, for 90 days before being charged off against the allowance for loan losses. All recoveries on charged-off loans are credited to the allowance for loan losses. Quarterly, we evaluate the adequacy of the allowance for loan losses compared to the related gross loans receivable balances that include accrued interest. The aforementioned change was treated as a change in accounting estimate for accounting purposes and applied prospectively beginning January 1, 2017, which we refer to throughout this Annual Report as the "Q1 2017 Installment Loss Recognition Change". The change affected comparability to prior periods as follows: • Gross Combined Loans Receivable-balances in 2017 included Installment loans that were up to 90 days past-due with related accrued interest, while such balances periods prior to March 31, 2017 did not include these loans. Past-due Company-Owned Installment loans receivable as of December 31, 2019, 2018 and 2017 were $61.0 million, $66.9 million and $57.2 million, respectively. • Revenues-for the year ended December 31, 2017, revenues included accrued interest on past-due loan balances, while revenues for periods prior to March 31, 2017 did not include these amounts. • Provision for Losses-prospectively, loans charged off on day 91 included accrued interest. Thus, we adjusted allowance coverage rates in 2017 to include both principal and accrued interest. Cost of Providing Services • Salaries and Benefits-include personnel-related costs for our store operations, including salaries, benefits and bonuses and are driven by the number of employees. • Occupancy-includes rent expense for our leased facilities, as well as depreciation, maintenance, insurance and utility expense. • Office-includes expenses primarily related to bank service charges and credit scoring charges at store locations. • Other Costs of Providing Services-includes expenses related to operations such as processing fees, collections expense, security expense, taxes, repairs and professional fees incurred as part of store operations. • Advertising-costs are expensed as incurred. Advertising includes costs associated with attracting, retaining and/or reactivating customers as well as creating brand awareness. We have internal creative, web and print design capabilities and if we outsource these services, it is limited to mass-media production and placement. Advertising expense also includes costs for all marketing activities including paid search, advertising on social networking sites, affiliate programs, direct response television, radio air time and direct mail. Operating Expense • Corporate, District and Other Expenses-include costs such as salaries and benefits associated with our corporate and district-level employees, as well as other corporate-related costs such as rent, insurance, professional fees, utilities, travel and entertainment expenses and depreciation expense. Other income and expense includes the foreign currency impact to our intercompany balances, gains or losses on foreign currency exchanges and disposals of fixed assets and other miscellaneous income and expense amounts. • Interest Expense-includes interest primarily related to our Senior Secured Notes, our Non-Recourse SPV facilities and our Senior Revolver. Revenue by Product and Segment and Related Loan Portfolio Performance Revenue by Product Year-over-year comparisons for Open-End are affected by the Q1 2019 Open-End Loss Recognition Change. Additionally, we exclude financial results of our former U.K. operations for all periods presented, as they were discontinued for accounting and reporting purposes in February 2019. See “-Results of Discontinued Operations” for additional information. The following table summarizes revenue by product, including CSO fees, for 2019 and 2018 (in thousands): For the year ended December 31, 2019, total revenue grew $96.7 million, or 9.3%, to $1,141.8 million, compared to the prior year, predominantly driven by growth in Open-End loans in both countries. Geographically, total revenue in the U.S. and Canada grew 7.1% and 18.9%, respectively. From a product perspective, Unsecured Installment revenues rose $14.1 million, or 2.8%, in the U.S., with full-year comparisons affected by the fourth quarter 2019 portfolio repositioning and optimization in California due to recent regulatory changes, and a decrease in Canada of $6.6 million due to the continued transition to Open-End loans. Secured Installment revenues and related receivables were flat year-over-year as growth in other states offset California declines from portfolio repositioning. U.S. Single-Pay revenue increased $5.4 million, or 5.0%, compared to the prior year. Canadian Single-Pay usage and product profitability were impacted negatively year-over-year by regulatory changes in Ontario effective July 1, 2018, and the strategic transition of qualifying customers to Open-End loans. Open-End revenues rose $103.3 million, or 72.8%, on related loan growth in Canada and U.S., primarily in Tennessee, Virginia and Kansas. Ancillary revenues increased $13.7 million, or 27.3%, versus the prior year, primarily due to the sale of insurance to Installment and Open-End loan customers in Canada. The following table summarizes revenue by product, including CSO fees, for 2018 and 2017 (in thousands): For a comparison of our results of operations for the years ended December 31, 2018 and 2017, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Revenue by Product and Segment and Related Loan Portfolio Performance" in Part II Item 7 of our Current Report on Form 8-K for the year ended December 31, 2018, filed with the SEC on June 28, 2019. Loan Volume and Portfolio Performance Analysis The following table summarizes Company Owned gross loans receivable, a GAAP-basis balance sheet measure, with reconciliation to Gross combined loans receivable, a non-GAAP measure(1). Gross combined loans receivable includes loans originated by third-party lenders through CSO programs, which are not included in the Consolidated Financial Statements but from which we earn revenue by providing a guarantee to the unaffiliated lender (in millions). Gross combined loans receivable by product are presented below. Year-over-year comparisons for Open-End are affected by the Q1 2019 Open-End Loss Recognition Change. Excluding the impact of the Q1 2019 Open-End Loss Recognition Change, Open-End receivables increased $78.1 million, or 37.7%, year-over-year. Gross combined loans receivable increased $90.5 million, or 13.9%, to $742.5 million as of December 31, 2019 from $651.9 million as of December 31, 2018, primarily due to an increase in Open-End loans of 69.3% and 59.5% in the U.S. and Canada, respectively. Gross combined loans receivable performance by product is explained further in the following sections. Unsecured Installment Loans Unsecured Installment revenue and related gross combined loans receivable decreased 6.7% and 12.2%, respectively, from the prior-year quarter, due to portfolio repositioning and optimization in California to manage January 1, 2020 regulatory changes. Unsecured Installment gross combined loans receivable decreased $32.8 million compared to December 31, 2018. Unsecured Installment loans in California were $71.4 million, or 44.4%, of Company-Owned gross loans receivable as of December 31, 2019, a decrease of $30.1 million from $101.5 million as of December 31, 2018, and of $15.0 million from $86.4 million as of September 30, 2019. Unsecured Installment loans Guaranteed by the Company declined $3.1 million year-over-year due to regulatory change in Ohio, effective April 2019, and the subsequent conversion of some Ohio CSO volume to Company Owned loans, partially offset by growth in Texas. The NCO rate for Company Owned Unsecured Installment gross loans receivable in the fourth quarter of 2019 increased approximately 40 bps year-over-year, primarily due to mix shift associated with California portfolio repositioning and optimization. California NCO rates for Unsecured Installment loans historically are lower than our other major states. California comprised 48.8% of total U.S. Company Owned Unsecured Installment loans as of December 31, 2019, as compared to 58.0% in the prior year. Also, due to the repositioning, California NCO rates have increased slightly year-over-year. Company Owned Unsecured Installment NCO rates for the U.S. excluding California were flat year-over-year. The Unsecured Installment Allowance for loan losses as a percentage of Company Owned Unsecured Installment gross loans receivable ("allowance coverage") increased year-over-year from 19.8% as of December 31, 2018 to 22.1% as of December 31, 2019, primarily as a result of the aforementioned increase in U.S. NCO rates and higher past-due balances. Past-due receivables as a percentage of total gross receivables increased 100 bps from the same quarter a year ago, consistent with the change in NCO rates. Sequentially, allowance coverage increased from 21.9% to 22.1% as of December 31, 2019. NCO rates for Unsecured Installment loans Guaranteed by the Company improved 270 bps compared to the same quarter a year ago. The CSO liability for losses decreased sequentially from 14.4% to 14.2% for the fourth quarter of 2019. Secured Installment Loans Secured Installment revenue and the related gross combined loans receivable for the three months ended December 31, 2019 decreased 2.7% and 5.7%, respectively, compared to the prior-year period, primarily as a result of portfolio repositioning and optimization to manage California regulatory changes effective January 1, 2020. Secured Installment gross combined loans receivable decreased $5.5 million, compared to December 31, 2018. California accounted for $36.5 million, or 40.4%, of total Secured Installment gross combined loans receivable as of December 31, 2019, a decrease of $12.3 million from $48.8 million as of December 31, 2018, and of $4.9 million from $41.4 million as of September 30, 2019. Secured Installment Allowance for loan losses and CSO liability for losses as a percentage of Secured Installment gross combined loans receivable decreased year-over-year from 13.2% to 11.5% for the fourth quarter of 2019, and modestly increased on a sequential basis from 11.3% to 11.5% during the fourth quarter of 2019, reflecting the increase in past-due receivables. Open-End Loans Open-End loan balances as of December 31, 2019 increased by $128.2 million, or 61.8%, compared to December 31, 2018, on 45.5% growth in Canada and 12.4% growth in the U.S (excluding the impact of the Q1 2019 Open-End Loss Recognition Change). The Q1 2019 Open-End Loss Recognition Change, discussed further below, impacted comparability as $50.1 million of past-due Open-End loans as of December 31, 2019 would have been charged off under the former policy. The consolidated Open-End NCO rate during the fourth quarter of 2019 improved 165 bps versus the same quarter in the prior year, primarily as a result of seasoning of the Canada portfolio. Canada NCO rates improved 290 bps year-over-year. U.S. NCO rates increased 180 bps for the same periods from a combination of loan growth, mix shift to more online volume and advertising channel shifts. Q1 2019 Open-End Loss Recognition Change Effective January 1, 2019, we modified the timeframe in which we charge-off Open-End loans and made related refinements to our loss provisioning methodology. Prior to January 1, 2019, we deemed Open-End loans uncollectible and charged-off when a customer missed a scheduled payment and the loan was considered past-due. Because of our continuing shift to Open-End loans in Canada and our analysis of payment patterns on early-stage versus late-stage delinquencies, we revised our estimates and now consider Open-End loans uncollectible when the loan has been contractually past-due for 90 consecutive days. Consequently, past-due Open-End loans and related accrued interest now remain in loans receivable for 90 days before being charged off against the allowance for loan losses. All recoveries on charged-off loans are credited to the allowance for loan losses. We evaluate the adequacy of the allowance for loan losses compared to the related gross loans receivable balances that include accrued interest. The aforementioned change was treated as a change in accounting estimate for accounting purposes and applied prospectively beginning January 1, 2019. The change affects comparability to prior periods as follows: • Gross combined loans receivable: balances as of December 31, 2019 include $50.1 million of Open-End loans that are up to 90 days past-due with related accrued interest, while such balances for periods prior to March 31, 2019 do not include any past-due loans. • Revenues: for the three months and year ended December 31, 2019, gross revenues include interest earned on past-due loan balances of approximately $14 million and $49 million, respectively, while revenues in prior-year periods do not include comparable amounts. • Provision for Losses: prospectively from January 1, 2019, past-due, unpaid balances plus related accrued interest charge-off on day 91. Provision expense is affected by NCOs (total charge-offs less total recoveries) plus changes to the Allowance for loan losses. Because NCOs prospectively include unpaid principal and up to 90 days of related accrued interest, NCO amounts and rates are higher and the Open-End Allowance for loan losses as a percentage of Open-End gross loans receivable is higher. The Open-End Allowance for loan losses as a percentage of Open-End gross loans receivable increased to 16.4% at December 31, 2019, compared to 9.6% in the comparable prior-year period. The following table reports 2019 Open-End loan performance, including the effect of the Q1 2019 Open-End Loss Recognition Change: In addition, the following table illustrates, on a non-GAAP pro forma basis, the 2019 quarterly results as if the Q1 2019 Open-End Loss Recognition Change had been applied to our outstanding Open-End loan portfolio as of December 31, 2018. This table is illustrative of retrospective application to determine the NCOs that would have been incurred in each quarter of 2019 from the December 31, 2018 loan book. The primary purpose of this pro forma illustration is to provide a representative level of NCO rates from applying the Q1 2019 Open-End Loss Recognition Change. Single-Pay Single-Pay revenue during the three months ended December 31, 2019 remained flat compared to the three months ended December 31, 2018. U.S. Single-Pay receivables increased $1.4 million, or 3.2%, year-over-year, offset by a decrease in Canada receivables of $0.8 million, or 2.1%, from mix shift to Open-End loans. Year-over-year, NCO rates increased 30 bps, driven entirely by Canada. The Single-Pay Allowance for loan losses as a percentage of Single-Pay gross loans receivable decreased sequentially from 7.3% to 7.2%. Results of Consolidated Operations - Year Ended December 31, 2019 Compared with Year Ended December 31, 2018 Condensed Consolidated Statements of Operations (in thousands) Revenue and Net Revenue Revenue increased $96.7 million, or 9.3%, to $1,141.8 million for the year ended December 31, 2019 from $1,045.1 million for the year ended December 31, 2018. Revenue for the year ended December 31, 2019 included interest earned on past-due Open-End loan balances of approximately $49 million from the Q1 2019 Open-End Loss Recognition Change, offset by a higher provision rate and the higher allowance discussed further below. U.S. revenue increased 7.1%, driven by growth in Open-End loans. Canadian revenue increased 18.9% (21.8% on a constant currency basis), as loan growth offset yield compression from negative regulatory impacts on Single-Pay loan yields and the significant product mix-shift to lower-yielding Open-End loans. Provision for losses increased $47.0 million, or 11.1%, to $468.6 million for the year ended December 31, 2019, from $421.6 million for the year ended December 31, 2018, primarily due to the Q1 2019 Open-End Loss Recognition Change and loan growth year-over-year as further described in "-Segment Analysis" below. Cost of Providing Services The total cost of providing services decreased $3.4 million, or 1.1%, to $294.6 million in the year ended December 31, 2019, compared to $298.0 million in the year ended December 31, 2018, on lower advertising costs, offset by an increase of 1.1% in all other costs of providing services. The decline in advertising costs was primarily the result of reduced spending in California, and normalized levels in Canada compared to the elevated spending in the prior year due to the transition to Open-End loans in Ontario in the third quarter of 2018. Operating Expenses Corporate, district and other expenses increased $27.7 million, or 20.9%, primarily as a result of $8.8 million for obtaining the consent of our holders of the 8.25% Senior Secured Notes and our bondholders associated with discontinuing our U.K. operations and other related U.K. separation costs, $3.0 million of legal and related costs, $1.8 million of restructuring costs from our reduction-in-force implemented in January 2019 and $2.1 million of additional share-based compensation. Excluding these costs, corporate, district and other expenses increased by $11.7 million, or 9.4%, primarily due to higher professional fees and higher variable compensation based on financial performance. Our share of estimated losses for Katapult for the year ended December 31, 2019 was $6.3 million, which includes a market adjustment of $3.7 million for loss recognized in the second quarter of 2019 and $2.5 million of our share of estimated losses in 2019. The $90.6 million of loss on extinguishment of debt for the year ended December 31, 2018 was comprised of (i) $11.7 million incurred in the first quarter of 2018 for the redemption of $77.5 million of the CFTC 12.00% Senior Secured Notes due 2022, (ii) $69.2 million incurred in the third quarter of 2018 for the redemption of the remaining $525.7 million of these notes and (iii) $9.7 million incurred in the fourth quarter of 2018 for the redemption of the Non-Recourse U.S. SPV Facility. The $69.2 million of loss on extinguishment incurred in the third quarter of 2018 was comprised of a $54.0 million make whole premium and $15.2 million of deferred financing costs, net of premium/discounts. Interest Expense Interest expense decreased by $14.6 million, or 17.3%, compared to the prior-year period, primarily due to long-term debt refinancings in 2018. During the third quarter of 2018, we issued $690.0 million of 8.25% Senior Secured Notes and used the proceeds from the issuance to extinguish our $527.5 million 12.00% Senior Secured Notes and our Non-Recourse U.S. SPV Facility. In addition, we entered into a Non-Recourse Canada SPV Facility in the third quarter of 2018 with a lower interest rate than our previous Non-Recourse U.S. SPV Facility. Provision for Income Taxes The effective income tax rate for the year ended December 31, 2019 was 27.1%, compared to a tax rate of 9.2% for the year ended December 31, 2018. The effective income tax rate for the year ended December 31, 2019 included unfavorable impacts from the non-tax deductible loss on our equity method investment, changes in state income apportionment and a mix shift in taxable income between the U.S. and Canada. Excluding non-GAAP adjustments to Adjusted Net Income as presented in the reconciliation of Net income to Adjusted Net Income, the Adjusted effective income tax rate from continuing operations for the year ended December 31, 2019 was 25.9% compared to a tax rate of 24.7% for the year ended December 31, 2018. Segment Analysis We report financial results for two reportable segments: the U.S. and Canada. Following is a summary of results of operations for the segment and period indicated (in thousands): U.S. revenues increased by $60.4 million, or 7.1%, to $913.5 million. U.S. revenue growth was primarily driven by growth in Open-End loans, which increased $34.1 million, or 69.3%, compared to the prior year, offset by regulatory changes in California impacting Installment loans as discussed above. Additionally, U.S. revenue for the year ended December 31, 2019 included interest earned on past-due Open-End loan balances of approximately $42 million from the Q1 2019 Open-End Loss Recognition Change, offset by related higher provision rate and higher provision for losses. The provision for losses' increase of $43.5 million, or 12.5%, was primarily due to the Q1 2019 Open-End Loss Recognition Change. In addition, the year ended December 31, 2018 included $13.6 million of provision benefit from changes in allowance coverage rates, whereas the year ended December 31, 2019 included $1.2 million of incremental expense. U.S. cost of providing services for the year ended December 31, 2019 was $218.4 million, a decrease of $1.3 million, or 0.6%, compared to $219.7 million for the year ended December 31, 2018, primarily due to lower advertising costs associated with repositioning our California Installment loan portfolio in advance of regulatory changes. Corporate, district and other operating expenses increased $25.4 million, or 22.5%, compared to the prior year, primarily due to $8.8 million of U.K. disposition-related costs, $9.1 million higher performance-based variable compensation costs, $2.1 million of higher share-based compensation expense, $3.5 million higher legal and related costs and $1.6 million of restructuring costs. The $90.6 million of loss on extinguishment of debt for the year ended December 31, 2018 was comprised of (i) $11.7 million incurred in the first quarter of 2018 for the redemption of $77.5 million of the CFTC 12.00% Senior Secured Notes due 2022, (ii) $69.2 million incurred in the third quarter of 2018 for the redemption of the remaining $525.7 million of these notes and (iii) $9.7 million incurred in the fourth quarter of 2018 for the redemption of the Non-Recourse U.S. SPV Facility. The $69.2 million of loss on extinguishment incurred in the third quarter of 2018 was comprised of a $54.0 million make whole premium and $15.2 million of deferred financing costs, net of premium/discounts. U.S. interest expense for the year ended December 31, 2019 decreased by $21.1 million compared to the prior year, primarily due to our refinancing activities in 2018. During the third quarter of 2018, we issued $690.0 million of 8.25% Senior Secured Notes and used the proceeds from the issuance to extinguish our $527.5 million 12.00% Senior Secured Notes and our U.S. SPV facility. Canada revenue increased $36.4 million, or 18.9%, to $228.3 million for the year ended December 31, 2019 from $191.9 million in the prior-year period. On a constant currency basis, revenue increased $41.8 million, or 21.8%. Revenue growth in Canada was impacted favorably by the significant loan growth and successful transition from Single-Pay and Unsecured Installment loans to Open-End loans. Additionally, Canada revenues for the year ended December 31, 2019 included interest earned on past-due Open-End loan balances of approximately $7 million from the Q1 2019 Open-End Loss Recognition Change, offset by higher provision rate and higher provision for losses. Single-Pay revenue decreased $32.9 million, or 29.5%, to $78.5 million for the year ended December 31, 2019, and Single-Pay receivables decreased $0.8 million, or 2.1%, to $35.8 million from $36.6 million in the prior year. The decreases in Single-Pay revenue and receivables were due to product mix shift in Canada from Single-Pay loans to Open-End loans and by regulatory changes effective January and July 2018 that lowered Single Pay pricing year-over-year. Canada non-Single-Pay revenue increased $69.3 million, or 86.1%, to $149.8 million compared to $80.5 million for the prior-year period, on $93.1 million, or 53.7%, growth in related loan balances. The increase was driven by significant expansion of the Open-Ends, beginning with Ontario in the third quarter of 2018. Additionally, with increased Open-End loan volume and customer acquisitions, Ancillary revenue increased $14.2 million versus the same period a year ago, primarily driven by an increase in sales of insurance to Open-End loan customers. The provision for losses increased $3.5 million, or 4.7%, to $76.4 million for the year ended December 31, 2019 compared to $73.0 million in the prior-year period primarily due to provisioning on Open-End loans and mix shift from Single-Pay loans and Unsecured Installment to Open-End loans. Total Open-End loans grew by $14.8 million sequentially during the fourth quarter of 2019, compared to sequential growth of $19.4 million in the fourth quarter of 2018. Excluding the impact of the allowance coverage change, provision for losses increased $7.9 million, or 10.7%, because of the Q1 2019 Open-End Loss Recognition Change and increased earning asset volume year-over-year. On a constant currency basis, provision for losses increased by $5.3 million, or 7.3%, compared to the prior-year period. The total cost of providing services in Canada decreased $2.1 million, or 2.7%, to $76.2 million for the year ended December 31, 2019 compared to $78.3 million in the prior-year period. Advertising costs decreased by $3.9 million, or 36.7%, primarily from mix-shift and stability in our Canadian portfolio following the Ontario deployment of Open-End loans in the third quarter of 2018, partially offset by an increase in non-advertising cost of providing services of $1.7 million. There was no material impact on the cost of providing services from exchange rate changes. Canada operating expenses increased $8.7 million, or 36.9%, to $32.4 million in the year ended December 31, 2019 from $23.6 million in the prior-year period, primarily due to interest expense on the Non-Recourse Canada SPV Facility that began in August 2018. Results of Consolidated Operations - Year Ended December 31, 2018 Compared with Year Ended December 31, 2017 For a comparison of our results of operations for the years ended December 31, 2018 and 2017, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Consolidated Results of Operations" in Part II Item 7 of our Current Report on Form 8-K for the year ended December 31, 2018, filed with the SEC on June 28, 2019. Condensed Consolidated Statements of Operations (in thousands) Segment Analysis Following is a recap of results of operations for the segment and period indicated (in thousands): Currency Information We operate in the U.S. and Canada and our consolidated results are reported in U.S. dollars. Changes in our reported revenues and net income include the effect of changes in currency exchange rates. We translate all balance sheet accounts into U.S. dollars at the currency exchange rate in effect at the end of each period. We translate the statement of operations at the average rates of exchange for the period. We record currency translation adjustments as a component of Accumulated Other Comprehensive Income in Stockholders’ Equity. Constant Currency Analysis We have operations in the U.S. and Canada. For the years ended December 31, 2019 and 2018, approximately 20.0% and 18.4%, respectively, of our revenues were originated in Canadian Dollars. As a result, changes in our reported results include the impacts of changes in the foreign currency exchange rates for the Canadian Dollar. Years Ended December 31, 2019 and 2018 Years Ended December 31, 2018 and 2017 The following constant currency analysis removes the impact of the fluctuation in foreign exchange rates and utilizes constant currency results in our analysis of segment performance. Our constant currency assessment assumes foreign exchange rates in the current fiscal periods remained the same as in the prior fiscal periods. All conversion rates below are based on the U.S. Dollar equivalent to the Canadian Dollar. We believe that the constant currency assessment below is a useful measure in assessing the comparable growth and profitability of our operations. We calculated the revenues and gross margin below for the year ended December 31, 2019 using the actual average exchange rate for the year ended December 31, 2018 (in thousands). We calculated the revenues and gross margin below for the year ended December 31, 2018 using the actual average exchange rate for the year ended December 31, 2017 (in thousands). Liquidity and Capital Resources Our principal sources of liquidity to fund the loans we make to our customers are cash provided by operations, our Senior Revolver, our Cash Money Revolving Credit Facility, funds from third-party lenders under our CSO programs, and our Non-Recourse Canada SPV Facility (defined below). During August 2018, we issued $690.0 million of 8.25% Senior Secured Notes due September 2025 ("8.25% Senior Secured Notes") (i) to redeem the outstanding 12.00% Senior Secured Notes due 2022 of CFTC, (ii) to repay a portion of the outstanding indebtedness under the five-year revolving credit facility of CURO Receivables Finance I, LLC, our wholly-owned subsidiary, which consists of a term loan and revolving borrowing capacity, (iii) for general corporate purposes and (iv) to pay fees, expenses, premiums and accrued interest in connection with the foregoing. As of December 31, 2019, we were in compliance with all financial ratios, covenants and other requirements set forth in our debt agreements. We anticipate that our primary use of cash will be to fund growth in our working capital, finance capital expenditures, and meet our debt obligations. As we did for our repurchase programs announced in April 2019 and February 2020, we may also use cash to fund a return on capital for our stockholders through share repurchase programs or, as we announced in February 2020, in the form of dividends. Our level of cash flow provided by operating activities typically experiences some seasonal fluctuation related to our levels of net income and changes in working capital levels, particularly loans receivable. Unexpected changes in our financial condition or other unforeseen factors may result in our inability to obtain third-party financing or could increase our borrowing costs in the future. We have the ability to adjust our volume of lending to consumers which would reduce cash outflow requirements while increasing cash inflows through loan repayments to the extent we experience any short-term or long-term funding shortfalls. We may also sell or securitize our assets, draw on our available revolving credit facility or line of credit, enter into additional refinancing agreements and reduce our capital spending in order to generate additional liquidity. We believe our cash on hand and available borrowings provide us with sufficient liquidity for at least the next 12 months. Borrowings, Credit Facilities and Other Resources Our debt consisted of the following as of December 31, 2019 and 2018 (net of deferred financing costs) (in thousands): Refer to Note 9, "Debt," for details on each of our credit facilities and resources. Condensed Consolidating Financial Information The following condensed consolidating financial information is presented separately for: (i) Our subsidiary guarantors, which are comprised of its domestic subsidiaries, including CFTC as the issuer of the 12.00% Senior Secured Notes that were redeemed in August 2018, CURO Intermediate, and U.S. SPV as the issuer of the Non-Recourse U.S. SPV Facility that was extinguished in October 2018, and excluding Canada SPV (the “Subsidiary Guarantors”), on a consolidated basis, which are 100% owned by us, and which are guarantors of the 8.25% Senior Secured Notes issued in August 2018; (ii) Our other subsidiaries on a consolidated basis, which are not guarantors of the 8.25% Senior Secured Notes (the “Subsidiary Non-Guarantors”); (iii) The Non-recourse Canada SPV facility, a wholly-owned, bankruptcy-remote special purpose subsidiary; (iv) CURO as the issuer of the 8.25% Senior Secured Notes; (v) Consolidating and eliminating entries representing adjustments to: a. eliminate intercompany transactions between or among us, the Subsidiary Guarantors and the Subsidiary Non-Guarantors; and b. eliminate the investments in subsidiaries; (vi) The Company and its subsidiaries on a consolidated basis. Consolidating Balance Sheets Consolidating Statements of Operations Consolidating Statements of Cash Flows Balance Sheet Changes - December 31, 2019 compared to December 31, 2018 Cash. The increase in Cash from December 31, 2018 is primarily due to portfolio optimization in advance of regulatory changes in California impacting our Installment products and lower interest expense compared to the prior year, partially offset by net payments on our Senior Revolver and Non-Recourse Canada SPV Facility and repurchases of our common stock. Restricted Cash. The increase in Restricted cash from December 31, 2018 is primarily due to increased consumer demand for loans meeting the Non-Recourse Canada SPV Facility criteria as well as restricted cash balances related to Revolve Finance, our new demand deposit account. Gross Loans Receivable and Allowance for Loan Losses. As explained in "Discussion of Revenue by Product and Segment and Related Loan Portfolio Performance-Loan Volume and Portfolio Performance Analysis", changes in Gross Loans Receivable and related Allowance for Loan Losses were due to organic growth in Open-End loans (primarily in Canada). Right of use asset and lease liability and Deferred rent. Due to the adoption as of January 1, 2019 of ASU No. 2016-02, Leases, which requires lessees to record leases on the balance sheet and disclose key information about leasing arrangements, we had a right of use asset of $117.5 million and a lease liability of $125.0 million as of December 31, 2019. Cash Flows The following highlights our cash flow activity and the sources and uses of funding during the periods indicated: Years Ended December 31, 2019 and 2018 Continuing Operating Activities During the year ended December 31, 2019, our net cash provided by continuing operating activities was $651.1 million, including net income from continuing operations of $103.9 million and expenses, primarily non-cash, of $500.5 million. Major components of non-cash expenses include provision for loan losses of $468.6 million, depreciation and amortization of $18.6 million, loss from equity method investment of $6.3 million and share-based compensation expense of $10.3 million. Contributions from our operating assets and liabilities were $46.8 million and primarily related to an increase in our income tax receivable balance as a result of the disposal of our U.K. subsidiaries in the first quarter of 2019, partially offset by changes in fees and service charges on our loans receivables of $12.8 million. Continuing Investing Activities During the year ended December 31, 2019, our net cash used in investing activities was $530.3 million, primarily reflecting the net origination of loans of $508.1 million. In addition, we used cash to purchase approximately $14.0 million of property and equipment, including internally developed software, and $8.2 million to increase our investment in Katapult. Continuing Financing Activities Net cash used in financing activities for the year ended December 31, 2019 was $98.0 million. We repurchased $44.8 million of our common stock under the terms of our $50.0 million share repurchase program that we announced in April 2019. Separately, we repurchased 2,000,000 shares from FFL Holders for $27.1 million in August 2019. Refer to Note 23, "Share Repurchase Program" for additional details. We also had net payments of $20.0 million on our revolving credit facilities during 2019. Years Ended December 31, 2018 and 2017 For a comparison of our cash flows for the years ended December 31, 2018 and 2017, see "Management's Discussion and Analysis of Financial Condition and Results of Operations-Cash Flows" in Part II Item 7 of our Current Report on Form 8-K for the year ended December 31, 2018, filed with the SEC on June 28, 2019. Contractual Obligations Contractual obligations include agreements that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. For obligations with cancellation provisions, the amounts included in the following table were limited to the non-cancelable portion of the agreement or the minimum cancellation fee. The expected timing of payments of the obligations below is estimated based on current information. Timing of payments and actual amounts paid may be different, depending on the timing of receipt of goods or services, or changes to agreed-upon amounts for some obligations. The following table summarizes our significant contractual obligations and commitments as of December 31, 2019, based on current information, which could change in the future (in thousands): Off-Balance Sheet Arrangements We originate loans in all of our store locations and online, except for our operations in Texas and, prior to May 2019, Ohio. In these states, we operate as a CSO. Refer to "Critical Accounting Practices and Estimates-Credit Services Organization" below for further information on our CSO/CAB relationships and "Regulatory Environment and Compliance" in "Item 1. Business" for further information on developments in Ohio. As of December 31, 2019, the maximum amount payable under all such guarantees was $62.7 million, compared to $66.9 million at December 31, 2018. This liability is not included in our Consolidated Balance Sheets. If we are required to pay any portion of the total amount of the loans we have guaranteed, we will attempt to recover some or the entire amount from the customers. We hold no collateral in respect of the guarantees. We estimate a liability for losses associated with the guaranty provided to the CSO lenders using assumptions and methodologies similar to the allowance for loan losses, which we recognize for our consumer loans. The liability for incurred losses on CSO lender-owned consumer loans was $10.6 million at December 31, 2019 and $12.0 million at December 31, 2018, which we include as "Liability for losses on CSO lender-owned consumer loans" on the Consolidated Balance Sheets. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with US GAAP requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We consider the following accounting policies to be critical in understanding our historical and future performance and require management's most subjective and complex judgments. Allowance for Loan Losses Credit losses are an inherent part of outstanding loans receivable. We maintain an allowance for loan losses for loans and interest receivable at a level we estimate to be adequate to absorb incurred losses based primarily on our analysis of historical loss or charge-off rates by products containing similar risk characteristics. The allowance for losses on our Company Owned gross loans receivables reduces the outstanding gross loans receivables balance in the Consolidated Balance Sheets. We report the liability for incurred losses related to loans Guaranteed by the Company under CSO programs in “Liability for losses on CSO lender-owned consumer loans” in the Consolidated Balance Sheets. We record increases in either the allowance or the liability, net of charge-offs and recoveries, as “Provision for losses” in the Consolidated Statements of Operations. We also consider delinquency trends as well as any macro-economic conditions that we believe may affect portfolio losses. If a loan is deemed to be uncollectible before it is fully reserved based on information we become aware of (e.g., receipt of customer bankruptcy notice or death), we charge off such loan at that time. Qualitative factors such as the impact of new loan products, changes to underwriting criteria or lending policies, new store development or entrance into new markets, changes in jurisdictional regulations or laws, recent credit trends and general economic conditions impact management’s judgment on the overall adequacy of the allowance for loan losses. Any recoveries on loans previously charged to the allowance are credited to the allowance when collected. During the years ended December 31, 2019 and 2018, we changed the estimated allowance for loan losses for Open-End and Installment gross combined loans receivable, respectively. These were prospective changes in estimate affected by a change in accounting principle. Prior to the change in the estimate, we utilized historic collection experience by grouping accounts receivable aging for these products to assess losses inherent in the portfolio and incurred as of the balance sheet date. Given that we now has history on performance, we refined the estimation process to utilize charge-off and recovery rates and estimate losses inherent in the portfolio. Credit Services Organization Through our CSO programs, we act as a CSO/CAB on behalf of customers in accordance with applicable state laws. We currently offer loans through CSO programs in stores and online in the state of Texas. Prior to May 2019, we operated as a CSO in Ohio. See Item 1. “Business-Regulatory Environment and Compliance” for additional details. We estimate a liability for losses associated with the guaranty provided to the CSO lenders using assumptions and methodologies similar to the allowance for loan losses, which we recognize for our consumer loans. Our liability for incurred losses on CSO loans guaranteed by the Company was $10.6 million and $12.0 million at December 31, 2019 and 2018, respectively. We calculate CSO fees based on the amount of the customer’s outstanding loan and in accordance with the applicable jurisdiction’s laws. These laws generally define the services that we can provide to consumers and require us to provide a contract to the customer outlining our services and related costs. For services we provide under our CSO programs, we receive payments from customers on their scheduled loan repayment due dates. The CSO fee is earned ratably over the term of the loan as the customers make payments. If a loan is paid off early, no additional CSO fees are due or collected. The maximum CSO loan term is 180 days in Texas. During the year ended December 31, 2019 and 2018, approximately 58.2% and 57.3%, respectively, of Unsecured Installment loans, and 54.3% and 54.5%, respectively, of Secured Installment loans originated under CSO programs were paid off prior to the original maturity date. Since CSO loans are made by a third-party lender, we do not include them in our Consolidated Balance Sheets as loans receivable; instead, we include them in “Prepaid expense and other” in our Consolidated Balance Sheets. We receive payments from customers for these fees on their scheduled loan repayment due dates. Income Taxes We utilize the asset and liability method of accounting for income taxes as set forth in ASC 740. Under the liability method, deferred taxes are determined based on the temporary differences between the financial statement and tax basis of assets and liabilities using tax rates expected to be in effect during the years in which the basis differences reverse. A valuation allowance is recorded when it is more likely than not that some of the deferred tax assets will not be realized. In determining the need for valuation allowances, we consider projected future taxable income and the availability of tax planning strategies. If in the future we determine that we would not be able to realize the recorded deferred tax assets, an increase in the valuation allowance would be recorded, decreasing earnings in the period in which such determination is made. We are subject to income taxes throughout the U.S. and Canada and, prior to deconsolidation of the U.K. subsidiaries, in the U.K. We recognize the financial statement benefits for uncertain tax positions as set forth in ASC 740 only if it is more-likely-than-not to be sustained in the event of challenges by relevant taxing authorities based on the technical merit of each tax position. The amounts of uncertain tax positions recognized are the largest benefits that have a greater than 50 percent likelihood of being realized upon settlement with the relevant tax authorities. Recently Issued Accounting Pronouncements See Note 1, "Summary of Significant Accounting Policies and Nature of Operations" of our Notes to Consolidated Financial Statements for a discussion of recent accounting pronouncements.

<s>[INST] Overview We are a growthoriented, technologyenabled, highlydiversified, multichannel and multiproduct consumer finance company serving a wide range of underbanked consumers in the U.S. and Canada. We believe that we have the only true omnichannel customer acquisition, onboarding and servicing platform that is integrated across store, online, mobile and contact center touchpoints. Our IT platform, which we refer to as “Curo,” seamlessly integrates customer acquisition loan underwriting, scoring, servicing, collections, regulatory compliance and reporting activities into a single, centralized system. We use advanced risk analytics powered by proprietary algorithms and nearly 20 years of loan performance data to efficiently and effectively score our customers’ loan applications. From 2010 through December 31, 2019, we extended $18.5 billion in credit across approximately 46.7 million loans. In the U.S., our stores operate under “Speedy Cash” and “Rapid Cash.” In the second quarter of 2017, we launched “Avio Credit,” an online Installment and OpenEnd brand. In February 2019, we launched Revolve Finance, as discussed below. In Canada, our stores are branded “Cash Money” and we offer “LendDirect” Installment and OpenEnd loans online and at certain stores. As of December 31, 2019, our store network consisted of 416 locations across 14 U.S. states and seven Canadian provinces and we offered our online services in 27 U.S. states and five Canadian provinces. Recent Developments Share Repurchase Program. Our Board of Directors authorized a share repurchase program in April 2019 providing for the repurchase of up to $50.0 million of our common stock. The repurchase program, which commenced June 2019, was fully expended as of February 5, 2020. In February 2020, our Board of Directors authorized a new share repurchase program up to $25.0 million of our common stock. See Note 23, "Share Repurchase Program" of the Notes to Consolidated Financial Statements for additional details. Dividend Program. In February 2020, we initiated a dividend program and declared our first quarterly cash dividend of $0.055 per share ($0.22 per share annualized). See Note 24, "Subsequent Events" of the Notes to Consolidated Financial Statements for additional details. Ad Astra Acquisition. In January 2020, we acquired Ad Astra, our exclusive provider of thirdparty collection services for the U.S. business. See Note 24, "Subsequent Events" of the Notes to Consolidated Financial Statements for additional details. FFL Repurchase. In August 2019, we entered into a Share Repurchase Agreement (the “Share Repurchase Agreement”) with FFL, a related party. Pursuant to the Share Repurchase Agreement, we repurchased 2,000,000 shares of its common stock, par value $0.001 per share, owned by FFL, in a private transaction at a purchase price equal to $13.55 per share of common stock. This transaction occurred outside of the share repurchase program authorized in April 2019. Revolve Finance. In February 2019, we launched Revolve Finance, sponsored by Republic Bank of Chicago, which is being introduced across our U.S. stores. This product provides customers a checking account solution, with FDICinsured deposits, that combines a Visabranded debit card, a number of technologyenabled tools and optional overdraft protection. Bank Relationships. In September 2019, we terminated the previously disclosed marketing and servicing agreement with MetaBank, a whollyowned subsidiary of Meta Financial Group, Inc. In the fourth quarter of 2019, we signed with Stride Bank to launch an Unsecured Installment loan originated by Stride Bank. We market and service loans on behalf of the bank and Stride licenses our proprietary credit decisioning for Stride Bank's scoring and approval. This product is offered in two U.S. states currently, and we expect to expand it [/INST] Negative. </s>

Brighthouse Financial, Inc.

2018-03-16

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Index to Management’s Discussion and Analysis of Financial Condition and Results of Operations Page Introduction Executive Summary Industry Trends and Uncertainties Summary of Critical Accounting Estimates Non-GAAP and Other Financial Disclosures Economic Capital Results of Operations Effects of Inflation Investments Derivatives Off-Balance Sheet Arrangements Policyholder Liabilities Liquidity and Capital Resources Glossary Introduction For purposes of this discussion, “Brighthouse,” the “Company,” “we,” “our” and “us” refer to Brighthouse Financial, Inc. a corporation incorporated in Delaware in 2016, and its subsidiaries. Brighthouse Financial, Inc. was formerly a wholly-owned subsidiary of MetLife, Inc. (MetLife, Inc., together with its subsidiaries and affiliates, “MetLife”). Following this summary is a discussion addressing the consolidated results of operations and financial condition of the Company for the periods indicated. This discussion should be read in conjunction with “Note Regarding Forward-Looking Statements,” “Risk Factors,” “Selected Financial Data,” “Quantitative and Qualitative Disclosures About Market Risk” and the Company’s consolidated financial statements included elsewhere herein. The following discussion may contain forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this report, particularly in “Note Regarding Forward-Looking Statements” and “Risk Factors.” Presentation Prior to discussing our Results of Operations, we present background information and definitions that we believe are useful to understanding the discussion of our financial results. This information precedes the Results of Operations and is most beneficial when read in the sequence presented. A summary of key informational sections is as follows: • “Executive Summary” contains the following sub-sections: • “Overview” provides information regarding our business, reporting segments and results as discussed in the Results of Operations. • “Background” presents details of the Company’s legal entity structure and key events that led up to the completion of the Separation. • “Industry Trends and Uncertainties” discusses updates and changes to a number of trends and uncertainties that we believe may materially affect our future financial condition, results of operations or cash flows. • “Summary of Critical Accounting Estimates” explains the most critical estimates and judgments applied in determining our GAAP results. • “Non-GAAP and Other Financial Disclosures” defines key financial measures presented in the Results of Operations that are not calculated in accordance with GAAP but are used by management in evaluating company and segment performance. As described in this section, adjusted earnings is presented by key business activities which are derived from, but different than, the line items presented in the GAAP statement of operations. This section also refers to certain other terms used to describe our insurance business and financial and operating metrics, but is not intended to be exhaustive. • The Results of Operations section begins with two introductory sections to facilitate an understanding of the results discussion: • “Significant Business Actions” defines certain actions that had a significant impact to either or both net income (loss) and adjusted earnings, as defined in “- Non-GAAP and Other Financial Disclosures”, which are not indicative of performance in the respective periods. Events defined in this section are referred to in the Results of Operations discussion. • “Actuarial Assumption Review” describes the changes in key assumptions applied in 2017 and 2016, respectively, resulting in a favorable impact to net income (loss) in the current period. Executive Summary Overview We are a major provider of annuity products and life insurance in the United States through multiple independent distribution channels and marketing arrangements with a diverse network of distribution partners. For operating purposes, we have established three reporting segments: (i) Annuities, (ii) Life and (iii) Run-off, which consists of operations relating to products we are not actively selling and which are separately managed. In addition, we report certain of our results of operations not included in the segments in Corporate & Other. In the third quarter of 2016, the Company reorganized its businesses in anticipation of the Separation. Also, in the fourth quarter of 2016, the Company moved the universal life policies with secondary guarantees business from the Life segment to the Run-off segment (“ULSG Re-segmentation”). These changes were applied retrospectively and did not have an impact on total consolidated net income (loss) or adjusted earnings in the prior periods. See “Business - Segments and Corporate & Other” and Note 2 of the Notes to the Consolidated and Combined Financial Statements for further information on our segments and Corporate & Other. The following table presents a summary of our net income (loss) and adjusted earnings. For a detailed discussion of our results see “- Results of Operations.” For the year ended December 31, 2017, we had a net loss of $378 million and $920 million of adjusted earnings as compared to a net loss of $2.9 billion and $686 million of adjusted earnings for the year ended December 31, 2016. Despite higher adjusted earnings, the net loss for the year ended December 31, 2017 was driven by unfavorable changes in our derivative instruments resulting from strong equity market performance and rising interest rates. In the third quarter of 2017 we recognized a $1.1 billion tax charge in connection with the Separation which was substantially offset by a benefit of $947 million recorded in the fourth quarter of 2017 in connection with changes to the federal tax code. The net loss for the year ended December 31, 2016 was driven by reserve strengthening, including the effect of our 2016 annual actuarial review for our variable annuities business, our second quarter refinement in the actuarial model which we use to calculate the reserves for our in-force book of ULSG products and the loss recognition, mostly in the form of a write down of deferred acquisition costs, triggered by the move of our ULSG products into the Run-off segment in the fourth quarter of 2016. In addition to reserve strengthening, derivative losses on our economic hedges of certain liabilities also contributed to the net loss, primarily due to the impact of the fourth quarter 2016 rise in interest rates without an offset from the liabilities being hedged due to the insensitivity of those accounting principles generally accepted in the United States (“GAAP”) liabilities to changes in interest rates. See “- Results of Operations.” Background Brighthouse Financial, Inc., which until the completion of the Separation on August 4, 2017 was a wholly-owned subsidiary of MetLife, Inc., is a holding company incorporated in Delaware on August 1, 2016 to own the legal entities that have historically operated a substantial portion of MetLife’s former Retail segment, as well as certain portions of its former Corporate Benefit Funding segment, which is included in our Run-off segment. This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help the reader understand the results of operations, financial condition and cash flows of Brighthouse for the periods indicated. In addition to Brighthouse Financial, Inc., the companies and businesses included in the results of operations, financial condition and cash flows are: • Brighthouse Life Insurance Company (together with its subsidiaries and affiliates, “BLIC”), formerly MetLife Insurance Company USA, our largest insurance operating entity, domiciled in Delaware and licensed to write business in 49 states; • Brighthouse Life Insurance Company of NY (“BHNY”), formerly First MetLife Investors Insurance Company, domiciled in New York and licensed to write business in New York, which is a subsidiary of Brighthouse Life Insurance Company; • New England Life Insurance Company (“NELICO”), domiciled in Massachusetts and licensed to write business in all 50 states; • Brighthouse Reinsurance Company of Delaware (“BRCD”), our single reinsurance company licensed in Delaware, which is a subsidiary of Brighthouse Life Insurance Company; • Brighthouse Investment Advisers, LLC (“Brighthouse Advisers”), formerly MetLife Advisers, LLC, serving as investment advisor to certain proprietary mutual funds that are underlying investments under our and MetLife’s variable insurance products; • Brighthouse Services, LLC (“Brighthouse Services”), an internal services and payroll company; • Brighthouse Securities, LLC (“Brighthouse Securities”), registered as a broker-dealer with the SEC, approved as a member of FINRA and registered as a broker-dealer and licensed as an insurance agency in all required states; and • Brighthouse Holdings, LLC (“BH Holdings”), a wholly-owned holding company subsidiary of Brighthouse Financial, Inc. domiciled in Delaware. The Separation On January 12, 2016, MetLife, Inc. announced its plan to pursue the separation of a substantial portion of its former U.S. retail business. Additionally, on July 21, 2016, MetLife, Inc. announced that the separated business would be rebranded as “Brighthouse Financial.” In July 2016, MetLife, Inc. completed the sale to MassMutual of MetLife’s U.S. retail advisor force and certain assets associated with MPCG, including all of the issued and outstanding shares of MetLife’s affiliated broker-dealer, MetLife Securities, Inc., a wholly-owned subsidiary of MetLife, Inc. (the “U.S. Retail Advisor Force Divestiture”). MassMutual assumed all of the liabilities related to such assets that arise or occur (or have arisen or occurred) after the sale was closed. As part of the transactions, MetLife, Inc. and MassMutual entered into a product development agreement under which Brighthouse is the exclusive developer of certain annuity products to be issued by MassMutual. In connection with the Separation, we entered into an agreement with MetLife, Inc., that among other things, provides for the sharing of certain liabilities that may arise with respect to this relationship. On October 5, 2016, Brighthouse Financial, Inc., which until the completion of the Separation on August 4, 2017 was a wholly-owned subsidiary of MetLife, Inc., filed a registration statement on Form 10 with the SEC that was declared effective by the SEC on July 6, 2017. The Form 10 disclosed MetLife, Inc.’s plans to undertake several actions, including an internal reorganization involving its U.S. retail business (the “Restructuring”) and include, among others, Brighthouse Life Insurance Company, BHNY, NELICO, Brighthouse Advisers and certain affiliated reinsurance companies in the separated business, and distribute at least 80.1% of the shares of Brighthouse Financial, Inc.’s common stock on a pro rata basis to the holders of MetLife, Inc. common stock. In connection with the Restructuring, effective April 2017 following receipt of applicable regulatory approvals, MetLife, Inc. contributed certain affiliated reinsurance companies and BHNY to Brighthouse Life Insurance Company. The affiliated reinsurance companies were then merged into BRCD, a licensed reinsurance subsidiary of Brighthouse Life Insurance Company (the “Reinsurance Merger”). On June 20, 2017, BH Holdings issued $50 million aggregate liquidation preference of fixed rate cumulative preferred units to MetLife, Inc., which MetLife, Inc. subsequently resold to unaffiliated third parties. These preferred units are reported as noncontrolling interests on the consolidated and combined balance sheet. Additionally, on June 16, 2017 in connection with the Separation, MetLife, Inc. forgave the $750 million principal amount of 8.595% surplus notes, and on July 28, 2017, MetLife, Inc. contributed BH Holdings to Brighthouse Financial, Inc. On August 4, 2017, MetLife, Inc. completed the distribution of Brighthouse Financial, Inc. shares to its shareholders through a distribution of 96,776,670 of the 119,773,106 shares of the Company’s common stock, representing 80.8% of MetLife’s interest in Brighthouse, to holders of MetLife common stock. Industry Trends and Uncertainties Throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations, we discuss a number of trends and uncertainties that we believe may materially affect our future financial condition, results of operations or cash flows. Where these trends or uncertainties are specific to a particular aspect of our business, we often include such a discussion under the relevant caption of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, as part of our broader analysis of that area of our business. In addition, the following factors represent some of the key general trends and uncertainties that have influenced the development of our business and our historical financial performance and that we believe will continue to influence our business and results of operations in the future. Financial and Economic Environment Our business and results of operations are materially affected by conditions in the capital markets and the economy generally. Stressed conditions, volatility and disruptions in the capital markets, particular markets, or financial asset classes can have an adverse effect on us. The impact on capital markets and the economy generally of the priorities and policies of the Trump administration is uncertain. See “Risk Factors - Economic Environment and Capital Markets-Related Risks - If difficult conditions in the capital markets and the U.S. economy generally persist or are perceived to persist, they may materially adversely affect our business and results of operations.” Equity market performance can affect our profitability for variable annuities and other separate account products as a result of the effects it has on product demand, revenues, expenses, reserves and our risk management effectiveness. The level of long-term interest rates and the shape of the yield curve can have a negative effect on the demand for, and the profitability of, spread-based products such as fixed annuities, index-linked annuities and universal life insurance. Low interest rates and risk premium, including credit spread, affect new money rates on invested assets and the cost of product guarantees. Insurance premium growth and demand for our products is impacted by the general health of U.S. economic activity. The above factors affect our expectations regarding future margins, which in turn, affect the amortization of certain of our intangible assets such as DAC and VOBA. Significantly lower expected margins may cause us to accelerate the amortization of DAC and VOBA, thereby reducing net income in the affected reporting period. We review our long-term assumptions about capital market returns and interest rates, along with other assumptions such as contract holder behavior, as part of our actuarial assumption review. As additional company specific and/or industry information on contract holder behavior becomes available, related assumptions may change and may potentially have a material impact on liability valuations and net income. In addition, the change in accounting estimate relating to the liability valuations that occurred in the second quarter of 2016 may result in greater income statement volatility in the future. As reported in February 2017, the Federal Reserve indicated that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen and inflation will rise to 2.0% over the medium term. On March 15, 2017, the Federal Reserve increased the Federal Funds Target Rate by 25 basis points to a target range of 0.75% to 1.0%. See “- Summary of Critical Accounting Estimates - Deferred Policy Acquisition Costs and Value of Business Acquired” and “- Results of Operations - Actuarial Assumption Review.” Demographics We believe that demographic trends in the U.S. population, the increase in under-insured individuals, the potential risk to governmental social safety net programs and the shifting of responsibility for retirement planning and financial security from employers and other institutions to individuals, highlight the need of individuals to plan for their long-term financial security and will create opportunities to generate significant demand for our products. Moreover, we believe that the Secure Seniors, Middle Aged Strivers and Diverse and Protected customer segments, the three customer segments we intend to target, represent a significant portion of the market opportunity. Our research indicates that these segments are open to financial guidance and, accordingly, we expect that they will be receptive to the products we intend to sell. See “Business - Overview - Our Business Strategy.” By focusing our product development and marketing efforts to meeting the needs of these customer segments we will be able to focus on offering a smaller number of products that we believe are appropriately priced given current economic conditions, which we believe will benefit our expense ratio thereby increasing our profitability. Competitive Environment The life insurance industry remains highly fragmented and competitive. See “Business - Segments and Corporate & Other” for each of our segments. In particular, we believe that financial strength and financial flexibility are highly relevant differentiators from the perspective of customers and distributors. We believe we are adequately positioned to compete in this environment. Regulatory Developments Our life insurance companies are regulated primarily at the state level, with some products and services also subject to federal regulation. In addition, Brighthouse Financial, Inc. and its insurance subsidiaries are subject to regulation under the insurance holding company laws of various U.S. jurisdictions. Furthermore, some of our operations, products and services are subject to ERISA, consumer protection laws, securities, broker-dealer and investment advisor regulations, and environmental and unclaimed property laws and regulations. In addition, in marketing certain of Brighthouse’s products and services to tax-qualified pension plans, retirement plans and IRAs, new rules issued by the DOL on April 6, 2016 that became applicable on June 8, 2017 raise the standard for recommendations to such plans and IRAs to purchase variable and index-linked annuities to a fiduciary standard. See “Business - Regulation” and “Risk Factors - Regulatory and Legal Risks.” Summary of Critical Accounting Estimates The preparation of financial statements in conformity with GAAP requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported on the Consolidated and Combined Financial Statements. The most critical estimates include those used in determining: i. liabilities for future policy benefits; ii. accounting for reinsurance; iii. capitalization and amortization of DAC and the establishment and amortization of VOBA; iv. estimated fair values of investments in the absence of quoted market values; v. investment impairments; vi. estimated fair values of freestanding derivatives and the recognition and estimated fair value of embedded derivatives requiring bifurcation; vii. measurement of income taxes and the valuation of deferred tax assets; and viii. liabilities for litigation and regulatory matters. In applying our accounting policies, we make subjective and complex judgments that frequently require estimates about matters that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance and financial services industries; others are specific to our business and operations. Actual results could differ from these estimates. The above critical accounting estimates are described below and in Note 1 of the Notes to the Consolidated and Combined Financial Statements. Liability for Future Policy Benefits Generally, future policy benefits are payable over an extended period of time and related liabilities are calculated as the present value of future expected benefits to be paid, reduced by the present value of future expected premiums. Such liabilities are established based on methods and underlying assumptions that are in accordance with GAAP and applicable actuarial standards. The principal assumptions used in the establishment of liabilities for future policy benefits are mortality, morbidity, benefit utilization and withdrawals, policy lapse, retirement, disability incidence, disability terminations, investment returns, inflation, expenses and other contingent events as appropriate to the respective product type. These assumptions, intended to estimate the experience for the period the policy benefits are payable, are established at the time the policy is issued and locked in. Utilizing these assumptions, liabilities are established on a block of business basis. If experience is less favorable than assumed, DAC may be reduced and/or additional insurance liabilities established, resulting in a reduction in earnings. Future policy benefit liabilities for GMDBs and GMIBs relating to certain variable annuity contracts are based on estimates of the expected value of benefits in excess of the projected account balance, recognizing the excess ratably over the accumulation period based on total expected assessments. Liabilities for universal and variable life secondary guarantees are determined by estimating the expected value of death benefits payable when the account balance is projected to be zero and recognizing those benefits ratably over the contract period based on total expected assessments. The assumptions used in estimating the excess benefits under variable annuity guarantees and the secondary guarantee liabilities under universal and variable life policies are consistent with those used for amortizing DAC, and are therefore subject to the same variability and risk. The assumptions of investment performance and volatility for variable products are consistent with historical experience of the appropriate underlying equity index, such as the S&P 500 Index. We regularly review our assumptions supporting our estimates of actuarial liabilities for future policy benefits. For universal life and annuity product guarantees, assumptions are updated periodically, whereas for traditional life products, such as term life and non-participating whole life insurance, assumptions are established and locked in at inception but reviewed periodically to determine whether a premium deficiency exists that would trigger an unlocking of assumptions. We also review our actuarial liabilities to determine if profits are projected in earlier years followed by losses projected in later years, which could require us to establish an additional liability. Differences between actual experience and the assumptions used in pricing our policies and guarantees, as well as adjustments to the related liabilities, result in variances in profit and could result in losses. In assessing loss recognition and profits followed by losses, product groupings are limited by segment. Historically, all of our universal life business was grouped together for evaluating loss recognition and profits followed by losses. In the second quarter of 2016, an actuarial model change reduced expected future gross profits for ULSG and triggered loss recognition resulting in a loss of $258 million, after tax. Subsequently, in the fourth quarter of 2016, ULSG was moved from our Life segment to our Run-off segment, triggering a change in groupings for loss recognition testing that resulted in an additional loss of $399 million, after tax. See “- Results of Operations - Significant Business Actions - ULSG Re-segmentation.” For an overview of our products and balance sheet accounts impacted by actuarial assumptions, see “- Results of Operations - Actuarial Assumption Review.” See Note 1 of the Notes to the Consolidated and Combined Financial Statements for additional information on our accounting policy relating to variable annuity guarantees and liability for future policy benefits and Note 3 of the Notes to the Consolidated and Combined Financial Statements for future policyholder benefit liabilities. Reinsurance Accounting for reinsurance requires extensive use of assumptions and estimates, particularly related to the future performance of the underlying business and the potential impact of counterparty credit risk with respect to reinsurance receivables. We periodically review actual and anticipated experience compared to the aforementioned assumptions used to establish assets and liabilities relating to ceded and assumed reinsurance and evaluate the financial strength of counterparties to our reinsurance agreements using criteria similar to those evaluated in our security impairment process. See “- Investment Impairments.” Additionally, for each of our reinsurance agreements, we determine whether the agreement provides indemnification against loss or liability relating to insurance risk, in accordance with applicable accounting standards. We review all contractual features, including those that may limit the amount of insurance risk to which the reinsurer is subject or features that delay the timely reimbursement of claims. We evaluate present values of projected future cash flows on blocks of policies subject to new reinsurance agreements in light of all such contractual features to determine whether our reinsurance counterparties are exposed to a reasonable possibility of significant loss. Such analysis involves management estimates as to the cash flow projections, as well as management judgment as to what constitutes a reasonable possibility of significant loss. If we determine that a reinsurance agreement does not expose the reinsurer to a reasonable possibility of a significant loss from insurance risk, we record the agreement using the deposit method of accounting. See Note 5 of the Notes to the Consolidated and Combined Financial Statements for additional information on our reinsurance programs. Deferred Policy Acquisition Costs and Value of Business Acquired We incur significant costs in connection with acquiring new and renewal insurance business. Costs that relate directly to the successful acquisition or renewal of insurance contracts are deferred as DAC. In addition to commissions and other direct costs, deferrable costs include the portion of an employee’s total compensation and benefits related to time spent selling, underwriting or processing the issuance of new and renewal insurance business only with respect to actual policies acquired or renewed. We utilize various techniques to estimate the portion of an employee’s time spent on qualifying acquisition activities that result in actual sales, including surveys, interviews, representative time studies and other methods. These estimates include assumptions that are reviewed and updated on a periodic basis or more frequently to reflect significant changes in processes or distribution methods. VOBA represents the excess of book value over the estimated fair value of acquired insurance, annuity and investment-type contracts in force at the acquisition date. The estimated fair value of the acquired liabilities is based on projections, by each block of business, of future policy and contract charges, premiums, mortality and morbidity, separate account performance, surrenders, operational expenses, investment returns, nonperformance risk adjustment and other factors. Actual experience on the purchased business may vary from these projections. The recovery of DAC and VOBA is dependent upon the future profitability of the related business. Separate account rates of return on variable universal life contracts and variable deferred annuity contracts affect in-force account balances on such contracts each reporting period, which can result in significant fluctuations in amortization of DAC and VOBA, which is based on estimated gross profits. Our practice to determine the impact of gross profits resulting from returns on separate accounts assumes that long-term appreciation in equity markets is not changed by short-term market fluctuations, but is only changed when sustained interim deviations are expected. We monitor these events and only change the assumption when our long-term expectation changes. The effect of an increase (decrease) by 100 basis points in the assumed future rate of return is reasonably likely to result in a decrease (increase) in the DAC and VOBA amortization with an offset to our unearned revenue liability which nets to approximately $230 million. We use a mean reversion approach to separate account returns where the mean reversion period is five years with a long-term separate account return after the five-year reversion period is over. The current long-term rate of return assumption for the variable universal life contracts and variable deferred annuity contracts is in the mid-6% range. We also generally review other long-term assumptions underlying the projections of estimated gross profits on an annual basis. These assumptions primarily relate to investment returns, interest crediting rates, mortality, persistency, benefit elections and withdrawals, and expenses to administer business. Assumptions used in the calculation of estimated gross profits which may have significantly changed are updated annually. If the update of assumptions causes expected future gross profits to increase, DAC and VOBA amortization will generally decrease, resulting in a current period increase to earnings. The opposite result occurs when the assumption update causes expected future gross profits to decrease. Our most significant assumption updates resulting in a change to the expected future gross profits and the amortization of DAC and VOBA are due to revisions to expenses, in-force or persistency assumptions, benefit elections, withdrawals and expected future investment returns on annuity contracts and variable and universal life insurance policies. We expect these assumptions to be the ones most reasonably likely to cause significant changes in the future. Changes in these assumptions can be offsetting and we are unable to predict their movement or offsetting impact over time. In addition, we update the estimated gross profits with actual gross profits in each reporting period. When the change in estimated gross profits principally relates to the difference between actual and estimates in the current period, an increase in profits will generally result in an increase in amortization and a decrease in profits will generally result in a decrease in amortization. See Note 4 of the Notes to the Consolidated and Combined Financial Statements for additional information relating to DAC and VOBA amortization. At December 31, 2017, 2016 and 2015, our DAC and VOBA was $6.3 billion, $6.3 billion and $6.4 billion, respectively. Amortization of DAC and VOBA associated with the variable and universal life policies and the annuity contracts was significantly impacted by changes including: (i) updating assumptions that impact the future estimated gross profits; and (ii) updating the estimated gross profits of the most current period for actual experience including market performance. To illustrate the impact on amortization of DAC and VOBA from these two types of changes, the following highlights the significant items contributing to the amortization of DAC and VOBA during each of the years ended December 31, 2017, 2016 and 2015. DAC and VOBA amortization was approximately $430 million lower than expected for the year ended December 31, 2017, which consisted of: • A decrease of approximately $250 million related to variable annuity net derivative losses, mainly hedge losses in the first three quarters of the year, offset by higher amortization related to the impact from the favorable change to nonperformance risk; • An increase of approximately $150 million related to changes to the GMIB insurance liabilities; and • A decrease of approximately $370 million due to assumption updates related to refinements in the amortization horizon. DAC and VOBA amortization was approximately $380 million lower than expected for the year ended December 31, 2016, which consisted of: • A reversal of previous amortization of approximately $1.4 billion related to net derivative losses driven mostly by assumption updates increasing the variable annuity guarantees accounted for as embedded derivatives and net losses from the freestanding derivatives hedging these guarantees; partially offset by • An acceleration of approximately $360 million, mainly resulting from reserve adjustments from modeling improvements for universal life products; • An acceleration of approximately $560 million related to loss recognition triggered by the move of ULSG into the Run-off segment; and • An increase of amortization of approximately $140 million primarily associated with the variable annuity assumption updates other than that related to the embedded derivatives described above. DAC and VOBA amortization was approximately $70 million lower than expected for the year ended December 31, 2015, which consisted of: • A reversal of previous amortization of approximately $200 million related to net derivative losses which resulted from an increase in variable annuity guarantees, partially offset by market-to-market changes from free standing derivatives hedging these guarantees; and • Improvements in persistency related to both adjustments for actual experience and assumption updates which caused an increase in actual and expected future gross profits resulting in a net decrease of approximately $120 million; partially offset by • An increase of approximately $140 million from a net gain for the period related to the GMIB insurance liabilities and associated hedges; and • An increase associated with net investment gains of approximately $70 million. Our DAC and VOBA balance is also impacted by unrealized investment gains (losses) and the amount of amortization which would have been recognized if such gains and losses had been realized. The change in unrealized investment gains (losses) decreased the DAC and VOBA balance by $40 million for the year ended December 31, 2017, decreased the DAC and VOBA balance by $10 million for the year ended December 31, 2016 and increased the DAC and VOBA balance by $190 million in 2015. See Notes 4 and 6 of the Notes to the Consolidated and Combined Financial Statements for information regarding the DAC and VOBA offset to unrealized investment losses. Estimated Fair Value of Investments In determining the estimated fair value of our investments, fair values are based on unadjusted quoted prices for identical investments in active markets that are readily and regularly obtainable. When such quoted prices are not available, fair values are based on quoted prices in markets that are not active, quoted prices for similar but not identical investments, or other observable inputs. If these inputs are not available, or observable inputs are not determinable, unobservable inputs and/or adjustments to observable inputs requiring management judgment are used to determine the estimated fair value of investments. The methodologies, assumptions and inputs utilized are described in Note 8 of the Notes to the Consolidated and Combined Financial Statements. Financial markets are susceptible to severe events evidenced by rapid depreciation in asset values accompanied by a reduction in asset liquidity. Our ability to sell investments, or the price ultimately realized for investments, depends upon the demand and liquidity in the market and increases the use of judgment in determining the estimated fair value of certain investments. Investment Impairments One of the significant estimates related to AFS securities is our impairment evaluation. The assessment of whether an other-than-temporary impairment (“OTTI”) occurred is based on our case-by-case evaluation of the underlying reasons for the decline in estimated fair value on a security-by-security basis. Our review of each fixed maturity and equity security for OTTI includes an analysis of gross unrealized losses by three categories of severity and/or age of gross unrealized loss. An extended and severe unrealized loss position on a fixed maturity security may not have any impact on the ability of the issuer to service all scheduled interest and principal payments. Accordingly, such an unrealized loss position may not impact our evaluation of recoverability of all contractual cash flows or the ability to recover an amount at least equal to its amortized cost based on the present value of the expected future cash flows to be collected. In contrast, for certain equity securities, greater weight and consideration are given to a decline in estimated fair value and the likelihood such estimated fair value decline will recover. Additionally, we consider a wide range of factors about the security issuer and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in our evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Factors we consider in the OTTI evaluation process are described in Note 6 of the Notes to the Consolidated and Combined Financial Statements. The determination of the amount of allowances and impairments on the remaining invested asset classes is highly subjective and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. See Notes 1 and 6 of the Notes to the Consolidated and Combined Financial Statements for additional information relating to our determination of the amount of allowances and impairments. Derivatives We use freestanding derivative instruments to hedge various capital market risks in our products, including: (i) certain guarantees, some of which are reported as embedded derivatives; (ii) current or future changes in the fair value of our assets and liabilities; and (iii) current or future changes in cash flows. All derivatives, whether freestanding or embedded, are required to be carried on the balance sheet at fair value with changes reflected in either net income (loss) or in OCI, depending on the type of hedge. Below is a summary of critical accounting estimates by type of derivative. Freestanding Derivatives The determination of the estimated fair value of freestanding derivatives, when quoted market values are not available, is based on market standard valuation methodologies and inputs that management believes are consistent with what other market participants would use when pricing such instruments. Derivative valuations can be affected by changes in interest rates, foreign currency exchange rates, financial indices, credit spreads, default risk, nonperformance risk, volatility, liquidity and changes in estimates and assumptions used in the pricing models. See Note 7 of the Notes to the Consolidated and Combined Financial Statements for additional information on significant inputs into the OTC derivative pricing models and credit risk adjustment. Embedded Derivatives We issue variable annuity products with guaranteed minimum benefits, some of which are embedded derivatives measured at estimated fair value separately from the host variable annuity product, with changes in estimated fair value reported in net derivative gains (losses). The estimated fair values of these embedded derivatives are determined based on the present value of projected future benefits minus the present value of projected future fees attributable to the guarantee. The projections of future benefits and future fees require capital markets and actuarial assumptions, including expectations concerning policyholder behavior. A risk neutral valuation methodology is used under which the cash flows from the guarantees are projected under multiple capital market scenarios using observable risk-free rates. Market conditions, including, but not limited to, changes in interest rates, equity indices, market volatility and variations in actuarial assumptions, including policyholder behavior, mortality and risk margins related to non-capital market inputs, as well as changes in our nonperformance risk adjustment may result in significant fluctuations in the estimated fair value of the guarantees that could materially affect net income. Changes to actuarial assumptions, principally related to contract holder behavior such as annuitization utilization and withdrawals associated with GMIB riders, can result in a change of expected future cash outflows of a guarantee between the accrual-based model for insurance liabilities and the fair-value based model for embedded derivatives. See Note 1 of the Notes to the Consolidated and Combined Financial Statements for additional information relating to the determination of the accounting model. Risk margins are established to capture the non-capital market risks of the instrument which represent the additional compensation a market participant would require to assume the risks related to the uncertainties in certain actuarial assumptions. The establishment of risk margins requires the use of significant management judgment, including assumptions of the amount and cost of capital needed to cover the guarantees. With respect to assumptions regarding policyholder behavior, we have recorded charges, and in some cases benefits, in prior years as a result of the availability of sufficient and credible data at the conclusion of each review. During the second quarter of 2016, MetLife undertook its annual review of actuarial assumptions for its U.S. retail variable annuity business in light of the availability of updated industry studies and a larger body of cumulative actual experience data than had been previously available. This data provided greater insight into contract holder behavior for GMIB riders passing the initial 10-year waiting period before benefits can be fully utilized. As a result of this review, we made changes to contract holder benefit utilization behavior and long-term economic assumptions, as well as risk margins. These assumption updates resulted in a change in our estimate of expected future cash flows and moved certain of those cash flows from the accrual-based insurance liabilities model to the fair value-based embedded derivatives model. This change in accounting estimate and the resulting charge to earnings were primarily due to an increase in the anticipated level of forced annuitizations where the non-life contingent portion is now reported as an embedded derivative. With more of the estimated future cash outflows being accounted for as embedded derivatives, the GMIB rider liabilities are more sensitive to market changes and thus may result in greater income statement volatility. In addition, in the third quarter of 2016, we performed the annual review of our actuarial assumptions for our remaining annuity and life businesses. We ceded the risk associated with certain of the variable annuities with guaranteed minimum benefits described in the preceding paragraphs. The value of the embedded derivatives on the ceded risk is determined using a methodology consistent with that described previously for the guarantees directly written by us with the exception of the input for nonperformance risk that reflects the credit of the reinsurer. However, because certain of the reinsured guarantees do not meet the definition of an embedded derivative and, thus are not accounted for at fair value, significant fluctuations in net income may occur when the change in the fair value of the reinsurance recoverable is recorded in net income without a corresponding and offsetting change in fair value of the directly written guaranteed liability. See Note 7 of the Notes to the Consolidated and Combined Financial Statements for additional information on our embedded derivatives. Nonperformance Risk Adjustment The valuation of our embedded derivatives includes an adjustment for the risk that we fail to satisfy our obligations, which we refer to as our nonperformance risk. The nonperformance risk adjustment, which is captured as a spread over the risk-free rate in determining the discount rate to discount the cash flows of the liability, was previously determined by taking into consideration publicly available information relating to spreads in the secondary market for MetLife, Inc.’s debt, including related credit default swaps. In the third quarter of 2017, in connection with the Separation, we updated our assumptions for determining the credit spread underlying the nonperformance risk adjustment to be based on Brighthouse Financial, Inc.’s creditworthiness instead of that of MetLife, Inc. The credit spread was determined by taking into consideration publicly available information relating to spreads in the secondary market for Brighthouse Financial, Inc.’s debt. These observable spreads are then adjusted, as necessary, to reflect the financial strength ratings of the issuing insurance subsidiaries as compared to the credit rating of Brighthouse Financial, Inc. The impact of this change in methodology resulted in an increase in net income (loss) before provision for income tax of $521 million ($339 million, net of income tax). The following table illustrates the impact that a range of reasonably likely variances in credit spreads would have on our consolidated and combined balance sheet, excluding the effect of income tax, related to the embedded derivative valuation on certain variable annuity products measured at estimated fair value. Even when credit spreads do not change, the impact of the nonperformance risk adjustment on fair value will change when the cash flows within the fair value measurement change. The table only reflects the impact of changes in credit spreads on the balance sheet and not these other potential changes. In determining the ranges, we have considered current market conditions, as well as the market level of spreads that can reasonably be anticipated over the near term. Income Taxes We provide for federal and state income taxes currently payable, as well as those deferred due to temporary differences between the financial reporting and tax bases of assets and liabilities. Our accounting for income taxes represents our best estimate of various events and transactions. Tax laws are often complex and may be subject to differing interpretations by the taxpayer and the relevant governmental taxing authorities. In establishing a provision for income tax expense, we must make judgments and interpretations about the application of tax laws. We must also make estimates about when in the future certain items will affect taxable income in the various taxing jurisdictions. In establishing a liability for unrecognized tax benefits, assumptions may be made in determining whether, and to what extent, a tax position may be sustained. Once established, unrecognized tax benefits are adjusted when there is more information available or when events occur requiring a change. Valuation allowances are established against deferred tax assets, particularly those arising from carryforwards, when management determines, based on available information, that it is more likely than not that deferred income tax assets will not be realized. The realization of deferred tax assets related to carryforwards depends upon the existence of sufficient taxable income within the carryforward periods under the tax law in the applicable tax jurisdiction. Significant judgment is required in projecting future taxable income to determine whether valuation allowances should be established, as well as the amount of such allowances. See Note 1 of the Notes to the Consolidated and Combined Financial Statements for additional information relating to our determination of such valuation allowances. We may be required to change our provision for income taxes when estimates used in determining valuation allowances on deferred tax assets significantly change, or when new information indicates the need for adjustment in valuation allowances. Additionally, future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the financial statements in the year these changes occur. On December 22, 2017, President Trump signed the Tax Act into law. The Tax Act reduced the corporate tax rate to 21%, reduced interest expense deductibility, increased capitalization amounts for deferred acquisition costs, eliminated the corporate alternative minimum tax, provided for determining reserve deductions at 92.81% of statutory reserves, and reduced the dividend received deduction. Most of the changes in the Tax Act are effective on January 1, 2018. The reduction in the corporate rate required a one-time remeasurement of certain deferred tax items as of December 31, 2017. For the estimated impact of the Tax Act on the financial statements, including the estimated impact resulting from the remeasurement of deferred tax assets and liabilities, see Note 13 for more information. Actual results may materially differ from the Company’s current estimate due to, among other things, further guidance that may be issued by tax authorities or regulatory bodies and/or changes in interpretations and assumptions preliminarily made. The Company will continue to analyze the Tax Act to finalize its financial statement impact. In December 2017, the SEC issued Staff Accounting Bulletin (“SAB”) 118, addressing the application of GAAP in situations when a registrant does not have necessary information available to complete the accounting for certain income tax effects of the Tax Act. SAB 118 provides guidance for registrants under three scenarios: (1) the measurement of certain income tax effects is complete, (2) the measurement of certain income tax effects can be reasonably estimated, and (3) the measurement of certain income tax effects cannot be reasonably estimated. SAB 118 provides that the measurement period is complete when a company’s accounting is complete. The measurement period cannot extend beyond one year from the enactment date. SAB 118 acknowledges that a company may be able to complete the accounting for some provisions earlier than others. As such, it may need to apply all three scenarios in determining the accounting for the Tax Act based on information that is available. The Company has not fully completed its accounting for the tax effects of the Tax Act, and thus certain items relating to accounting for the Tax Act are provisional, including accounting for reserves. However, it has recorded the effects of the Tax Act as reasonable estimates due to the need for further analysis of the provisions within the Tax Act and collection, preparation and analysis of relevant data necessary to complete the accounting. The corporate rate reduction also left certain tax effects, which were originally booked using the previous corporate rate, stranded in AOCI. The Company adopted new accounting guidance as of December 31, 2017 that allowed the Company to reclassify the stranded tax effects from AOCI into retained earnings. The Company elected to reclassify amounts based on the difference between the previously enacted federal corporate tax rate and the newly enacted rate as applied on an aggregate basis. See Notes 1 and 13 of the Notes to the Consolidated and Combined Financial Statements for additional information on our income taxes. Litigation Contingencies We are a party to a number of legal actions and are involved in a number of regulatory investigations. Given the inherent unpredictability of these matters, it is difficult to estimate the impact on our financial position. Liabilities are established when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. On a quarterly and annual basis, we review relevant information with respect to liabilities for litigation, regulatory investigations and litigation-related contingencies to be reflected in our results of operations and financial condition. See Note 15 of the Notes to the Consolidated and Combined Financial Statements for additional information regarding our assessment of litigation contingencies. Non-GAAP and Other Financial Disclosures Non-GAAP Financial Disclosures Adjusted Earnings In this report, we present adjusted earnings as a measure of our performance that is not calculated in accordance with GAAP. We believe that this non-GAAP financial measure enhances the understanding of our performance by highlighting the results of operations and the underlying profitability drivers of our business. However, adjusted earnings should not be viewed as a substitute for net income (loss), which is the most directly comparable financial measure calculated in accordance with GAAP. See “- Results of Operations” for a reconciliation of adjusted earnings to net income (loss). A reconciliation of adjusted earnings to net income (loss) is not accessible on a forward-looking basis because we believe it is not possible without unreasonable efforts to provide other than a range of net investment gains and losses and net derivative gains and losses, which can fluctuate significantly within or outside the range and from period to period and may have a material impact on net income (loss). Our definitions of the non-GAAP and other financial measures discussed in this report may differ from those used by other companies. For example, as indicated below, we exclude GMIB revenues and related embedded derivatives gains (losses), as well as GMIB benefits and associated DAC and VOBA offsets from adjusted earnings, thereby excluding substantially all GMLB activity from adjusted earnings. Adjusted earnings, which may be positive or negative, is used by management to evaluate performance, allocate resources and facilitate comparisons to industry results. This financial measure focuses on our primary businesses principally by excluding the impact of market volatility, which could distort trends, as well as businesses that have been or will be sold or exited by us, referred to as divested businesses. The following are the significant items excluded from total revenues, net of income tax, in calculating adjusted earnings: • Net investment gains (losses); • Net derivative gains (losses) except earned income on derivatives and amortization of premium on derivatives that are hedges of investments or that are used to replicate certain investments, but do not qualify for hedge accounting treatment (“Investment Hedge Adjustments”); and • Amortization of unearned revenue related to net investment gains (losses) and net derivative gains (losses) and certain variable annuity GMIB fees (“GMIB Fees”). The following are the significant items excluded from total expenses, net of income tax, in calculating adjusted earnings: • Amounts associated with benefits and hedging costs related to GMIBs (“GMIB Costs”); • Amounts associated with periodic crediting rate adjustments based on the total return of a contractually referenced pool of assets and market value adjustments associated with surrenders or terminations of contracts (“Market Value Adjustments”); and • Amortization of DAC and VOBA related to (i) net investment gains (losses), (ii) net derivative gains (losses), (iii) GMIB Fees and GMIB Costs and (iv) Market Value Adjustments. The tax impact of the adjustments mentioned are calculated net of the U.S. statutory tax rate, which could differ from our effective tax rate. We present adjusted earnings in a manner consistent with management’s view of the primary business activities that drive the profitability of our core businesses. The following table illustrates how each component of adjusted earnings is calculated from the GAAP statement of operations line items: _______________ (1) Italicized items indicate GAAP statement of operations line items. Consistent with GAAP guidance for segment reporting, adjusted earnings is also our GAAP measure of segment performance. Accordingly, we report adjusted earnings by segment in Note 2 of the Notes to the Consolidated and Combined Financial Statements. Other Financial Disclosures The following additional information is relevant to an understanding of our performance results: • We sometimes refer to sales activity for various products. Statistical sales information for life sales are calculated using the LIMRA definition of sales for core direct sales, excluding company-sponsored internal exchanges, corporate-owned life insurance, bank-owned life insurance, and private placement variable universal life insurance. Annuity sales consist of 10% of direct statutory premiums, excluding company sponsored internal exchanges. These sales statistics do not correspond to revenues under GAAP, but are used as relevant measures of business activity. • Allocated equity is the portion of common stockholders’ equity that management allocates to each of its segments and sub-segments. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Executive Summary - Overview” and Note 2 of the Notes to the Consolidated and Combined Financial Statements for further details regarding allocated equity and the use of an internal capital model. Economic Capital Economic capital is an internally developed risk capital model, the purpose of which is to measure the risk in the business and to provide a basis upon which capital is deployed. The economic capital model accounts for the unique and specific nature of the risks inherent in our business. Our economic capital model, coupled with considerations of regulatory capital requirements, aligns segment allocated equity with emerging standards and consistent risk principles. The model applies statistics-based risk evaluation principles to the material risks to which the Company is exposed. These consistent risk principles include calibrating required economic capital shock factors to a specific confidence level and time horizon while applying an industry standard method for the inclusion of diversification benefits among risk types. Segment net investment income is credited or charged based on the level of allocated equity; however, changes in allocated equity do not impact our consolidated net investment income, adjusted earnings or income (loss) from continuing operations, net of income tax. Net investment income is based upon the actual results of each segment’s specifically identifiable investment portfolios adjusted for allocated equity. Other costs are allocated to each of the segments based upon: (i) a review of the nature of such costs; (ii) time studies analyzing the amount of employee compensation costs incurred by each segment; and (iii) cost estimates included in the Company’s product pricing. This model was used through December 31, 2017. Going forward, for variable annuities, the Company will deploy capital consistent with its Variable Annuity Risk Exposure Management Strategy, which defines Variable Annuity’s capital target based on statutory capital oriented risk principles. For businesses other than variable annuity, the allocation will be based on a percentage of statutory risk based capital. The Company’s management is responsible for the ongoing production and enhancement of the Variable Annuity capital model and reviews its approach periodically to ensure it remains consistent with emerging industry practice standards. Economic capital-based risk estimation is an evolving science, and industry best practices have emerged and continue to evolve. Areas of evolving industry best practices include stochastic liability valuation techniques, alternative methodologies for the calculation of diversification benefits, and the quantification of appropriate shock levels. Results of Operations Index to Results of Operations Page Significant Business Actions Actuarial Assumption Review Consolidated Results for the Years Ended December 31, 2017, 2016, and 2015 Reconciliation of Net Income (Loss) to Adjusted Earnings Consolidated Results for the Years Ended December 31, 2017, 2016 and 2015 - Adjusted Earnings Segments and Corporate & Other - Adjusted Earnings for the Years Ended December 31, 2017, 2016 and 2015 GMLB Riders for the Years Ended December 31, 2017, 2016 and 2015 Significant Business Actions The following table presents the effect on income (loss) before provision for income tax and pre-tax adjusted earnings from certain business actions undertaken by management that resulted in significant earnings impacts but are not indicative of underlying business performance in the period. These actions do not include the results from the annual review of actuarial assumptions used in determining our insurance liabilities, which are separately discussed, nor other significant impacts to earnings from events that may occur as a result of normal business operations, such as market factors or regulatory changes. Items discussed in this section are referred to in the discussion of our results of operations and are intended to facilitate an understanding of that discussion. ULSG Model Change. In the second quarter of 2016, we refined our actuarial model which calculates the reserves for our ULSG products (the “ULSG Model Change”). The new model treats projected premiums and death claims differently than the previous model. This change resulted in a one-time charge to both income (loss) before provision for income tax and pre-tax adjusted earnings of $652 million for the year ended December 31, 2016. Of this one-time charge, $262 million resulted directly from the model refinements, as follows: • a $231 million increase in insurance-related liabilities; • a $24 million decrease in amortization of unearned revenue; and • a $7 million increase in amortization of DAC. The above impacts from the model change also resulted in a reduction of expected future gross profits, which drove our loss recognition margins negative, resulting in a further DAC write-off of $358 million and an increase in insurance-related liabilities of $32 million for the year ended December, 31, 2016. In addition to the one-time charges, as a result of the lower expected future gross profits, we have recognized ongoing increases in insurance-related liabilities of $218 million and $132 million for the years ended December 31, 2017 and 2016, respectively, that are not included in the preceding table. We expect to recognize similar ongoing increases in future periods. ULSG Re-segmentation. In the fourth quarter of 2016, we moved the ULSG products out of the Life segment and into the Run-off segment. The move was triggered by the decision in late 2016 to cease sales of all ULSG products in early 2017 and to manage this business separately from the rest of the Life business. In accordance with our accounting policies, the move to a different segment required us to separately evaluate and test the ULSG products for loss recognition without being able to offset losses with future earnings from the variable and universal life products remaining in the Life segment. This re-segmentation driven loss recognition resulted in a decrease in both income (loss) before provision for income tax and pre-tax adjusted earnings of $614 million, of which $562 million was from the write-off of DAC and $52 million was from an increase in insurance-related liabilities. SPDA Recaptures. In 2016, in contemplation of the Separation, we recaptured certain blocks of single premium deferred annuities ceded to MLIC, a subsidiary of MetLife, on a 90% coinsurance basis (together, the “SPDA Recaptures”). The SPDA Recaptures resulted in a benefit to both income (loss) before provision for income tax and pre-tax adjusted earnings of $413 million for the year ended December 31, 2016, comprised of higher fee income of $303 million due to a net favorable settlement and a recovery of DAC amortization of $110 million. The SPDA Recaptures were primarily settled with market-adjusted assets-in-kind, which increased the invested asset base but also resulted in lower yields as compared to the yield used in determining the interest income recognized on the reinsurance receivable balances prior to the recaptures. Together these changes had additional impacts to net investment spread on a comparative basis which are not reflected in the preceding table. VA Recaptures. Effective January 1, 2017, certain ceded and assumed variable annuity reinsurance agreements with MLIC were recaptured (“VA Recaptures”). The initial settlement of these transactions resulted in a charge in the first quarter of 2017 which decreased income (loss) before provision for income tax by $277 million. Of this amount, $265 million was included in GMLB Riders, recognized in net derivative gains (losses). The remaining $12 million was included in pre-tax adjusted earnings, recognized in other expenses, net of DAC capitalization, partially offset by lower amortization of DAC and VOBA. Upon final settlement in the second quarter of 2017, we recognized a benefit of $137 million, of which $110 million was included in GMLB Riders in net derivative gains (losses), and $27 million was included in adjusted earnings in other revenue. ULSG Actions. In the fourth quarter of 2017, several actions involving our USLG business resulted in a net decrease to both income (loss) before provision for income tax and pre-tax adjusted earnings of $82 million. These actions included the following: • the recapture of certain Unaffiliated Third-party Reinsurance agreements which resulted in net charges totaling $147 million; partially offset by • refinements to the actuarial valuation model, resulting in a net favorable impact of $65 million. Actuarial Assumption Review As a result of the 2016 actuarial assumption review related to our variable annuity business, we made certain changes to policyholder behavior and long-term economic assumptions, primarily relating to annuitization utilization, as well as withdrawals and risk margins. The 2016 review included an analysis of a larger body of actual experience than was previously available which, when combined with relevant industry-wide data that had recently become available, we believed provided greater insight into anticipated policyholder behavior for variable annuity contracts that are in the money. This experience included a statistically significant amount of our GMIB policies passing the ten year waiting period required to allow contract holders to use certain benefits and a longer period of experience in a low interest rate environment. For the 2017 variable annuity review, we (i) made certain changes to policyholder behavior; (ii) harmonized models and assumptions between GAAP and statutory; and (iii) reflected Brighthouse specific variables after the completion of the Separation from our former parent. The policyholder behavior updates were for lapse assumptions on all variable annuities with living benefits, and withdrawal assumptions on GMWBs to reflect contract age, in addition to client age over time. This change resulted in earlier client withdrawals for GMWB contracts. This policyholder behavior update was in part informed by the recent quantitative impact study (“QIS”) conducted as part of the NAIC variable annuity reserve and capital reform initiative that is still under development. In the harmonization category of changes, on economic assumptions, we lowered our long-term rate of return assumption to the mid-6% range for separate account funds, consistent with our base case projections which are the basis for setting our financial targets. Additionally, in this category, we refined the DAC model time horizon to be harmonized with the estimated weighted average life of the liabilities. In the third and final category, triggered by the Separation, we updated our assumptions for determining the credit spread underlying the nonperformance risk adjustment in the valuation of our embedded derivative liabilities to be based on Brighthouse’s creditworthiness instead of that of MetLife. See “- Summary of Critical Accounting Estimates - Derivatives - Nonperformance Risk Adjustment.” Updates to assumptions for our life businesses were related to realized experience in terms of mortality, lapses and premium payment patterns. Additionally, while we did not revise our long term general account rate setting methodology inherited from our former parent this year, we did experience positive impacts from differentiating the blended general account earned rates between the Life and Run-off segments. We may review and update these general account assumptions in future annual actuarial reviews. The following table presents the impact on pre-tax adjusted earnings and net income (loss) before provision for income tax from the actuarial assumption reviews. The impact related to GMLBs is included in net income (loss), but not included in adjusted earnings. See “- Non-GAAP and Other Financial Disclosures.” Consolidated Results for the Years Ended December 31, 2017, 2016, and 2015 Business Overview. We continue to evaluate our product offerings with the goal to provide new products that are simpler, more transparent and provide value to our advisors, clients and shareholders. New business efforts in 2017 centered on the sale of Shield Annuities, which increased 50% compared to 2016. In addition, as part of our distribution agreement with MassMutual, we launched a new fixed indexed annuity product in the second half of 2017. However, overall 2017 sales declined on a comparative basis due to impacts from Separation-related events that occurred in 2016, including the sale of MPCG to MassMutual and the suspension of sales by Fidelity, as well as our migration away from participating whole life and certain term life products. Unless otherwise noted, all amounts in the following discussions of our results of operations are stated before income tax except for adjusted earnings, which are presented net of income tax. The following table presents the components of net income (loss), in addition to adjusted earnings: Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Overview. Income (loss) before provision for income tax increased $4.1 billion ($2.6 billion, net of income tax) compared to 2016. In addition to higher adjusted earnings, this increase was driven primarily by favorable changes from freestanding derivatives and GMLB Riders. Additionally, after-tax results were impacted by a non-cash charge recognized in the third quarter of 2017 in connection with the Separation of $1.1 billion which was substantially offset by the favorable impact recognized in the fourth quarter of 2017 of $947 million related to the enactment of the Tax Act. Excluding the impacts from the annual actuarial assumption review, income (loss) before provision for income tax increased $1.6 billion. GMLB Riders. The GMLB Riders reflect (i) changes in the carrying value of GMLB liabilities, including GMIBs, GMWBs and GMABs; (ii) changes in the fair value of the hedges and reinsurance of the GMLB liabilities; (iii) the fees earned from the GMLB liabilities; and (iv) the effects related to DAC and VOBA amortization offsets to each of the preceding components. Comparative results from GMLB Riders were favorable by $1.3 billion as benefits recognized from lower liability reserves were partially offset by unfavorable impacts from the related DAC offsets and market factor impacts on our hedging program. For a detailed discussion of the GMLB Riders, see “- GMLB Riders for the Years Ended December 31, 2017, 2016 and 2015.” Other Derivative Instruments. We have other derivative instruments, in addition to the hedges and embedded derivatives included in the GMLB Riders, for which changes in fair value are recognized in net derivative gains (losses). Changes in the fair value of our other derivative instruments had a favorable impact on comparative results of $1.8 billion. Freestanding Derivatives. We have freestanding derivatives that economically hedge certain invested assets and insurance liabilities. The majority of this hedging activity is focused in the following areas: • use of interest rate swaps when we have duration mismatches where suitable assets with maturities similar to those of our long-dated liabilities are not readily available in the market; and • use of foreign currency swaps when we hold fixed maturity securities denominated in foreign currencies that are matching insurance liabilities denominated in U.S. dollars. The market impacts on the hedges are accounted for in net income (loss) while the offsetting economic impact on the items they are hedging are either not recognized or recognized through OCI in equity. In 2016, in connection with the Separation, we entered into additional interest rate swaps in order to hedge the risk of a decline in the statutory capital of the Company from further declines in interest rates. Changes in the fair value of freestanding derivatives had a $1.8 billion favorable impact on comparative results, primarily due to favorable changes in interest rates on the fair value of our interest rate swaps. This favorable change was partially offset by unfavorable changes in our foreign currency swaps due to the U.S. dollar weakening against key foreign currencies in the current period when compared to the prior period. Embedded Derivatives. Certain ceded reinsurance agreements in our Life and Run-off segments are written on a coinsurance with funds withheld basis. The funds withheld component is accounted for as an embedded derivative with changes in the fair value recognized in net income (loss) in the period in which they occur. In addition, the changes in liability values of our index-linked annuity products that result from changes in the underlying equity index are accounted for as embedded derivatives. Changes in the fair value of embedded derivatives had a favorable impact on comparative results of $16 million, primarily due to lower unfavorable impacts recognized in the current period on our Shield Annuities. In connection with the transition to our new variable annuity hedging program, changes in the fair value of the Shield Annuities are included in the direct written liabilities component of GMLB Riders beginning in the third quarter of 2017 on a prospective basis. Other Adjustments. Other adjustments to determine adjusted earnings had a favorable impact on comparative results of $214 million, primarily due to charges in the prior period for an impairment of goodwill in our Run-off segment and the write-off of previously capitalized items in Corporate & Other in connection with the sale of MPCG to MassMutual. Income Tax Expense (Benefit). Income tax benefit for the year ended December 31, 2017 was $237 million, or 39% of income (loss) before provision for income tax, compared to $1.8 billion, or 38% of income (loss) before provision for income tax for the year ended December 31, 2016. Our effective tax rate differs from the U.S. statutory rate primarily due to the impacts of the dividend received deductions and utilization of tax credits. In the current period, we recognized an additional $1.1 billion non-cash tax charge in connection with the Separation, as well as a $725 million tax benefit related to the enactment of the Tax Act. Adjusted Earnings. As more fully described in “- Non-GAAP and Other Financial Disclosures,” we use adjusted earnings, which does not equate to net income (loss), as determined in accordance with GAAP, to analyze our performance, evaluate segment performance, and allocate resources. We believe that the presentation of adjusted earnings, as we measure it for management purposes, enhances the understanding of our performance by highlighting the results of operations and the underlying profitability drivers of the business. Adjusted earnings and other financial measures based on adjusted earnings allow analysis of our performance relative to our business plan and facilitate comparisons to industry results. Adjusted earnings should not be viewed as a substitute for net income (loss). Adjusted earnings before provision for income tax increased $730 million ($234 million, net of income tax) for the year ended December 31, 2017, compared to the prior period. Adjusted earnings is discussed in greater detail below. Year Ended December 31, 2016 Compared with the Year Ended December 31, 2015 Overview. Income (loss) before provision for income tax decreased $6.2 billion ($4.1 billion, net of income tax) to a loss in 2016 compared to income in 2015. In addition to lower adjusted earnings, this decrease was primarily due to unfavorable results from GMLB Riders and unfavorable changes in other derivative instruments. Excluding the impact of the annual actuarial assumption review, income (loss) before provision for income tax decreased $3.8 billion ($2.5 billion, net of income tax). GMLB Riders. Comparative results from GMLB Riders were unfavorable by $2.7 billion, as our annual actuarial assumption review resulted in changes to assumptions regarding policyholder behavior which significantly increased the carrying value of the liabilities. In addition, market factors resulted in a significant decrease in the fair value of our related hedges. These decreases were partially offset by the favorable impacts on the GMLB Riders liabilities due to those same market factors, as well as favorable impacts to DAC amortization. Excluding the impact of the annual actuarial assumption review, comparative results from GMLB Riders were unfavorable by $466 million. Other Derivative Instruments. Changes in the fair value of our other derivative instruments had an unfavorable impact on comparative results of $1.9 billion. Freestanding Derivatives. Changes in the fair value of freestanding derivatives had an unfavorable impact on comparative results of $1.7 billion, primarily due to the unfavorable changes in our receive fixed interest rate swaps and interest rate total return swaps resulting from long-term interest rates increasing in 2016, including a significant increase in the fourth quarter, compared to decreasing in 2015. Embedded Derivatives. Changes in the fair value of embedded derivatives, primarily our Shield Annuity liabilities, had an unfavorable impact on comparative results of $181 million due to increases in equity index levels. Net Investment Gains (Losses). Net investment gains (losses) had an unfavorable impact on comparative results of $85 million, primarily due to realized gains on real estate and real estate joint ventures recognized in 2015 and higher impairments on real estate joint ventures in 2016, compared to 2015. These decreases were partially offset by lower impairments of fixed maturity securities in 2016, compared to 2015. Other Adjustments. Other adjustments to determine adjusted earnings had an unfavorable impact on comparative results of $256 million, primarily due to: • an impairment of goodwill in 2016 in our Run-off segment of $161 million ($109 million, net of income tax); and • higher expenses of $72 million in 2016 in Corporate & Other related to the write-off of previously capitalized items in connection with the sale of MPCG to MassMutual. Income Tax Expense (Benefit). Income tax benefit for the year ended December 31, 2016 was $1.8 billion, or 38% of income (loss) before provision for income tax, compared to income tax expense of $343 million, or 23% of income (loss) before provision for income tax, for the year ended December 31, 2015. Our effective tax rate differs from the U.S. statutory rates primarily due to the impacts of the dividend received deductions and utilization of tax credits. Adjusted earnings. Adjusted earnings before provision for income tax decreased $1.2 billion ($855 million, net of income tax) for the year ended December 31, 2016, compared to 2015. Adjusted earnings is discussed in greater detail below. Reconciliation of Net Income (Loss) to Adjusted Earnings The following tables reconcile net income (loss) to adjusted earnings: Consolidated Results for the Years Ended December 31, 2017, 2016 and 2015 - Adjusted Earnings The following table presents the components of adjusted earnings: Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Overview. Adjusted earnings increased $234 million, primarily driven by lower amortization of DAC which was partially offset by higher expenses and lower net investment income. In addition, we recognized a non-cash tax charge of $1.1 billion in the third quarter of 2017, which was substantially offset by the favorable impact of $947 million in the fourth quarter of 2017 related to the enactment of the Tax Act. Excluding the impacts from the annual actuarial assumption review, adjusted earnings decreased $47 million. Fee Income. Fee income decreased by $50 million, primarily due to a decline in our Annuities segment related to the SPDA Recaptures which was partially offset by higher asset-based fees and a tax-related increase in Corporate & Other. Excluding the impact of the annual actuarial assumption review, fee income decreased by $119 million. Net Investment Spread. Net investment spread decreased $262 million, primarily due to lower net investment income recognized in our Annuities segment and Corporate & Other, which is discussed in greater detail below. Insurance-related Activities. Net costs from insurance-related activities decreased by $185 million, primarily due to charges recognized in the prior period, net of additional charges in the current period, related to the ULSG Model Change and associated loss recognition in our Run-off segment, as well as a favorable change in the fair value of the underlying ceded separate account assets related to a related party reinsurance agreement for certain variable annuity contracts. Excluding the impact of the annual actuarial assumption review, insurance-related costs decreased by $109 million. Amortization of DAC and VOBA. DAC amortization is affected by estimated future gross profits, as well as differences between actual gross profits and estimates in the current period. See “- Summary of Critical Accounting Estimates - Deferred Policy Acquisition Costs and Value of Business Acquired.” Lower amortization of DAC and VOBA had a favorable impact comparative results of $1.3 billion, primarily due to charges recognized in the prior period from loss recognition triggered by the ULSG Model Change in our Run-off segment and refinements to the amortization period as a result of the current period annual actuarial assumption review in our Annuities segment. Excluding the impact of the annual actuarial assumption review, lower amortization of DAC and VOBA had a favorable impact on comparative results of $1.0 billion. Other Expenses, Net of DAC Capitalization. Expenses increased by $448 million, primarily due to establishment costs related to our technology transformation and branding in Corporate & Other, as well as increases in operating expenses as a result of being a stand-alone company and higher asset-based expenses in our Annuities segment. Actuarial Assumption Review. The results from the annual actuarial assumption review, which are included in the amounts discussed above, had a favorable impact on comparative results of $431 million, primarily due to lower amortization of DAC in our Annuities segment from refinements in the amortization period along with other changes discussed in greater detail below. Income Tax Expense (Benefit). Income tax expense for the year ended December 31, 2017 was $677 million compared to $181 million for the year ended December 31, 2016. Our effective tax rate typically differs from the U.S. statutory rate primarily due to the dividend received deductions and utilization of tax credits. In the current period, we recognized a $1.1 billion non-cash tax charge in connection with the Separation. We also recognized a tax benefit in the current period of $725 million due to the Tax Act. These adjustments resulted in effective tax rate percentages that are not meaningful for comparison purposes and accordingly have not been included. Year Ended December 31, 2016 Compared with the Year Ended December 31, 2015 Overview. The $855 million decrease in adjusted earnings resulted from a decrease in our Run-off segment, partially offset by increases in our Annuities segment and Corporate & Other. The decrease in our Run-off segment was due primarily to the ULSG Model Change and ULSG Re-segmentation. The increase in our Annuities segment was primarily due to higher fee income, lower amortization of DAC and VOBA and higher net investment spread, partially offset by higher GMDB costs. The increase in Corporate & Other was due primarily to higher net investment spread. Excluding the impact of the annual actuarial assumption review, adjusted earnings decreased $777 million. Fee Income. Fee income increased by $230 million, primarily due to the impacts of the SPDA Recaptures and the recapture of several reinsurance agreements in our Life segment, which was partially offset by lower asset-based fees in our Annuities segment. Excluding the impact of the annual actuarial assumption review, fee income increased by $218 million. Net Investment Spread. Net investment spread increased by $60 million, primarily due to higher net investment income resulting from higher invested asset bases in our Annuities segment and Corporate & Other, partially offset by a lower invested asset base in our Run-off segment. The overall increase in net investment income was partially offset by lower yields earned on the reinvestment of fixed maturity securities throughout our portfolios as a result of the low interest rate environment and lower returns on real estate joint ventures and securities lending in our Run-off segment. Net investment spread was further reduced by a decrease in income on the reinsurance deposit funds related to the SPDA Recaptures. Insurance-Related Activities. Net costs from insurance-related activities increased by $715 million primarily due to higher liabilities in our Run-off segment resulting from the ULSG Model Change and ULSG Re-segmentation and higher GMDB costs in our Annuities segment. Excluding the impact of the annual actuarial assumption review discussed below, net costs from insurance-related activities increased by $708 million. Amortization of DAC and VOBA. Higher amortization of DAC and VOBA had an unfavorable impact on comparative earnings of $900 million, primarily due to the impacts of the ULSG Re-segmentation and the ULSG Model Change. Excluding the impact of the annual actuarial assumption review, higher amortization of DAC and VOBA had an unfavorable impact on comparative results of $775 million. Other Expenses, Net of DAC Capitalization. Expenses decreased by $79 million, primarily due to the impact of the sale of MPCG to MassMutual in our Annuities and Life segments and lower asset-based costs in our Annuities segment, partially offset by higher allocated software amortization in our Annuities and Life segments as a result of certain projects being completed and placed into service in 2016. Actuarial Assumption Review. The results of the annual actuarial assumption review, which are included in the amounts discussed above, had an unfavorable impact on comparative results of $119 million, primarily due to higher DAC amortization and an increase in insurance-related liabilities in our Annuities segment, partially offset by a decrease in insurance-related liabilities in our Run-off segment. Income Tax Expense (Benefit). Income tax expense for the year ended December 31, 2016 was $181 million, or 21% of adjusted earnings before provision for income tax, compared to income tax expense of $572 million, or 27% of adjusted earnings before income tax, for the year ended December 31, 2015. Our effective tax rate typically differs from the U.S. statutory rate primarily due to the impacts of the dividend received deductions and utilization of tax credits. Segments and Corporate & Other - Adjusted Earnings for the Years Ended December 31, 2017, 2016 and 2015 Annuities The following table presents the components of adjusted earnings for our Annuities segment: A significant portion of our adjusted earnings is driven by separate account balances related to our variable annuity business. Most directly, these balances determine asset-based fee income but they also impact DAC amortization and asset-based commissions. Separate account balances are driven by sales, market movements, surrenders, withdrawals, benefit payments, policy charges and transfers. Below is a rollforward of our variable annuities separate account balances. Variable annuities separate account balances increased in 2017 driven by the strong equity market performance partially offset by continued negative net flows. Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Overview. Adjusted earnings decreased $135 million, primarily due to higher expenses, lower fee income and lower net investment spread, partially offset by favorable changes in DAC amortization and insurance-related activities. Excluding the favorable impact from the annual actuarial assumption review, adjusted earnings decreased $407 million. Fee Income. Fee income decreased by $237 million, primarily due to: • a benefit recorded in the prior period of $303 million in connection with the SPDA Recaptures; and • a deferred gain of $47 million recognized in the prior period related to the reinsurance agreements that were part of the VA Recaptures; partially offset by • an increase of $82 million from additional revenue sharing fees which were passed through to third parties and had a corresponding offset in other expenses; and • an increase in asset-based fees in our variable annuity business of $55 million resulting from higher average separate account balances. Excluding the impact of the annual actuarial assumption review, fee income decreased by $222 million. Net Investment Spread. Net investment spread decreased by $213 million, primarily due to lower net investment income driven by (i) lower income on derivatives as a result of the termination of interest rate swaps, (ii) lower yields on fixed maturity securities and mortgage loans as proceeds from maturing investments were reinvested at rates lower than the portfolio average and (iii) lower prepayment fees. These decreases were partially offset by the impact from an increase in the average invested asset base, primarily due to positive net flows in the general account. There was also an increase in average invested assets from the SPDA Recaptures, however, much of the resulting increase in net investment income was offset by the elimination of interest credited payments on the related reinsurance receivable, recognized in other revenue. In addition, segment net investment income decreased due to lower interest on allocated equity resulting from decrease in both the interest credited rate and the allocated equity base. Insurance-related Activities. Net costs from insurance-related activities decreased by $231 million, primarily due to: • a favorable change of $108 million in the fair value of the underlying ceded separate account assets under a related party reinsurance agreement for certain variable annuity contracts; and • lower amortization of deferred sales inducements (“DSI”) of $106 million mostly from refinements to the amortization period as part of the annual actuarial assumption review. Excluding the impact of the annual actuarial assumption review, net costs from insurance-related activities decreased by $174 million. Amortization of DAC and VOBA. Lower DAC and VOBA amortization had a favorable impact on comparative results of $288 million, primarily due to: • lower amortization of $376 million from refinements to the amortization period in connection with the annual actuarial assumption review in the current period, partially offset by • higher amortization of $109 million as a result of the recovery recorded in the prior period in connection with the SPDA Recaptures. Excluding the impact of the annual actuarial assumption review, DAC and VOBA amortization had an unfavorable impact on comparative results of $88 million. Other Expenses, Net of DAC Capitalization. Expenses increased by $319 million, primarily due to increased operating costs as a result of being a stand-alone company, as well as an increase in pass-through variable annuity expenses. With respect to the variable annuity pass-through expenses, it is an increase of approximately $140 million driven by Separation related changes to arrangements with third parties impacting the recognition of pass-through investment management and revenue sharing fees, most of which is offset by an increase in fee income. Actuarial Assumption Review. The results of the annual actuarial assumption review, which are included in the amounts discussed above, had a favorable impact on comparative results of $418 million, primarily due to: • lower DAC amortization of $376 million resulting mostly from refinements to the amortization period; and • lower DSI amortization of $87 million, primarily from refinements to the amortization period; partially offset by • higher policyholder benefits and claims of $32 million resulting from a increase in insurance liabilities from changes in lapse and withdrawal rates, as well as separate account growth rates; and • lower amortization of unearned revenue of $15 million from refinements to the amortization period. Income Tax Expense (Benefit). Income tax expense for the year ended December 31, 2017 was $369 million, or 27% of adjusted earnings before provision for income tax, compared to $484 million, or 30% of adjusted earnings before provision for income tax, for the year ended December 31, 2016. Our effective tax rate typically differs from the U.S. statutory rate primarily due to the impacts of the dividend received deductions. In the current period, we recognized a tax benefit of $115 million related to the dividend received deductions. Year Ended December 31, 2016 Compared with the Year Ended December 31, 2015 Overview. Adjusted earnings increased $63 million, driven by higher fee income, lower DAC and VOBA amortization, higher net investment spread and lower expenses, partially offset by higher GMDB costs and unfavorable mortality experience. Excluding the impact of the annual actuarial assumption review, adjusted earnings increased $166 million. Fee Income. Fee income increased by $113 million, primarily due to: • an increase of $303 million resulting from the SPDA Recaptures; partially offset by • a decrease of $194 million in asset-based fees resulting from the lower average separate account balances noted above, a portion of which was offset by a decrease in other expenses, net of DAC capitalization, from lower asset-based commissions. Net Investment Spread. Net investment spread increased by $63 million, primarily due to higher net investment income and lower interest credited, partially offset by lower interest earned on the reinsurance deposit funds related to the SPDA Recaptures. Net investment income increased primarily due to an increase in the average invested asset base and higher returns on private equity investments, partially offset by the impact from the low interest rate environment, which resulted in investments in fixed maturity securities and mortgage loans at yields lower than the portfolio average. The average invested asset base increased as a result of the SPDA Recaptures, positive net flows in the general account and an increase in allocated equity. Interest credited on policyholder account balances decreased primarily due to lower average crediting rates in connection with the low interest rate environment. Insurance-related Activities. Net costs from insurance-related activities increased by $135 million, primarily due to: • higher costs associated with GMDBs of $109 million driven by an increase in liability balances resulting from changes in rider utilization assumptions, higher claims, and hedge losses; and • unfavorable mortality of $38 million in our income annuities business. Excluding the impact of the annual actuarial assumption review, net costs from insurance-related activities increased by $89 million. Amortization of DAC and VOBA. Lower DAC and VOBA amortization had a favorable impact on comparative results of $88 million. The decrease in amortization was primarily due to: • a decrease of $109 million from a recovery of DAC related to the SPDA Recaptures; • a decrease of $62 million from lower actual profits resulting from lower asset-based fees earned on the lower average separate account balances noted above, net of the inverse impact on amortization from reduced future expected gross profits due to the same lower fees; and • a decrease of $29 million from model refinements to DAC amortization related to affiliated reinsurance and hedges of variable annuities; partially offset by • an increase of $112 million from changes in annual actuarial assumptions discussed below. Excluding the impact of the actuarial assumption review, DAC and VOBA amortization had a favorable impact on comparative results of $200 million. Other Expenses, Net of DAC Capitalization. Expenses decreased by $55 million, primarily due (i) to the sale of MPCG to MassMutual, (ii) impacts from the suspension of sales by a major distributor, (iii) lower investment management fees resulting from lower assets under management in our proprietary funds, and (iv) lower asset-based commissions related to the lower average separate account balances noted above. These decreases were partially offset by higher allocated software amortization. Actuarial Assumption Review. The results from the annual actuarial assumption review, which is included in the amounts discussed above, had an unfavorable impact on comparative results of $158 million, primarily due to: • additional DAC amortization of $112 million from assumption changes related to rider utilization, separate account growth, market volatility and lapses; and • higher net costs from insurance-related activities of $46 million resulting from changes to rider utilization assumptions impacting GMDBs, net of changes in lapse assumptions. Income Tax Expense (Benefit). Income tax expense for the year ended December 31, 2016 was $484 million, or 30% of adjusted earnings before provision for income tax, compared to $363 million, or 25% of adjusted earnings before provision for income tax, for the year ended December 31, 2015. Our effective tax rate differs from the U.S. statutory rate primarily due to the impacts of the dividend received deductions. Life The following table presents the components of adjusted earnings for our Life segment: Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Overview. Adjusted earnings decreased $10 million, primarily due to unfavorable impacts from insurance-related activities partially offset by lower amortization of DAC and VOBA. Excluding the impact of the annual actuarial assumption review, adjusted earnings increased $10 million. During 2016 we recaptured several reinsurance agreements from an affiliate of MetLife and a third party. While these recaptures did not result in a material impact to adjusted earnings, the primary impacts of the recaptures resulted in a significant increase in amortization of DAC that was mostly offset by higher fee income. Fee Income. Fee income increased by $9 million, primarily due to (i) the recapture from a former affiliate of a yearly renewable term reinsurance agreement for certain life contracts (“YRT Recapture”) in the second quarter of 2017, (ii) a refinement in the allocation of ceded reinsurance fees between the Run-off and Life segments, and (iii) amortization of unearned revenue mostly related to changes in assumptions regarding maintenance expenses and mortality in connection with the annual actuarial assumption review. These favorable items were partially offset by lower fees resulting from the prior year reinsurance recapture transactions. Excluding the impact from the annual actuarial assumption review, fee income decreased by $55 million. Net Investment Spread. Net investment spread decreased by $13 million, primarily driven by a decrease in net investment income, partially offset by lower interest credited to policyholders. The decline in net investment income was primarily due to (i) lower investment yields on fixed maturity securities, as proceeds from maturing investments were invested at lower yields than the portfolio average, (ii) lower funds withheld assets as a result of reinsurance recapture activity and (iii) a reduction in interest on allocated equity as a result of reduced interest credited and allocated equity assets. These decreases were partially offset by higher returns on other limited partnership interests driven by an improvement in equity market performance. Interest credited to policyholders decreased due to lower imputed interest on insurance liabilities driven by the prior year reinsurance recapture transactions, partially offset by higher interest credited on higher average policyholder account balances resulting from positive net flows. Insurance-related Activities. Insurance-related activities had an unfavorable impact on comparative results of $70 million, primarily due to lower ceded claim recoveries resulting from the current period YRT Recapture and a higher volume of low severity claims below our reinsurance retention limits, partially offset by lower direct claims and favorable impacts from the prior year reinsurance recapture transactions. Amortization of DAC and VOBA. Lower amortization of DAC and VOBA had a favorable impact on comparative results of $61 million, primarily due to the prior year reinsurance recapture transactions and the impact on gross profits from higher policyholder benefits and claims in 2017, partially offset by the impact from changes in assumptions regarding mortality and maintenance expenses in connection with the annual actuarial assumption review. Excluding the impact of the annual actuarial assumption review, amortization of DAC and VOBA had a favorable impact on comparative results of $150 million. Other Expenses, Net of DAC Capitalization. Expenses increased by $6 million, primarily due to increased operating costs as a result of being a stand-alone company and from one-time, separation-related reinsurance activity, partially offset by lower operational expenses as a result of the sale of MPCG to MassMutual. Actuarial Assumption Review. The results of the annual actuarial assumption review, which are included in the amounts discussed above, had an unfavorable impact on comparative results of $30 million, primarily due to: • higher DAC amortization of $89 million mostly driven by changes in mortality and maintenance expense assumptions and, to a lesser extent, projected premiums and separate account growth rates; partially offset by • higher amortization of unearned revenue of $64 million due to changes in mortality and maintenance expense assumptions. Income Tax Expense (Benefit). Income tax benefit for the year ended December 31, 2017 was $9 million. There was no tax expense for the year ended December 31, 2016. Our effective tax rate typically differs from the U.S. statutory rate primarily due to the impacts of the dividend received deductions. In the current period, we recognized an additional benefit related to true-ups for the dividend received deductions. Year Ended December 31, 2016 Compared with the Year Ended December 31, 2015 Overview. Adjusted earnings increased $6 million resulting primarily from lower amortization of DAC and VOBA excluding the 2016 reinsurance recapture transactions and lower expenses, partially offset by unfavorable underwriting experience. Fee Income. Fee income increased by $132 million, primarily due to the impact from the 2016 reinsurance recapture transactions. Net Investment Spread. Net investment spread decreased by $8 million, primarily due to higher implied interest on insurance liabilities due to growth in the average liability balances. Insurance-related Activities. Insurance-related activities had an unfavorable impact on comparative results of $41 million, primarily due to higher frequency and severity of claims in our variable and universal life business. Amortization of DAC and VOBA. Higher amortization of DAC and VOBA had an unfavorable impact on comparative results of $94 million, primarily due to: • higher amortization of $120 million resulting from the 2016 reinsurance recapture transactions; partially offset by • lower amortization of $37 million from a decline in expected gross profits resulting from the aging of the business. Other Expenses, Net of DAC Capitalization. Expenses decreased by $16 million, primarily due to the impacts from the sale of MPCG to MassMutual, partially offset by higher allocated software amortization and costs related to the 2016 reinsurance recapture transactions. Actuarial Assumption Review. There was not a significant impact to comparative results from the annual actuarial assumption review. Income Tax Expense (Benefit). There was no income tax expense or benefit for the year ended December 31, 2016 compared to income tax expense of $1 million, or 5% of adjusted earnings before provision for income tax, for the year ended December 31, 2015. Our effective tax rate typically differs from the U.S. statutory rate primarily due to the impacts of the dividend received deductions. Run-off The following table presents the components of adjusted earnings for our Run-off segment: Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Overview. Adjusted earnings increased by $643 million, primarily due to lower amortization of DAC and VOBA and favorable impacts from ULSG-related charges recognized in the prior period, net of additional charges recognized in the current period. Excluding the impact from the annual actuarial assumption review, adjusted earnings increased by $615 million. Fee Income. Fee income decreased by $9 million, primarily due to a refinement in the allocation of ceded reinsurance fees between the Run-off and Life segments, as well as declines in separate account balances, partially offset by changes in assumptions regarding premium persistency and mortality in connection with the annual actuarial assumption review. Excluding the impact from the annual actuarial assumption review, fee income decreased by $29 million. Insurance-related Activities. Net costs from insurance-related activities decreased by $30 million, primarily due to: • a charge recognized in the prior period of $231 million related to the ULSG Model Change; partially offset by • higher net costs of $119 million associated with ULSG of which $66 million was attributable to the ULSG Actions and $53 million was driven by the recurring impact of the ULSG Re-segmentation combined with additional loss recognition from an increase in policyholder conversions from term life policies in anticipation of the discontinuation of the ULSG products; and • higher policyholder benefits and claims of $58 million resulting from an increase in pension risk transfer reserves. Excluding the impact from the annual actuarial assumption review, net costs from insurance-related activities decreased by $7 million. Amortization of DAC and VOBA. Lower amortization of DAC and VOBA had a favorable impact on comparative results of $954 million driven by charges in 2016 to write-down the DAC asset in connection with the loss recognition triggered by the ULSG Model Change and ULSG Re-segmentation, which also resulted in no ULSG-related amortization expense in the current period. Actuarial Assumption Review. The results from the annual actuarial assumption review, which are included in the amounts discussed above, had a favorable impact on comparative results of $43 million, primarily due to: • lower policyholder benefits and claims of $23 million from a decrease in insurance liabilities from changes in general account growth rates and mortality, net of changes regarding premium persistency and maintenance expenses; and • higher amortization of unearned revenue of $20 million due to changes in premium persistency and mortality. Income Tax Expense (Benefit). Income tax expense for the year ended December 31, 2017 was $43 million, or 29% of adjusted earnings before provision for income tax, compared to a benefit of $295 million, or 35% of adjusted earnings before provision for income tax, for the year ended December 31, 2016. Our effective tax rate typically differs from the U.S. statutory rate primarily due to the impacts of the dividend received deductions. Year Ended December 31, 2016 Compared with the Year Ended December 31, 2015 Overview. Adjusted earnings decreased by $1.0 billion primarily due to the impacts of the ULSG Model Change and the ULSG Re-segmentation as well as lower net investment spread. Fee Income. Fee income decreased by $46 million primarily due to our no longer selling ULSG products with lifetime guarantees and lower amortization of unearned revenue resulting from the ULSG Model Change. Net Investment Spread. Net investment spread decreased by $108 million, primarily due to the impacts to net investment income from a lower average invested asset base and lower yields. Average invested assets decreased due to continued repayments of funding agreements in our spread-based business. Investment yields declined primarily due to lower returns on real estate joint ventures. Net investment income also declined due to a reduction in the size of our securities lending program and lower margins on the remaining balances as a result of a flatter yield curve. Insurance-related Activities. Net costs from insurance-related activities increased by $511 million, primarily due to the following: • an increase in policyholder benefits and claims of $263 million resulting from higher insurance liabilities due to one-time impacts of the ULSG Model Change; • an increase in policyholder benefits and claims of $132 million resulting from higher insurance liabilities due to the recurring impact of lower expected future gross profits due to the ULSG Model Change; • an increase in policyholder benefits and claims of $52 million resulting from higher insurance liabilities due to the ULSG Re-segmentation; and • unfavorable mortality experience of $46 million due to higher claims in our ULSG products. Excluding the impact of the annual actuarial assumption review, net costs from insurance-related activities increased by $549 million. Amortization of DAC and VOBA. Higher amortization of DAC and VOBA had an unfavorable impact on comparative results of $896 million, primarily due to the following: • higher amortization of $562 million resulting from the ULSG Re-segmentation; and • higher amortization of $365 million resulting from the ULSG Model Change. Actuarial Assumption Review. The results of the annual actuarial assumption review, which are included in the amounts discussed above, had a favorable impact on comparative results of $42 million, primarily due to lower liabilities resulting from changes in assumptions related to surrenders in our ULSG business. Income Tax Expense (Benefit). Income tax benefit for the year ended December 31, 2016 was $295 million, or 35% of adjusted earnings before provision for income tax, compared to income tax expense of $249 million, or 35% of adjusted earnings before provision for income tax, for the year ended December 31, 2015. Corporate & Other The following table presents the components of adjusted earnings for Corporate & Other: Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Overview. Adjusted earnings decreased by $264 million, primarily due to net unfavorable tax adjustments recognized in the current period, higher expenses and lower net investment income. Excluding the impact of the current period tax adjustments, adjusted earnings decreased by $124 million. Fee Income. Fee income increased by $187 million, primarily from a reduction in the tax liability due to MetLife under the Tax Separation Agreement as a result of the enactment of the Tax Act. This adjustment was recognized in other revenue. See Note 13 of the Notes to the Consolidated and Combined Financial Statements for additional information regarding the Tax Separation Agreement. Net Investment Spread. Net investment income decreased by $46 million, primarily driven by (i) a reduction in the invested asset base, (ii) lower returns on other limited partnerships and (iii) lower income from our securities lending program. These decreases were partially offset by the impact from a lower interest credited rate on allocated equity. The invested asset base decreased as a result of the termination of certain collateral financing arrangements in connection with the formation of BRCD and a cash distribution paid to MetLife in the current period in connection with the Separation, as well as lower allocated equity managed on behalf of the segments. Income from our securities lending program decreased as a result of a reduction in program size, as well as lower margins resulting from a flatter yield curve. Other Expenses, Net of DAC Capitalization. Expenses increased by $119 million, primarily due to establishment costs related to our technology transformation and branding. In addition, certain corporate branding costs that had previously been allocated to the segments were reallocated to Corporate & Other. These increases were partially offset by lower project-related costs and lower marketing costs associated with our U.S. direct to consumer business. Income Tax Expense (Benefit). Income tax expense for the year ended December 31, 2017 was $274 million compared to $8 million benefit for the year ended December 31, 2016. Our effective tax rate typically differs from the U.S. statutory rate primarily due to the utilization of tax credits. We recognized a $1.1 billion non-cash tax charge in connection with the Separation. We also recognized an additional tax benefit of $725 million related to the Tax Act. These adjustments resulted in effective tax rate percentages that are not meaningful for comparison purposes and accordingly have not been included. Year Ended December 31, 2016 Compared with the Year Ended December 31, 2015 Overview. Adjusted earnings increased by $83 million primarily due to higher net investment spread. Net Investment Spread. Net investment spread increased by $113 million, primarily due to higher net investment income resulting from an increase in the average invested asset base, increased accruals on interest rate derivatives and higher returns on private equity investments, partially offset by lower yields. Average invested assets increased primarily as a result of a capital contribution from MetLife. Investment yields declined as we continued to encounter negative impacts of the low interest rate environment on the investment of fixed maturity securities at yields lower than the portfolio average. Income Tax Expense (Benefit). Income tax benefit for the year ended December 31, 2016 was $8 million, or 21% of adjusted earnings before provision for income tax, compared to $41 million, or 53% of adjusted earnings before provision for income tax, for the year ended December 31, 2015. Our effective tax rate differs from the U.S. statutory rate primarily due to the utilization of tax credits. GMLB Riders for the Years Ended December 31, 2017, 2016 and 2015 The following table presents the overall impact on income (loss) before provision for income tax from the performance of GMLB Riders for (i) changes in carrying value of the GAAP liabilities, (ii) the mark-to-market of hedges and reinsurance, (iii) fees, and (iv) associated DAC offsets. ______________ (1) Includes cumulative changes in fair value of the Shield Annuities embedded derivatives of ($305) million for the third and fourth quarters of 2017. Changes in the fair value of the Shield Annuities embedded derivatives were not included in the GMLB results for the first and second quarters of 2017 and the years ended December 31, 2016 and 2015. (2) Certain hedges of GMIB insurance liabilities were historically reported in policyholder benefits and claims. Amounts reported in policyholder benefits and claims were ($324) million, ($278) million and $14 million for the years ended December 2017, 2016 and 2015, respectively. Consistent with the hedge strategy now focused on a statutory target, with less emphasis on matching GAAP liabilities, all hedge program amounts will be recorded in net derivative gains (losses) beginning in 2018. (3) Excludes living benefit fees, included as a component of adjusted earnings, of $71 million, $76 million and $76 million for the years ended December 31, 2017, 2016 and 2015, respectively. Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Comparative results from GMLB Riders were favorable by $1.3 billion. Of this amount, a favorable change of $2.6 billion was recorded in net derivative gains (losses). Excluding the impact of the annual actuarial assumption review, comparative results from GLMB Riders were unfavorable by $735 million. GMLB Riders Liabilities. GMLB Riders liabilities represent our obligation to protect policyholders against the possibility that a downturn in the markets will reduce the specified benefits that can be claimed under the base annuity contract. Any periods of significant and/or sustained downturns in equity markets, increased equity volatility, or reduced interest rates could result in an increase in the valuation of the GMLB Riders liabilities. An increase in these liabilities would result in a decrease to our net income (loss), which could be significant. The change in carrying value of GMLB Riders Liabilities resulted in a favorable impact on comparative results of $3.0 billion primarily due to lower charges related to the annual actuarial assumption review in the current year than in the prior year combined with favorable market impacts resulting from higher equity market performance partially offset by interest rates increasing less in the current period than in the prior period. Included in this amount is a decrease of $305 million in the fair value of our Shield Annuities embedded derivatives which have been included in the directly written liability results beginning in the third quarter of 2017 on a prospective basis. Excluding the impact of the annual actuarial assumption review, GMLB Riders Liabilities had an unfavorable impact on comparative results of $61 million. GMLB Riders Hedging Program and Reinsurance. We enter into freestanding derivatives, and to a lesser extent reinsurance, to hedge the market risks inherent in the GMLB Riders liabilities. However, certain of the risks inherent in the GMLB Riders liabilities are unhedged, including the adjustment for nonperformance risk. Generally, the same market factors that impact the fair value of the GMLB Riders liabilities impact the value of the hedges, though in the opposite direction. However, due to the complex nature of the business and any unhedged risks, the changes in fair value of the GMLB Riders liabilities and GMLB Riders hedges and reinsurance are not always in an equal amount. The change in the fair value of GMLB Riders hedging program and reinsurance had an unfavorable impact on comparative results of $581 million primarily due to the inverse impact of the same equity market and interest rate factors that favorably impacted the GMLB Riders liabilities. GMLB Riders Fees.We earn fees on the GMLB Riders liabilities, which are calculated based on the policyholder’s Benefit Base. Fees calculated based on the Benefit Base are more stable in market downturns, compared to fees based on the account value because the Benefit Base excludes the impact of a decline in the market value of the policyholder’s account value. We use the fees directly earned from the GMLB Riders to fund the reserves, future claims and costs associated with the hedges of market risks inherent in the GMLB Riders liabilities. For GMLB Riders liabilities accounted for as embedded derivatives, the future fees are included in the fair value of the embedded derivative liabilities, with changes recorded in net derivative gains (losses). For GMLB Riders liabilities accounted for as insurance, while the related fees do affect the valuations of these liabilities, they are not included in the resulting liability values, but are recorded separately in universal life and investment-type policy fees. Fees from GMLB Riders were largely unchanged. DAC Offsets. DAC offsets, which are inversely related to the changes in certain components of the GMLB Riders discussed above, resulted in an unfavorable impact on comparative results by $1.1 billion. The DAC offset related to certain components of the directly written GMLB Riders is determined by the same factors that impact the respective component, but generally in the opposite direction. There is no DAC related to assumed reinsurance and, accordingly, no DAC offset. Excluding the impact of the annual actuarial assumption review, DAC offsets had an unfavorable impact on comparative results of $90 million. Actuarial Assumption Review. As previously discussed, we review and update, on an annual basis, our long-term assumptions used in the calculations of the GMLB Riders liabilities. The annual actuarial assumption review, which is included in the amounts discussed above, resulted in a favorable impact on comparative results of $2.0 billion, primarily due to the following: • lower net derivative losses of $3.0 billion resulting from the prior period increase in GMLB Riders liabilities accounted for as embedded derivatives, of which $2.4 billion was primarily due to changes in behavioral assumptions regarding rider utilization and $571 million was due to changes in risk margins related to these behavioral assumption changes; and • a favorable change to comparative results of $521 million, recognized in net derivative gains (losses), from the current period adjustment for nonperformance risk resulting from a change in the assumption for the underlying credit spread being based on Brighthouse’s post-separation creditworthiness, instead of that of MetLife; partially offset by • unfavorable DAC amortization offsets of $1.1 billion primarily due to (i) the large offset benefit recorded in the prior period, (ii) an unfavorable offset adjustment in the current period related to the change in nonperformance risk and (iii) refinements in the current period to the amortization period; and • higher policyholder benefits and claims of $146 million resulting from net favorable changes in the prior period to GMLB Riders liabilities accounted for as insurance, of which $326 million was primarily due behavioral assumption changes, mainly relating to rider utilization, reduced by $180 million related to economic assumptions, primarily lower projected interest rates. Year Ended December 31, 2016 Compared with the Year Ended December 31, 2015 Comparative results from GMLB Riders were unfavorable by $2.7 billion. Of this amount, an unfavorable change of $3.7 billion was recorded in net derivative gains (losses). Excluding the impact of the annual actuarial assumption review, comparative results from GMLB Riders were unfavorable by $466 million. GMLB Riders Liabilities. The change in the carrying value of GMLB Riders liabilities resulted in an unfavorable impact on comparative results of $1.4 billion, primarily due to: • net derivative losses of $3.3 billion due to increased reserves resulting from non-market risks that generally cannot be hedged, primarily changes in actuarial assumptions related to policyholder behavior, mainly rider utilization, net of a favorable impact from the associated nonperformance risk adjustment, and the risk margins related to these policyholder behavior assumptions; partially offset by • a favorable adjustment to net derivative gains (losses) of $1.9 billion due to decreased reserves resulting from market factors, as higher equity market performance and a decrease in key equity market volatility measures, as compared to 2015, together with the impact from long-term interest rates increasing during 2016, compared to decreasing in 2015, resulted in a favorable change in our liabilities accounted for as embedded derivatives. Excluding the impact of the actuarial assumption review, GMLB Riders liabilities had an unfavorable impact on comparative results of $1.6 billion. GMLB Riders Hedging Program and Reinsurance. The change in the fair value of GMLB Riders hedges and reinsurance had an unfavorable impact on comparative results of $2.6 billion, primarily due to the inverse effect on the hedges from the interest rate and equity market factors that impacted the GMLB Rider liabilities. GMLB Riders Fees. GMLB Riders fees increased by $10 million, primarily due to the impact from the roll-up of the average Benefit Base. DAC Offsets. DAC offsets, which are inversely related to the changes in certain components of GMLB Riders discussed above, resulted in a favorable impact on comparative results of $1.3 billion. Excluding the impact of the annual actuarial assumption review, DAC offsets had a favorable impact on comparative results of $552 million. Actuarial Assumption Review. As previously discussed, we review and update, on an annual basis, our long-term assumptions used in the calculations of the GMLB Riders liabilities. The annual assumption review, which is included in the amounts discussed above, resulted in an unfavorable impact on comparative results of $2.3 billion, primarily due to the following: • net derivative losses of $3.0 billion from an increase in GMLB Riders liabilities accounted for as embedded derivatives, of which $2.4 billion was primarily due to changes in behavioral assumptions regarding rider utilization and $571 million was due to changes in risk margins related to these behavioral assumption changes; and • higher policyholder benefits and claims resulting from an increase in GMLB Riders liabilities accounted for as insurance of $7 million, of which $250 million was due to unfavorable impacts of economic assumption changes mainly related to lower projected interest rates and long-term separate account returns, mostly offset by $247 million related to behavioral assumption changes, primarily regarding rider utilization; partially offset by • favorable DAC amortization offsets of $756 million, which are inversely related to the assumption changes above. Effects of Inflation Management believes that inflation has not had a material effect on the Company’s results of operations, except insofar as inflation may affect interest rates. An increase in inflation could affect our business in several ways. During inflationary periods, the value of fixed income investments falls which could increase realized and unrealized losses. Inflation also increases expenses for labor and other materials, potentially putting pressure on profitability if such costs cannot be passed through in our product prices. Prolonged and elevated inflation could adversely affect the financial markets and the economy generally, and dispelling it may require governments to pursue a restrictive fiscal and monetary policy, which could constrain overall economic activity, inhibit revenue growth and reduce the number of attractive investment opportunities. Investments Investment Risks Our primary investment objective is to optimize risk-adjusted net investment income and risk-adjusted total return while appropriately matching assets and liabilities. In addition, the investment process is designed to ensure that the portfolio has an appropriate level of liquidity, quality and diversification. We are exposed to the following primary sources of investment risks: • credit risk, relating to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest; • interest rate risk, relating to the market price and cash flow variability associated with changes in market interest rates. Changes in market interest rates will impact the net unrealized gain or loss position of our fixed income investment portfolio and the rates of return we receive on both new funds invested and reinvestment of existing funds; • market valuation risk, relating to the variability in the estimated fair value of investments associated with changes in market factors such as credit spreads and equity market levels. A widening of credit spreads will adversely impact the net unrealized gain (loss) position of the fixed income investment portfolio, will increase losses associated with credit-based non-qualifying derivatives while we assume credit exposure, and, if credit spreads widen significantly or for an extended period of time, will likely result in higher OTTI. Credit spread tightening will reduce net investment income associated with new purchases of fixed maturity securities and will favorably impact the net unrealized gain (loss) position of the fixed income investment portfolio; • liquidity risk, relating to the diminished ability to sell certain investments, in times of strained market conditions; • real estate risk, relating to commercial, agricultural and residential real estate, and stemming from factors, which include, but are not limited to, market conditions, including the demand and supply of leasable commercial space, creditworthiness of borrowers and their tenants and joint venture partners, capital markets volatility and inherent interest rate movements; and • currency risk, relating to the variability in currency exchange rates for foreign denominated investments. We manage these risks through asset-type allocation and industry and issuer diversification. Risk limits are also used to promote diversification by asset sector, avoid concentrations in any single issuer and limit overall aggregate credit and equity risk exposure. Real estate risk is managed through geographic and property type and product type diversification. We manage interest rate risk as part of our Asset Liability Management (“ALM”) strategies. Product design, such as the use of market value adjustment features and surrender charges, is also utilized to manage interest rate risk. These strategies include maintaining an investment portfolio with diversified maturities that targets a weighted average duration that reflects the duration of our estimated liability cash flow profile. For certain of our liability portfolios, it is not possible to invest assets to the full liability duration, thereby creating some asset/liability mismatch. We also use certain derivatives in the management of currency, credit, interest rate, and equity market risks. Current Environment Our business and results of operations are materially affected by conditions in capital markets and the economy, generally. As a U.S. insurance company, we are affected by the monetary policy of the Federal Reserve Board in the United States. In December 2017, the Federal Open Market Committee increased the federal funds rate, the third such increase in 2017. The Federal Reserve may take further actions to influence interest rates in the future, which may have an impact on the pricing levels of risk-bearing investments and may adversely impact the level of product sales. We are also affected by the monetary policy of central banks around the world due to the diversification of our investment portfolio. See “- Industry Trends - Financial and Economic Environment.” Selected Country and Sector Investments Recent elevated levels of market volatility have affected the performance of various asset classes. Contributing factors include concerns about economic conditions and capital markets; declining sales and increased online competition in the retail sector and recent country and sector specific volatility due to local economic and/or political concerns have affected the performance of certain of our investments. See “- Industry Trends - Financial and Economic Environment” We have exposure to global market volatility, as we maintain general account investments in Puerto Rico, among other countries, through our global portfolio diversification. Our exposure to sovereign fixed maturity securities and total fixed maturity securities of Puerto Rico totaled $3 million and $20 million, at estimated fair value, respectively, at December 31, 2017. There has been an increased market focus on retail sector investments as a result of declining sales and the effects of online competition. Our exposure to retail sector corporate fixed maturity securities was $1.5 billion, of which 95% were investment grade, with unrealized gains of $90 million at December 31, 2017. We manage direct and indirect investment exposure in the selected countries and retail sectors through fundamental credit analysis and we continually monitor and adjust our level of investment exposure. We do not expect that our general account investments in these countries and retail sectors will have a material adverse effect on our results of operations or financial condition. Current Environment Summary All of these factors have had and could continue to have an adverse effect on the financial results of companies in the financial services industry, including us. Such global economic conditions, as well as the global financial markets, continue to impact our net investment income, net investment gains (losses), net derivative gains (losses), level of unrealized gains (losses) within the various asset classes in our investment portfolio, and our level of investment in lower yielding cash equivalents, short-term investments and government securities. See “- Industry Trends and Uncertainties” and “Risk Factors - Economic Environment and Capital Markets-Related Risks - We are exposed to significant financial and capital markets risks which may adversely affect our results of operations, financial condition and liquidity, and may cause our net investment income and net income to vary from period to period.” Investment Portfolio Results The table below presents the yield and adjusted net investment income for our investment portfolio. As described below, this table reflects certain differences from the presentation of net investment income presented in the GAAP statement of operations. This summary yield table presentation is consistent with how we measure our investment performance for management purposes, and we believe it enhances understanding of our investment portfolio results. _______________ (1) Yields are calculated as investment income as a percent of average quarterly asset carrying values. Investment income excludes recognized gains and losses and reflects the adjustments presented in footnote (3) below to arrive at adjusted net investment income. Asset carrying values exclude unrealized gains (losses), collateral received in connection with our securities lending program, freestanding derivative assets, collateral received from derivative counterparties and the effects of consolidated securitization entities (“CSEs”). (2) Adjusted net investment income included in yield calculations includes Investment Hedge Adjustments. (3) Adjusted net investment income presented in the yield table varies from the most directly comparable GAAP measure due to certain reclassifications and adjustments and excludes the effects of CSEs, as presented below. See “- Results of Operations - Consolidated Results - Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016” and “- Results of Operations - Consolidated Results -Year Ended December 31, 2016 Compared with the Year Ended December 31, 2015,” for an analysis of the year over year changes in net investment income. Fixed Maturity and Equity Securities AFS The following table presents fixed maturity and equity securities AFS by type (public or private) held at: Valuation of Securities. We engage MetLife Investment Advisors, LLC (“MLIA”), a related party investment manager, to execute on our valuation controls and policies to determine the estimated fair value of our investments. The estimated fair value of publicly-traded securities is determined after considering one of three primary sources of information: quoted market prices in active markets, independent pricing services, or independent broker quotations. The estimated fair value of privately-placed securities is determined after considering one of three primary sources of information: market standard internal matrix pricing, market standard internal discounted cash flow techniques, or independent pricing services (after the independent pricing services’ use of available observable market data is determined). For publicly-traded securities, the number of quotations obtained varies by instrument and depends on the liquidity of the particular instrument. Generally, prices are obtained from multiple pricing services to cover all asset classes and obtain multiple prices for certain securities, but ultimately use the price with the highest placement in the fair value hierarchy. Independent pricing services that value these instruments use market standard valuation methodologies based on data about market transactions and inputs from multiple pricing sources that are market observable or can be derived principally from or corroborated by observable market data. See Note 8 of the Notes to the Consolidated and Combined Financial Statements for a discussion of the types of market standard valuation methodologies utilized and key assumptions and observable inputs used in applying these standard valuation methodologies. When a price is not available in the active market or through an independent pricing service, the security is priced primarily using non-binding quotations from independent brokers who are knowledgeable about these securities. Independent non-binding broker quotations use inputs that may be difficult to corroborate with observable market data. As shown in the following section, less than 1% of our fixed maturity securities were valued using non-binding quotations from independent brokers at December 31, 2017. The Company is responsible for monitoring and providing the oversight over the valuation controls and policies, including reviewing and approving new transaction types and markets, for ensuring that observable market prices and market-based parameters are used for valuation, wherever possible, and for determining that valuation adjustments, when applied, are based upon established policies and are applied consistently over time. See Note 8 of the Notes to the Consolidated and Combined Financial Statements for further information on our valuation controls and procedures including our formal process to challenge any prices received from independent pricing services that are not considered representative of estimated fair value. We have reviewed the significance and observability of inputs used in the valuation methodologies to determine the appropriate fair value hierarchy level for each of our securities. Based on the results of this review and investment class analysis, each instrument is categorized as Level 1, 2 or 3 based on the lowest level significant input to its valuation. See Note 8 of the Notes to the Consolidated and Combined Financial Statements for information regarding the valuation techniques and inputs by level within the three level fair value hierarchy by major classes of invested assets. Fair Value of Fixed Maturity and Equity Securities - AFS Fixed maturity and equity securities AFS measured at estimated fair value on a recurring basis and their corresponding fair value pricing sources are as follows: See Note 8 of the Notes to the Consolidated and Combined Financial Statements for the fixed maturity securities and equity securities AFS fair value hierarchy. The composition of fair value pricing sources for and significant changes in Level 3 securities at December 31, 2017 are as follows: • The majority of the Level 3 fixed maturity and equity securities AFS were concentrated in three sectors: U.S. and foreign corporate securities and residential mortgage-backed securities (“RMBS”). • Level 3 fixed maturity securities are priced principally through market standard valuation methodologies, independent pricing services and, to a much lesser extent, independent non-binding broker quotations using inputs that are not market observable or cannot be derived principally from or corroborated by observable market data. Level 3 fixed maturity securities consist of less liquid securities with very limited trading activity or where less price transparency exists around the inputs to the valuation methodologies. • During the year ended December 31, 2017, Level 3 fixed maturity securities decreased by $887 million, or 22%. The decrease was driven by net transfers out of Level 3 and sales in excess of purchases, partially offset by an increase in estimated fair value recognized in OCI. See Note 8 of the Notes to the Consolidated and Combined Financial Statements for a rollforward of the fair value measurements for fixed maturity securities and equity securities AFS measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs; transfers into and/or out of Level 3; and further information about the valuation techniques and inputs by level by major classes of invested assets that affect the amounts reported above. Fixed Maturity Securities AFS See Notes 1 and 6 of the Notes to the Consolidated and Combined Financial Statements for information about fixed maturity securities AFS by sector, contractual maturities and continuous gross unrealized losses. Fixed Maturity Securities Credit Quality - Ratings The Securities Valuation Office of the NAIC evaluates the fixed maturity security investments of insurers for regulatory reporting and capital assessment purposes and assigns securities to one of six credit quality categories called “NAIC designations.” If no designation is available from the NAIC, then, as permitted by the NAIC, an internally developed designation is used. The NAIC designations are generally similar to the credit quality ratings of the NRSRO for fixed maturity securities, except for certain structured securities as described below. Rating agency ratings are based on availability of applicable ratings from rating agencies on the NAIC credit rating provider list, including Moody’s Investors Service, Inc. (“Moody’s”), S&P, Fitch, Dominion Bond Rating Service, A.M. Best, Kroll Bond Rating Agency, Egan Jones Ratings Company and Morningstar, Inc. (“Morningstar”). If no rating is available from a rating agency, then an internally developed rating is used. The NAIC has adopted revised methodologies for certain structured securities comprised of non-agency RMBS, commercial mortgage-backed securities (“CMBS”) and asset backed securities (“ABS”). The NAIC’s objective with the revised methodologies for these structured securities was to increase the accuracy in assessing expected losses, and to use the improved assessment to determine a more appropriate capital requirement for such structured securities. The revised methodologies reduce regulatory reliance on rating agencies and allow for greater regulatory input into the assumptions used to estimate expected losses from structured securities. We apply the revised NAIC methodologies to structured securities held by our insurance subsidiaries that maintain the NAIC statutory basis of accounting. The NAIC’s present methodology is to evaluate structured securities held by insurers using the revised NAIC methodologies on an annual basis. If our insurance subsidiaries acquire structured securities that have not been previously evaluated by the NAIC, but are expected to be evaluated by the NAIC in the upcoming annual review, an internally developed designation is used until a final designation becomes available. The following table presents total fixed maturity securities by NRSRO rating and the applicable NAIC designation from the NAIC published comparison of NRSRO ratings to NAIC designations, except for certain structured securities, which are presented using the revised NAIC methodologies, as well as the percentage, based on estimated fair value that each NAIC designation is comprised of at: The following tables present total fixed maturity securities, based on estimated fair value, by sector classification and by NRSRO rating and the applicable NAIC designations from the NAIC published comparison of NRSRO ratings to NAIC designations, except for certain structured securities, which are presented using the NAIC methodologies as described above: U.S. and Foreign Corporate Fixed Maturity Securities We maintain a diversified portfolio of corporate fixed maturity securities across industries and issuers. This portfolio does not have any exposure to any single issuer in excess of 1% of total investments and the top ten holdings in aggregate comprise 2% of total investments at both December 31, 2017 and 2016. The tables below present our U.S. and foreign corporate securities holdings by industry at: Structured Securities We held $13.2 billion and $14.5 billion of structured securities, at estimated fair value, at December 31, 2017 and 2016, respectively, as presented in the RMBS, CMBS and ABS sections below. RMBS The following table presents our RMBS holdings at: See also “- Structured Securities - RMBS” for further information about collateralized mortgage obligations and pass-through mortgage-backed securities, as well as agency, prime, alternative residential mortgage loan and sub-prime RMBS. Historically, we have managed our exposure to sub-prime RMBS holdings by focusing primarily on senior tranche securities, stress testing the portfolio with severe loss assumptions and closely monitoring the performance of the portfolio. Our sub-prime RMBS portfolio consists predominantly of securities that were purchased after 2012 at significant discounts to par value and discounts to the expected principal recovery value of these securities. The vast majority of these securities are investment grade under the NAIC designations (e.g., NAIC 1 and NAIC 2). The estimated fair value of our sub-prime RMBS holdings purchased since 2012 was $976 million and $1.2 billion at December 31, 2017 and 2016, respectively, with unrealized gains (losses) of $65 million and $17 million at December 31, 2017 and 2016, respectively. CMBS Our CMBS holdings are diversified by vintage year. The following tables present our CMBS holdings by rating agency rating and by vintage year at: The tables above reflect rating agency ratings assigned by NRSROs, including Moody’s, S&P, Fitch and Morningstar. CMBS designated NAIC 1 were 100.0% of total CMBS at both December 31, 2017 and 2016. ABS Our ABS are diversified both by collateral type and by issuer. The following table presents our ABS holdings at: Evaluation of AFS Securities for OTTI and Evaluating Temporarily Impaired AFS Securities See Note 6 of the Notes to the Consolidated and Combined Financial Statements for information about the evaluation of fixed maturity securities and equity securities AFS for OTTI and evaluation of temporarily impaired AFS securities. OTTI Losses on Fixed Maturity and Equity Securities AFS Recognized in Earnings See Note 6 of the Notes to the Consolidated and Combined Financial Statements for information about OTTI losses and gross gains and gross losses on AFS securities sold. Overview of Fixed Maturity and Equity Security OTTI Losses Recognized in Earnings Impairments of fixed maturity and equity securities were $5 million, $24 million and $34 million for the years ended December 31, 2017, 2016 and 2015, respectively. Impairments of fixed maturity securities were $1 million, $22 million and $31 million for the years ended December 31, 2017, 2016 and 2015, respectively. Impairments of equity securities were $4 million, $2 million and $3 million for the years ended December 31, 2017, 2016 and 2015, respectively. Credit-related impairments of fixed maturity securities were $1 million, $20 million and $31 million for the years ended December 31, 2017, 2016 and 2015, respectively. Explanations of changes in fixed maturity and equity securities impairments are as follows: Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Overall OTTI losses recognized in earnings on fixed maturity and equity securities were $5 million for the year ended December 31, 2017 as compared to $24 million for the year ended December 31, 2016. A decrease of $16 million in OTTI losses on U.S. and foreign corporate industrial securities in the current period primarily reflects impairments on energy sector impairments in the prior period. Year Ended December 31, 2016 Compared with the Year Ended December 31, 2015 Overall OTTI losses recognized in earnings on fixed maturity and equity securities were $24 million for the year ended December 31, 2016 as compared to $34 million for the year ended December 31, 2015. A decrease of $8 million in OTTI losses on RMBS in the current period reflected the impact of improving economic and employment fundamentals. Future Impairments Future OTTI will depend primarily on economic fundamentals, issuer performance (including changes in the present value of future cash flows expected to be collected), and changes in credit ratings, collateral valuation, interest rates and credit spreads, as well as a change in our intention to hold or sell a security that is in an unrealized loss position. If economic fundamentals deteriorate or if there are adverse changes in the above factors, OTTI may be incurred in upcoming periods. Securities Lending We participate in a securities lending program whereby securities are loaned to third parties, primarily brokerage firms and commercial banks. We obtain collateral, usually cash, in an amount generally equal to 102% of the estimated fair value of the securities loaned, which is obtained at the inception of a loan and maintained at a level greater than or equal to 100% for the duration of the loan. We monitor the estimated fair value of the securities loaned on a daily basis with additional collateral obtained as necessary throughout the duration of the loan. Securities loaned under such transactions may be sold or repledged by the transferee. We are liable to return to our counterparties the cash collateral under our control. Security collateral received from counterparties may not be sold or repledged, unless the counterparty is in default, and is not reflected in the financial statements. These transactions are treated as financing arrangements and the associated cash collateral liability is recorded at the amount of the cash received. See “- Liquidity and Capital Resources - The Company - Liquidity and Capital Uses - Securities Lending” and Note 6 of the Notes to the Consolidated and Combined Financial Statements for information regarding our securities lending program. Mortgage Loans Our mortgage loans are principally collateralized by commercial, agricultural and residential properties. Mortgage loans and the related valuation allowances are summarized as follows at: The information presented in the tables herein exclude mortgage loans where we elected the fair value option (“FVO”). Such amounts are presented in Note 6 of the Notes to the Consolidated and Combined Financial Statements. We diversify our mortgage loan portfolio by both geographic region and property type to reduce the risk of concentration. Of our commercial and agricultural mortgage loan portfolios, at December 31, 2017 and 2016, 97% and 96%, respectively, were collateralized by properties located in the U.S. and the remainder was collateralized by properties located outside of the U.S. The carrying value as a percentage of total commercial and agricultural mortgage loans for the top three states in the U.S. is as follows at: Additionally, we manage risk when originating commercial and agricultural mortgage loans by generally lending up to 75% of the estimated fair value of the underlying real estate collateral. We manage our residential mortgage loan portfolio in a similar manner to reduce risk of concentration. All residential mortgage loans were collateralized by properties located in the U.S. at both December 31, 2017 and 2016. The carrying value as a percentage of total residential mortgage loans for the top three states in the U.S. is as follows at: Commercial Mortgage Loans by Geographic Region and Property Type. Commercial mortgage loans are the largest component of the mortgage loan invested asset class. The tables below present the diversification across geographic regions and property types of commercial mortgage loans at: Mortgage Loan Credit Quality - Monitoring Process. We monitor our mortgage loan investments on an ongoing basis, including a review of loans that are current, past due, restructured and under foreclosure. See Note 6 of the Notes to the Consolidated and Combined Financial Statements for information on mortgage loans by credit quality indicator, past due and nonaccrual mortgage loans, as well as impaired mortgage loans. We review our commercial mortgage loans on an ongoing basis. These reviews may include an analysis of the property financial statements and rent roll, lease rollover analysis, property inspections, market analysis, estimated valuations of the underlying collateral, loan-to-value ratios, debt service coverage ratios and tenant creditworthiness. The monitoring process focuses on higher risk loans, which include those that are classified as restructured, delinquent or in foreclosure, as well as loans with higher loan-to-value ratios and lower debt service coverage ratios. The monitoring process for agricultural mortgage loans is generally similar, with a focus on higher risk loans, such as loans with higher loan-to-value ratios, including reviews on a geographic and sector basis. We review our residential mortgage loans on an ongoing basis. See Note 6 of the Notes to the Consolidated and Combined Financial Statements for information on our evaluation of residential mortgage loans and related valuation allowance methodology. Loan-to-value ratios and debt service coverage ratios are common measures in the assessment of the quality of commercial mortgage loans. Loan-to-value ratios are a common measure in the assessment of the quality of agricultural mortgage loans. Loan-to-value ratios compare the amount of the loan to the estimated fair value of the underlying collateral. A loan-to-value ratio greater than 100% indicates that the loan amount is greater than the collateral value. A loan-to-value ratio of less than 100% indicates an excess of collateral value over the loan amount. Generally, the higher the loan-to-value ratio, the higher the risk of experiencing a credit loss. The debt service coverage ratio compares a property’s net operating income to amounts needed to service the principal and interest due under the loan. Generally, the lower the debt service coverage ratio, the higher the risk of experiencing a credit loss. For our commercial mortgage loans, our average loan-to-value ratio was 51% and 49% at December 31, 2017 and 2016, respectively, and our average debt service coverage ratio was 2.3x and 2.2x at December 31, 2017 and 2016, respectively. The debt service coverage ratio, as well as the values utilized in calculating the ratio, is updated annually on a rolling basis, with a portion of the portfolio updated each quarter. In addition, the loan-to-value ratio is routinely updated for all but the lowest risk loans as part of our ongoing review of our commercial mortgage loan portfolio. For our agricultural mortgage loans, our average loan-to-value ratio was 43% and 40% at December 31, 2017 and 2016, respectively. The values utilized in calculating the agricultural mortgage loan loan-to-value ratio are developed in connection with the ongoing review of the agricultural loan portfolio and are routinely updated. Mortgage Loan Valuation Allowances. Our valuation allowances are established both on a loan specific basis for those loans considered impaired where a property specific or market specific risk has been identified that could likely result in a future loss, as well as for pools of loans with similar risk characteristics where a property specific or market specific risk has not been identified, but for which we expect to incur a loss. Accordingly, a valuation allowance is provided to absorb these estimated probable credit losses. The determination of the amount of valuation allowances is based upon our periodic evaluation and assessment of known and inherent risks associated with our loan portfolios. Such evaluations and assessments are based upon several factors, including our experience for loan losses, defaults and loss severity, and loss expectations for loans with similar risk characteristics. These evaluations and assessments are revised as conditions change and new information becomes available, which can cause the valuation allowances to increase or decrease over time as such evaluations are revised. Negative credit migration, including an actual or expected increase in the level of problem loans, will result in an increase in the valuation allowance. Positive credit migration, including an actual or expected decrease in the level of problem loans, will result in a decrease in the valuation allowance. See Notes 6 and 8 of the Notes to the Consolidated and Combined Financial Statements for information about how valuation allowances are established and monitored, activity in and balances of the valuation allowance, and the estimated fair value of impaired mortgage loans and related impairments included within net investment gains (losses) at and for the years ended December 31, 2017 and 2016. Real Estate Joint Ventures Real estate joint ventures is comprised of joint ventures with interests in single property income-producing real estate, and to a lesser extent joint ventures with interests in multi-property projects with varying strategies ranging from the development of properties to the operation of income-producing properties, as well as a runoff portfolio of real estate private equity funds. The carrying values of real estate joint ventures was $433 million and $215 million, or 0.5% and 0.3% of cash and invested assets, at December 31, 2017 and 2016, respectively. The estimated fair value of the real estate joint venture investment portfolios was $594 million and $377 million at December 31, 2017 and 2016, respectively. Other Limited Partnership Interests Other limited partnership interests are comprised of private equity funds and hedge funds. The carrying value of other limited partnership interests was $1.7 billion and $1.6 billion at December 31, 2017 and 2016, respectively, which included $104 million and $210 million of hedge funds at December 31, 2017 and 2016, respectively. Cash distributions on these investments are generated from investment gains, operating income from the underlying investments of the funds and liquidation of the underlying investments of the funds. We estimate that the underlying investments of the funds will typically be liquidated over the next two to 10 years. Other Invested Assets The following table presents the carrying value of our other invested assets by type at: _______________ (1) In April 2017, MetLife, Inc. repaid its loans to the Company. See Note 6 of the Notes to the Consolidated and Combined Financial Statements. Derivatives Derivative Risks We are exposed to various risks relating to our ongoing business operations, including interest rate, foreign currency exchange rate, credit and equity market. We use a variety of strategies to manage these risks, including the use of derivatives. See Note 7 of the Notes to the Consolidated and Combined Financial Statements: • A comprehensive description of the nature of our derivatives, including the strategies for which derivatives are used in managing various risks. • Information about the gross notional amount, estimated fair value, and primary underlying risk exposure of our derivatives by type of hedge designation, excluding embedded derivatives held at December 31, 2017, 2016 and 2015. • The statement of operations effects of derivatives in cash flow, fair value, or nonqualifying hedge relationships for the years ended December 31, 2017, 2016 and 2015. See “Business - Segments and Corporate & Other - Annuities” and “Business - Risk Management Strategies - ULSG Market Risk Exposure Management” for more information about our use of derivatives by major hedge programs, as well as “- Results of Operations - Actuarial Assumption Review.” Fair Value Hierarchy See Note 7 of the Notes to the Consolidated and Combined Financial Statements for derivatives measured at estimated fair value on a recurring basis and their corresponding fair value hierarchy. The valuation of Level 3 derivatives involves the use of significant unobservable inputs and generally requires a higher degree of management judgment or estimation than the valuations of Level 1 and Level 2 derivatives. Although Level 3 inputs are unobservable, management believes they are consistent with what other market participants would use when pricing such instruments and are considered appropriate given the circumstances. The use of different inputs or methodologies could have a material effect on the estimated fair value of Level 3 derivatives and could materially affect net income. Derivatives categorized as Level 3 at December 31, 2017 include: credit default swaps priced using unobservable credit spreads, or that are priced through independent broker quotations; equity variance swaps with unobservable volatility inputs; and equity index options with unobservable correlation inputs. At December 31, 2017, 1% of the estimated fair value of our derivatives were priced through independent broker quotations. See Note 8 of the Notes to Consolidated and Combined Financial Statements for a roll-forward of the fair value measurements for derivatives measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs. Credit Risk See Note 7 of the Notes to the Consolidated and Combined Financial Statements for information about how we manage credit risk related to derivatives and for the estimated fair value of our net derivative assets and net derivative liabilities after the application of master netting agreements and collateral. Our policy is not to offset the fair value amounts recognized for derivatives executed with the same counterparty under the same master netting agreement. This policy applies to the recognition of derivatives on the balance sheets, and does not affect our legal right of offset. Credit Derivatives The following table presents the gross notional amount and estimated fair value of credit default swaps at: The maximum amount at risk related to our written credit default swaps is equal to the corresponding gross notional amount. In a replication transaction, we pair an asset on our balance sheet with a written credit default swap to synthetically replicate a corporate bond, a core asset holding of life insurance companies. Replications are entered into in accordance with the guidelines approved by insurance regulators and are an important tool in managing the overall corporate credit risk within the Company. In order to match our long-dated insurance liabilities, we will seek to buy long-dated corporate bonds. In some instances, these may not be readily available in the market, or they may be issued by corporations to which we already have significant corporate credit exposure. For example, by purchasing Treasury bonds (or other high-quality assets) and associating them with written credit default swaps on the desired corporate credit name, we, at times, can replicate the desired bond exposures and meet our ALM needs. In addition, given the shorter tenor of the credit default swaps (generally five-year tenors) versus a long-dated corporate bond, we have more flexibility in managing our credit exposures. Embedded Derivatives See Note 8 of the Notes to the Consolidated and Combined Financial Statements for information about embedded derivatives measured at estimated fair value on a recurring basis and their corresponding fair value hierarchy. See Note 8 of the Notes to the Consolidated and Combined Financial Statements for a rollforward of the fair value measurements for net embedded derivatives measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs. See Note 7 of the Notes to the Consolidated and Combined Financial Statements for information about the nonperformance risk adjustment included in the valuation of guaranteed minimum benefits accounted for as embedded derivatives. See “- Summary of Critical Accounting Estimates - Derivatives” for further information on the estimates and assumptions that affect embedded derivatives. Off-Balance Sheet Arrangements Credit and Committed Facilities On December 2, 2016, we entered into the Revolving Credit Facility and, on July 21, 2017, we entered into the 2017 Term Loan Facility. See Note 9 of the Notes to the Consolidated and Combined Financial Statements for further information regarding the Revolving Credit Facility and the 2017 Term Loan Facility. For the classification of expenses on such credit and committed facilities and the nature of the associated liability for letters of credit issued and drawdowns on these credit and committed facilities, see Note 9 of the Notes to the Consolidated and Combined Financial Statements. Collateral for Securities Lending, Repurchase Programs and Derivatives We participate in a securities lending program in the normal course of business for the purpose of enhancing the total return on our investment portfolio. Periodically we receive non-cash collateral for securities lending from counterparties, which cannot be sold or repledged, and which is not recorded on our balance sheets. The amount of this collateral was $29 million and $27 million at estimated fair value at December 31, 2017 and 2016, respectively. See Note 6 of the Notes to the Consolidated and Combined Financial Statements, as well as “- Investments - Securities Lending” for discussion of our securities lending program, the classification of revenues and expenses, and the nature of the secured financing arrangement and associated liability. From time to time we participate in repurchase and reverse repurchase programs. In connection with these transactions, we obtain fixed maturity securities as collateral from unaffiliated financial institutions, which can be repledged, and which are not recorded on our balance sheets. We had no pledged or repledged securities at either December 31, 2017 or December 31, 2016. We enter into derivatives to manage various risks relating to our ongoing business operations. We have non-cash collateral from counterparties for derivatives, which can be sold or repledged subject to certain constraints, and which has not been recorded on our balance sheets. The amount of this non-cash collateral was $368 million and $564 million at December 31, 2017 and 2016, respectively. See Note 7 of the Notes to the Consolidated and Combined Financial Statements and “- Liquidity and Capital Resources - The Company - Liquidity and Capital Uses - Pledged Collateral” for information regarding the earned income on and the gross notional amount, estimated fair value of assets and liabilities and primary underlying risk exposure of our derivatives. Guarantees See “Guarantees” in Note 15 of the Notes to the Consolidated and Combined Financial Statements. Other Additionally, we enter into commitments in the normal course of business for the purpose of enhancing the total return on our investment portfolio: mortgage loan commitments and commitments to fund partnerships, bank credit facilities and private corporate bond investments. See “Net Investment Income” and “Net Investment Gains (Losses)” in Note 6 of the Notes to the Consolidated and Combined Financial Statements for information on the investment income, investment expense, gains and losses from such investments. See also “- Investments - Fixed Maturity and Equity Securities AFS” and “- Investments - Mortgage Loans” for information on our investments in fixed maturity securities and mortgage loans. See “- Investments - Real Estate and Real Estate Joint Ventures” and “- Investments - Other Limited Partnership Interests” for information on our partnership investments. Other than the commitments disclosed in Note 15 of the Notes to the Consolidated and Combined Financial Statements, there are no other material obligations or liabilities arising from the commitments to fund mortgage loans, partnerships, bank credit facilities, and private corporate bond investments. For further information on commitments to fund partnership investments, mortgage loans, bank credit facilities and private corporate bond investments. See “- Liquidity and Capital Resources - The Company - Contractual Obligations.” Policyholder Liabilities We establish, and carry as liabilities, actuarially determined amounts that are calculated to meet policy obligations or to provide for future annuity payments. Amounts for actuarial liabilities are computed and reported in the financial statements in conformity with GAAP. For more details on policyholder liabilities. See “- Summary of Critical Accounting Estimates.” Due to the nature of the underlying risks and the uncertainty associated with the determination of actuarial liabilities, we cannot precisely determine the amounts that will ultimately be paid with respect to these actuarial liabilities, and the ultimate amounts may vary from the estimated amounts, particularly when payments may not occur until well into the future. We periodically review the assumptions supporting our estimates of actuarial liabilities for future policy benefits. We revise estimates, to the extent permitted or required under GAAP, if we determine that future expected experience differs from assumptions used in the development of actuarial liabilities. We charge or credit changes in our liabilities to expenses in the period the liabilities are established or re-estimated. If the liabilities originally established for future benefit payments prove inadequate, we must increase them. Such an increase could adversely affect our earnings and have a material adverse effect on our business, results of operations and financial condition. We have experienced, and will likely in the future experience, catastrophe losses and possibly acts of terrorism, as well as turbulent financial markets that may have an adverse impact on our business, results of operations, and financial condition. Due to their nature, we cannot predict the incidence, timing, severity or amount of losses from catastrophes and acts of terrorism, but we make broad use of catastrophic and non-catastrophic reinsurance to manage risk from these perils. Future Policy Benefits We establish liabilities for amounts payable under insurance policies. See “- Summary of Critical Accounting Estimates - Liability for Future Policy Benefits” and Notes 1 and 3 of the Notes to the Consolidated and Combined Financial Statements. A discussion of future policy benefits by segment, as well as Corporate & Other follows. Annuities Future policy benefits for the annuities business are comprised mainly of liabilities for life-contingent income annuities, and liabilities for the variable annuity guaranteed minimum benefits accounted for as insurance. Life Future policy benefits for the life business are comprised mainly of liabilities for traditional life and for universal and variable life insurance contracts. In order to manage risk, we have often reinsured a portion of the mortality risk on life insurance policies. The reinsurance programs are routinely evaluated and this may result in increases or decreases to existing coverage. We have entered into various derivative positions, primarily interest rate swaps, to mitigate the risk that investment of premiums received and reinvestment of maturing assets over the life of the policy will be at rates below those assumed in the original pricing of these contracts. Run-off Future policy benefits primarily include liabilities for structured settlement annuities and pension risk transfers. There is no interest rate crediting flexibility on the liabilities for payout annuities. As a result, a sustained low interest rate environment could negatively impact earnings; however, we mitigate our risks by applying various ALM strategies, including the use of derivative positions, primarily interest rate swaps, to mitigate the risks associated with such a scenario. Corporate & Other Future policy benefits primarily include liabilities for certain run-off long-term care and workers’ compensation business. Additionally, future policy benefits historically included liabilities for variable annuity guaranteed minimum benefits assumed from a former operating joint venture in Japan that were accounted for as insurance prior to 2014. Policyholder Account Balances Policyholder account balances are generally equal to the account value, which includes accrued interest credited, but excludes the impact of any applicable charge that may be incurred upon surrender. See “- Variable Annuity Guarantees” and “Quantitative and Qualitative Disclosures About Market Risk - Market Risk - Fair Value Exposures - Interest Rates.” See Notes 1 and 3 of the Notes to the Consolidated and Combined Financial Statements for additional information for a discussion of policyholder account balances by segment, as well as Corporate & Other, follows. Annuities Policyholder account balances for annuities are held for fixed deferred annuities, the fixed account portion of variable annuities, and non-life contingent income annuities. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. A sustained low interest rate environment could negatively impact earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We have various derivative positions, including interest rate floors, to partially mitigate the risks associated with such a scenario. Additionally, policyholder account balances are held for variable annuity guaranteed minimum living benefits that are accounted for as embedded derivatives. The following table presents the breakdown of account value subject to minimum guaranteed crediting rates for Annuities at: ______________ (1) These amounts are not adjusted for policy loans. As a result of acquisitions, we establish additional liabilities known as excess interest reserves for policies with credited rates in excess of market rates as of the applicable acquisition dates. Excess interest reserves for Annuities were $297 million and $317 million at December 31, 2017 and 2016, respectively. Life Life policyholder account balances are held for retained asset accounts, universal life policies and the fixed account of universal variable life insurance policies. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. A sustained low interest rate environment could negatively impact earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We have various derivative positions, including interest rate floors, to partially mitigate the risks associated with such a scenario. The following table presents the breakdown of account value subject to minimum guaranteed crediting rates for Life at: _______________ (1) These amounts are not adjusted for policy loans. As a result of acquisitions, we establish additional liabilities known as excess interest reserves for policies with credited rates in excess of market rates as of the applicable acquisition dates. Excess interest reserves for Life were $28 million and $27 million at December 31, 2017 and 2016, respectively. Run-off Policyholder account balances in Run-off are comprised of funding agreements and COLI. Interest crediting rates vary by type of contract, and can be fixed or variable. Variable interest crediting rates are generally tied to an external index, most commonly (one-month or three-month) London InterBank Offered Rate (“LIBOR”). We are exposed to interest rate risks, when guaranteeing payment of interest and return on principal at the contractual maturity date. We may invest in floating rate assets or enter into receive-floating rate swaps, also tied to external indices, as well as caps, to mitigate the impact of changes in market interest rates. We also mitigate our risks by applying various ALM strategies. The following table presents the breakdown of account value subject to minimum guaranteed crediting rates for Run-off as of: _______________ (1) These amounts are not adjusted for policy loans. As a result of acquisitions, we establish additional liabilities known as excess interest reserves for policies with credited rates in excess of market rates as of the applicable acquisition dates. Excess interest reserves for Run-off were $64 million and $73 million at December 31, 2017 and 2016, respectively. Corporate & Other Policyholder account balances were historically held for variable annuity guaranteed minimum benefits assumed from a former operating joint venture in Japan that were accounted for as embedded derivatives prior to 2014. Variable Annuity Guarantees We issue directly and assume from an affiliate through reinsurance certain variable annuity products with guaranteed minimum benefits that provide the policyholder a minimum return based on their initial deposit (i.e., the Benefit Base) less withdrawals. In some cases, the Benefit Base may be increased by additional deposits, bonus amounts, accruals or optional market value step-ups. Certain of our variable annuity guarantee features are accounted for as insurance liabilities and recorded in future policy benefits while others are accounted for at fair value as embedded derivatives and recorded in policyholder account balances. Generally speaking, a guarantee is accounted for as an insurance liability if the guarantee is paid only upon either (i) the occurrence of a specific insurable event, or (ii) annuitization. Alternatively, a guarantee is accounted for as an embedded derivative if a guarantee is paid without requiring (i) the occurrence of specific insurable event, or (ii) the policyholder to annuitize, that is, the policyholder can receive the guarantee on a net basis. In certain cases, a guarantee may have elements of both an insurance liability and an embedded derivative and in such cases the guarantee is split and accounted for under both models. Further, changes in assumptions, principally involving behavior, can result in a change of expected future cash outflows of a guarantee between portions accounted for as insurance liabilities and portions accounted for as embedded derivatives. Guarantees accounted for as insurance liabilities in future policy benefits include GMDBs, the life contingent portion of the GMWBs and the portion of the GMIBs that require annuitization, as well as the life contingent portion of the expected annuitization when the policyholder is forced into an annuitization upon depletion of their account value. These insurance liabilities are accrued over the accumulation phase of the contract in proportion to actual and future expected policy assessments based on the level of guaranteed minimum benefits generated using multiple scenarios of separate account returns. The scenarios are based on best estimate assumptions consistent with those used to amortize DAC. When current estimates of future benefits exceed those previously projected or when current estimates of future assessments are lower than those previously projected, liabilities will increase, resulting in a current period charge to net income. The opposite result occurs when the current estimates of future benefits are lower than those previously projected or when current estimates of future assessments exceed those previously projected. At each reporting period, we update the actual amount of business remaining in-force, which impacts expected future assessments and the projection of estimated future benefits resulting in a current period charge or increase to earnings. See Note 3 of the Notes to the Consolidated and Combined Financial Statements for additional details of guarantees accounted for as insurance liabilities. Guarantees accounted for as embedded derivatives in policyholder account balances include the non-life contingent portion of GMWBs, GMABs, and for GMIBs the non-life contingent portion of the expected annuitization when the policyholder is forced into an annuitization upon depletion of their account value, as well as the Guaranteed Principal Option. The estimated fair values of guarantees accounted for as embedded derivatives are determined based on the present value of projected future benefits minus the present value of projected future fees. At policy inception, we attribute to the embedded derivative a portion of the projected future guarantee fees to be collected from the policyholder equal to the present value of projected future guaranteed benefits. Any additional fees represent “excess” fees and are reported in universal life and investment-type product policy fees. In valuing the embedded derivative, the percentage of fees included in the fair value measurement is locked-in at inception. The projections of future benefits and future fees require capital market and actuarial assumptions including expectations concerning policyholder behavior. A risk neutral valuation methodology is used to project the cash flows from the guarantees under multiple capital market scenarios to determine an economic liability. The reported estimated fair value is then determined by taking the present value of these risk-free generated cash flows using a discount rate that incorporates a spread over the risk-free rate to reflect our nonperformance risk and adding a risk margin. For more information on the determination of estimated fair value. See Note 8 of the Notes to the Consolidated and Combined Financial Statements. Liquidity and Capital Resources Liquidity refers to our ability to generate adequate cash flows from our normal operations to meet the cash requirements of our operating, investing and financing activities. Capital refers to our long-term financial resources available to support our business operations and contribute to future growth. Our ability to generate and maintain sufficient liquidity and capital depends on the profitability of the businesses, timing of cash flows on investments and products, general economic conditions and access to the Revolving Credit Facility and the Term Loan Facility described below and access to the capital markets and the alternate sources of liquidity and capital described herein. Parent Company Liquidity In evaluating liquidity it is important to distinguish the cash flow needs of the parent company, Brighthouse Financial, Inc., from the cash flow needs of the combined group of companies. Brighthouse Financial, Inc. is largely dependent on cash flows from its insurance subsidiaries to meet its obligations. The principal sources of funds available to Brighthouse Financial, Inc. will include dividends and returns of capital from its insurance and non-insurance subsidiaries, as well as its own cash and short-term investments. Such funds are paid to Brighthouse Financial, Inc. by BH Holdings, its direct wholly-owned holding company subsidiary. These sources of funds may also be supplemented by alternate sources of liquidity either directly or indirectly through our insurance subsidiaries. For example, we have established internal liquidity facilities to provide liquidity within and across our regulated and non-regulated entities to support our businesses. See Note 2 of the Schedule II - Condensed Financial Information (Parent Company Only). Liquid Assets and Short-term Liquidity An integral part of our liquidity management includes managing our levels of short-term liquidity and liquid assets. Short-term liquidity and liquid assets are made available from the issuance of the Senior Notes and from drawdowns under the 2017 Term Loan Facility. In addition, any undrawn capacity under our Revolving Credit Facility is a potential source of liquidity. In order to manage our capital more efficiently, we have also established internal liquidity facilities to provide liquidity within and across the combined group of companies. See Note 3 of the Notes to the Condensed Financial Information included in Schedule II. At December 31, 2017 and 2016, Brighthouse Financial, Inc. and certain of its non-insurance subsidiaries had $656 million and $102 million, respectively, in liquid assets. Of these amounts, $563 million and $0 were held by Brighthouse Financial, Inc. at December 31, 2017 and 2016, respectively. Liquid assets include cash and cash equivalents, short-term investments and publicly-traded securities excluding assets that are pledged or otherwise committed. Assets pledged or otherwise committed include amounts received in connection with derivatives and collateral financing arrangements. Non-insurance company liquid assets are generated through borrowings, as well as through dividends and returns of capital from insurance subsidiaries, offset by payments for certain services provided from our insurance and non-insurance subsidiaries, which include, but are not limited to, executive oversight, treasury, finance, legal, human resources, tax planning, internal audit, financial reporting, information technology, distribution services and investor relations. Insurance subsidiary dividends are subject to local insurance regulatory requirements, as discussed in “- The Company - Capital - Restrictions on Dividends and Returns of Capital from Insurance Subsidiaries.” At December 31, 2017 and 2016, Brighthouse Financial, Inc. and certain of its non-insurance subsidiaries had $419 million and $122 million, respectively in short-term liquidity. Short-term liquidity includes cash and cash equivalents and short-term investments, excluding assets that are pledged or otherwise committed, including amounts received in connection with securities lending, repurchase agreements, derivatives and secured borrowings. Constraints on Parent Company Liquidity Constraints on Brighthouse Financial, Inc.’s liquidity may occur as a result of operational demands and/or as a result of compliance with regulatory requirements. For example, we may be constrained in the payment of dividends from our insurance subsidiaries pursuant to reserving requirements under actuarial guidelines whereby we are required to calculate the statutory reserves which support our variable annuity products in conformity with AG 43. As previously discussed, we intend to support our variable annuity contracts with assets which are $2.0 billion to $3.0 billion in excess of the amount of assets required under CTE95, for which we anticipate that the assets we hold to support our variable annuity contracts at CTE95 under our Base Case Scenario will exceed the amount required by AG 43 in the near term. Under this scenario, we then anticipate that beginning in approximately 2021 under AG 43 as currently in effect the Standard Scenario Reserve Amount will exceed the amount that would be required to be held consistent with CTE95 (although still less than CTE95 plus $2.0 billion to $3.0 billion), and that the amount of such excess will increase materially in subsequent years. During the period that the AG 43 reserving requirement materially exceeds CTE95, our insurance subsidiaries’ RBC ratios and surplus will be adversely affected to the extent we make distributions to our shareholders. Notwithstanding this impact, and although no assurances can be given, under our Base Case Scenario we believe that during this period our excess reserving requirements under the standard scenario will not impair our ability to make any such distributions as contemplated by our Base Case Scenario while still maintaining our Combined RBC ratio, surplus and financial strength ratings at levels necessary to market and sell our products in accordance with our business plan. Furthermore, if anticipated regulatory reform fails to bring AG 43 calculations in line with CTE90 calculations, we may seek regulatory relief or engage in transactions, including restructuring or financing transactions, to mitigate the effect of the standard scenario on the surplus and RBC ratios of our insurance subsidiaries. Capital We expect to maintain adequate liquidity at Brighthouse Financial, Inc., a debt-to-capital ratio of approximately 25% and a funding of $2.0 billion to $3.0 billion of assets in excess of CTE95 to support our variable annuity contracts during normal markets. We monitor our financial leverage ratio based on an average of our key leverage calculations of A.M. Best, Fitch, Moody’s and S&P. At December 31, 2017, assets above CTE95 were $2.6 billion. We may opportunistically look to pursue additional debt financing over time to reach our targeted debt-to-capital ratio of 25% and to refinance borrowings outstanding under our 2017 Term Loan Facility. Such debt financing may include the incurrence of term loans or the issuance of senior or subordinated debt securities. There can be no assurance that we will be able to complete any such debt financing transactions on terms and conditions favorable to us or at all. We do not currently anticipate declaring or paying regular cash dividends or making other distributions on our common stock in the near term. Any future declaration and payment of dividends or other distributions of capital will be at the discretion of our Board of Directors and will depend on and be subject to our financial condition, results of operations, earnings, cash needs, regulatory and other constraints, capital requirements (including capital requirements of our subsidiaries), contractual restrictions and any other factors that our Board of Directors deems relevant in making such a determination, including, without limitation, the Company’s continued development as a standalone public company. Therefore, there can be no assurance that we will pay any dividends or make other distributions on our common stock, or as to the amount of any such dividends or distributions of capital. See also “- The Company - Capital” for a discussion of how we manage our capital for the combined group of companies. The Company Sources and Uses of Liquidity and Capital Our principal sources of liquidity are insurance premiums and annuity considerations, net investment income and proceeds from the maturity and sale of investments. The primary uses of these funds are investing activities, payments of policyholder benefits, commissions and operating expenses, and contract maturities, withdrawals and surrenders. Summary of the Primary Sources and Uses of Liquidity and Capital The following table presents a summary of the primary sources and uses of liquidity and capital: ______________ Cash Flows from Operations. The principal cash inflows from our insurance activities come from insurance premiums, net investment income and annuity considerations. The principal cash outflows relate to life insurance and annuity products and operating expenses, as well as interest expense. Cash Flows from Investments. The principal cash inflows from our investment activities come from repayments of principal, proceeds from maturities and sales of investments and settlements of freestanding derivatives. The principal cash outflows relate to purchases of investments and settlements of freestanding derivatives. We typically have a net cash outflow from investing activities because cash inflows from insurance operations are reinvested in accordance with our ALM discipline to fund insurance liabilities. Cash Flows from Financing, Parent Company. The principal cash inflows from parent company financing activities come from issuances of debt and other securities and dividends form subsidiaries. The principal cash outflows from parent company financing activities come from interest expense on and repayments of debt, and payment of dividends on and repurchases of common or preferred stock. Cash Flows from Financing, The Company. The principal cash inflows from our financing activities come from issuances of debt and other securities, deposits of funds associated with policyholder account balances and lending of securities. The principal cash outflows come from interest expense on and repayment of debt, withdrawals associated with policyholder account balances and the return of securities on loan. Liquidity Liquidity Management Based upon our capitalization, expectations regarding maintaining our ratings, business mix and funding sources available to us, we believe we have sufficient liquidity to meet business requirements under current market conditions and certain stress scenarios. We continuously monitor and adjust our liquidity and capital plans in light of market conditions, as well as changing needs and opportunities. We determine our liquidity needs based on a rolling 12-month forecast by portfolio of invested assets which we monitor daily. We adjust the general account asset and derivatives mix and general account asset maturities based on this rolling 12-month forecast. To support this forecast, we conduct cash flow and stress testing, which include various scenarios of the potential increase to post or return collateral, reduction to new business sales, and risk of early contract holder and policyholder withdrawals, and lapses and surrenders of existing policies and contracts. We include provisions limiting withdrawal rights on many of our products. Certain of these provisions prevent the customer from making withdrawals prior to the maturity date of the product. In the event of significant cash requirements beyond anticipated liquidity needs, we have various alternatives available depending on market conditions and the amount and timing of the liquidity need. These potential available alternative sources of liquidity include cash flows from operations, sales of liquid assets, internal liquidity facilities, collateralized borrowing arrangements, such as from FHLB, and any undrawn capacity under our Revolving Credit Facility. Consolidated Liquid Assets and Short-term Liquidity Consolidated liquid assets were $38.3 billion and $31.7 billion at December 31, 2017 and 2016, respectively. Consolidated short-term liquidity was $1.6 billion and $5.0 billion at December 31, 2017 and 2016, respectively. Capital We manage our capital position to maintain our financial strength and credit ratings. Our capital position will be supported by our ability to generate cash flows within our insurance companies, our ability to effectively manage the risk of our businesses and our expected ability to borrow funds, and raise additional capital to meet operating and growth needs in the event of adverse market and economic conditions. Capital Management Our Board of Directors and senior management are directly involved in the governance of the capital management process, including proposed changes to the annual capital plan and capital targets. In connection with the Separation, we undertook various capitalization activities. For example, we have eliminated intercompany financing arrangements with or guaranteed by MetLife. We are targeting a debt-to-total capitalization ratio commensurate with our parent company credit ratings and our insurance subsidiaries’ financial strength ratings. Statutory Capital Our insurance companies have statutory surplus above the level needed to meet current regulatory requirements. At the date of the most recent annual statutory financial statements filed with insurance regulators, the total adjusted capital of each of these insurance subsidiaries subject to these requirements was in excess of each of those RBC levels. Restrictions on Dividends and Returns of Capital from Insurance Subsidiaries Our business is primarily conducted through our insurance subsidiaries. The insurance subsidiaries are subject to regulatory restrictions on the payment of dividends and other distributions imposed by the regulators of their respective state domiciles. See “Regulation - Insurance Regulation - Holding Company Regulation.” Any requested payment of dividends by Brighthouse Life Insurance Company and NELICO to Brighthouse Financial, Inc., or by BHNY to Brighthouse Life Insurance Company, in excess of the 2018 limit on the permitted payment of dividends without approval would be considered an extraordinary dividend and would require prior approval from the Delaware Department of Insurance or the Massachusetts Division of Insurance, and the New York State Department of Financial Services, respectively. Statutory accounting practices, as prescribed by insurance regulators of various states in which we conduct business, differ in certain respects from accounting principles used in financial statements prepared in conformity with GAAP. The significant differences relate to the treatment of DAC, certain deferred income tax, required investment liabilities, statutory reserve calculation assumptions, goodwill and surplus notes. The table below sets forth the dividends permitted to be paid by our insurance subsidiaries without insurance regulatory approval and the respective dividends paid. _______________ (1) Reflects dividend amounts that may be paid during 2018 without prior regulatory approval. However, because dividend tests may be based on dividends previously paid over rolling 12-month periods, if paid before a specified date during 2018, some or all of such dividends may require regulatory approval. (2) Reflects all amounts paid, including those requiring regulatory approval. (3) Reflects dividend amounts that could have been paid during the relevant year without prior regulatory approval. (4) Dividends paid by BLIC in 2016 and 2015 were paid to its former parent, MetLife, Inc. (5) Dividends paid by NELICO in 2016, including a $295 million extraordinary cash dividend, were paid to its former parent, MetLife, Inc. Dividends paid by NELICO in 2015 were paid to its former parent, MLIC. (6) Dividends are not anticipated to be paid by BHNY in 2018. In addition to the amounts presented above, prior to the Separation, we made cash payments to certain MetLife affiliates related to a profit sharing agreement of $40 million, $78 million and $72 million, for the years ended December 31, 2017, 2016 and 2015, respectively. Brighthouse Financial, Inc. received a $50 million cash distribution from BH Holdings during the year ended December 31, 2017. There were no cash dividends or returns of capital paid by our non-insurance subsidiaries for the years ended December 31, 2016 and 2015. Rating Agencies Rating agencies use an “outlook statement” of “positive,” “stable,” ‘‘negative’’ or “developing” to indicate a medium- or long-term trend in credit fundamentals which, if continued, may lead to a rating change. A rating may have a “stable” outlook to indicate that the rating is not expected to change; however, a “stable” rating does not preclude a rating agency from changing a rating at any time, without notice. Certain rating agencies assign rating modifiers such as “CreditWatch” or “under review” to indicate their opinion regarding the potential direction of a rating. These ratings modifiers are generally assigned in connection with certain events such as potential mergers, acquisitions, dispositions or material changes in a company’s results, in order for the rating agency to perform its analysis to fully determine the rating implications of the event. The following financial strength ratings represent each rating agency’s opinion of our principal insurance subsidiaries’ ability to pay obligations under insurance policies and contracts in accordance with their terms and are not evaluations directed toward the protection of investors in our securities. Financial strength ratings are not statements of fact nor are they recommendations to purchase, hold or sell any security, contract or policy. Each rating should be evaluated independently of any other rating. Our financial strength ratings at the date of this filing are indicated in the following table. All financial strength ratings have a stable outlook unless otherwise indicated. _______________ (1) Negative outlook. Our long-term issuer credit ratings at the date of this filing are indicated in the following table. All long-term issuer credit ratings have a stable outlook unless otherwise indicated. _______________ (1) Long-term Issuer Credit Rating refers to issuer credit rating, issuer default rating, long-term issuer rating and long-term counterparty credit rating for A.M. Best, Fitch Ratings, Moody’s and S&P Global Ratings, respectively. (2) Negative outlook. Additional information about financial strength ratings and credit ratings can be found on the respective websites of the rating agencies. Rating agencies may continue to review and adjust our ratings. A downgrade in the credit ratings of Brighthouse Financial, Inc., the parent company, would likely impact us in many ways, including the cost and availability of financing for Brighthouse Financial, Inc., and its subsidiaries. See Note 7 of the Notes to the Consolidated and Combined Financial Statements. See also “Risk Factors - Risks Related to our Business - A downgrade or a potential downgrade in our financial strength or credit ratings could result in a loss of business and materially adversely affect our financial condition and results of operations” for an in-depth description of the impact of a ratings downgrade. Downgrades in our financial strength ratings could have a material adverse effect on our financial condition and results of operations in many ways, including: • reducing new sales of insurance products and annuity products; • adversely affecting our relationships with independent sales intermediaries; • increasing the number or amount of policy surrenders and withdrawals by contract holders and policyholders; • requiring us to reduce prices for many of our products and services to remain competitive; • providing termination rights for the benefit of our derivative instrument counterparties; • triggering termination and recapture rights under certain of our ceded reinsurance agreements; • adversely affecting our ability to obtain reinsurance at reasonable prices, if at all; • requiring us to post additional collateral under certain of our financing and derivative transactions; and • subjecting us to potentially increased regulatory scrutiny. Additionally, downgrades in the credit ratings of Brighthouse Financial, Inc. or financial strength ratings of our insurance subsidiaries would likely impact us in the following ways: • impact our ability to generate cash flows from the sale of funding agreements and other capital market products we offer; and • impact the cost and availability of financing for Brighthouse. Reinsurance Financing Transactions Our reinsurance subsidiary, BRCD, was formed to manage our capital and risk exposures and to support our various operations, through the use of affiliated reinsurance arrangements and related reserve financing. Simultaneously with the Reinsurance Merger in April 2017, certain existing reserve financing arrangements were terminated and replaced with a single financing arrangement supported by a pool of highly rated third-party reinsurers. This financing arrangement has a total capacity of $10.0 billion and consists of credit-linked notes that each have a term of 20 years. As of December 31, 2017, there were no drawdowns on this facility and there was $8.3 billion of funding available under this financing arrangement. See “Risk Factors - Risks Related to Our Business - We may not be able to take credit for reinsurance, our statutory life insurance reserve financings may be subject to cost increases and new financings may be subject to limited market capacity” for further information. In April 2017, in connection with the Reinsurance Merger, a $2.8 billion collateral financing arrangement was terminated and the obligation outstanding was extinguished utilizing $2.8 billion of assets held in trust, which had been repositioned into short-term investments and cash equivalents. The remaining assets held in trust of $590 million were returned to MetLife, Inc. See “- Outstanding Debt and Collateral Financing Arrangement.” In connection with our reinsurance subsidiary restructuring, we were granted approval from the Delaware Department of Insurance to pay a dividend from BRCD to its parent, BLIC. The dividend consisted of (i) $535 million in cash, which was declared and paid in May 2017 and (ii) two surplus notes with an aggregate principal balance payable at maturity of $365 million, which have not yet been issued. All payments of principal and interest on these surplus notes would be subject to the prior approval of the Delaware Department of Insurance. BRCD can only make distributions of capital to BLIC over time and subject to the approval of the Delaware Department of Insurance. BRCD is capitalized with cash and invested assets, including funds withheld (“Minimum Initial Target Assets”) at a level that is sufficient to satisfy all of its future cash obligations assuming a permanent level yield curve, consistent with NAIC cash flow testing scenarios. BRCD utilizes a financing program to cover the difference between full required statutory assets (i.e., XXX/AXXX reserves plus target RBC) and Minimum Initial Target Assets. An admitted deferred tax asset, if any, would also serve to reduce the amount of funding required under this financing program. Primary Sources of Liquidity and Capital Liquidity is provided by a variety of funding sources, including funding agreements. Capital is provided by a variety of funding sources, including long-term debt, credit facilities and reserve financing facilities. The diversity of our funding sources enhances our funding flexibility, limits dependence on any one market or source of funds and generally lowers the cost of funds. In addition to senior note issuances, credit facilities and a reinsurance financing arrangement discussed in more detail in “- Outstanding Debt and Collateral Financing Arrangement,” our other funding sources include or have included: Federal Home Loan Bank Funding Agreements, Reported in Policyholder Account Balances BLIC is a member of the FHLB of Pittsburgh and has obligations outstanding with certain regional banks in the FHLB system. During the years ended December 31, 2017, 2016 and 2015, we issued $25 million, $4.7 billion and $4.1 billion, respectively, and repaid $75 million, $5.9 billion and $3.3 billion, respectively, under funding agreements with certain regional FHLBs. At December 31, 2017 and 2016, total obligations outstanding under these funding agreements were $595 million and $645 million, respectively. See Note 3 of the Notes to the Consolidated and Combined Financial Statements. Activity related to these funding agreements is reported in the Run-off segment. We intend to maintain a funding agreement program with the FHLB to support our liquidity needs; whereas historically this program was used in the spread-based business. Special Purpose Entity Funding Agreements, Reported in Policyholder Account Balances BLIC issued fixed and floating rate funding agreements which are denominated in either U.S. dollars or foreign currencies, to certain special purpose entities that have issued either debt securities or commercial paper for which payment of interest and principal is secured by such funding agreements. During the years ended December 31, 2017, 2016 and 2015, we issued $0, $1.4 billion and $13.0 billion, respectively, and repaid $6 million, $3.4 billion and $14.4 billion, respectively, under such funding agreements. At December 31, 2017 and 2016, total obligations outstanding under these funding agreements were $141 million and $127 million, respectively. See Note 3 of the Notes to the Consolidated and Combined Financial Statements. Activity related to these funding agreements is reported in the Run-off segment. We no longer maintain this funding agreement program to support our liquidity needs. Federal Agricultural Mortgage Corporation Funding Agreements, Reported in Policyholder Account Balances BLIC issued funding agreements to a subsidiary of the Federal Agricultural Mortgage Corporation. The obligations under all such funding agreements are secured by a pledge of certain eligible agricultural real estate mortgage loans. During the years ended December 31, 2017, 2016 and 2015, there were no issuances and we repaid $0, $0 and $200 million under such funding agreements, respectively. At December 31, 2017 and 2016, there were no obligations outstanding under these funding agreements. Activities related to these funding agreements are reported in the Run-off segment. Outstanding Debt and Collateral Financing Arrangement The following table summarizes our outstanding debt and collateral financing arrangement liability as of: _______________ (1) Includes unamortized debt issuance costs and debt discount totaling $34 million for the senior notes due 2027 and 2047 on a combined basis at December 31, 2017. (2) Represents non-recourse debt for which creditors have no access, subject to customary exceptions, to the general assets of the Company other than recourse to certain investment companies. (3) Excludes $11 million and $23 million of long-term debt related to CSEs at December 31, 2017 and 2016, respectively. See Note 6 of the Notes to the Consolidated and Combined Financial Statements for more information regarding CSEs and Note 9 of the Notes to the Consolidated and Combined Financial Statements for further information regarding long-term debt. Senior Notes On June 22, 2017, Brighthouse Financial, Inc. issued $1.5 billion of senior notes due June 2027, which bear interest at a fixed rate of 3.70%, payable semi-annually, and $1.5 billion of senior notes due June 2047, which bear interest at a fixed rate of 4.70%, payable semi-annually. Surplus Notes On June 16, 2017, MetLife, Inc. forgave Brighthouse Life Insurance Company’s obligation to pay the principal amount of $750 million,8.595% surplus notes held by MetLife, Inc., which were originally issued in 2008. The forgiveness of the surplus notes was treated as a capital transaction and recorded as an increase to additional paid-in-capital. On April 28, 2017, two surplus note obligations due to MetLife, Inc. totaling $1.1 billion, which were originally issued in 2012 and 2013, were due on September 30, 2032 and December 31, 2033 and bore interest at 5.13% and 6.00%, respectively, were satisfied in a non-cash exchange for $1.1 billion of loans due from MetLife, Inc. Credit Facilities On December 2, 2016, Brighthouse Financial, Inc. entered into a $2.0 billion five-year senior unsecured Revolving Credit Facility and a $3.0 billion three-year term loan facility (the “2016 Term Loan Facility”) with a syndicate of banks. On July 21, 2017, Brighthouse Financial, Inc. entered into a new term loan agreement (the “2017 Term Loan Agreement”) with respect to a new $600 million unsecured delayed draw term loan facility due December 2, 2019 (the “2017 Term Loan Facility”). Also on July 21, 2017, concurrently with entering into the 2017 Term Loan Agreement, the 2016 Term Loan Facility was terminated without penalty. At December 31, 2017, there were no drawdowns under the Revolving Credit Facility and there was $600 million outstanding under the 2017 Term Loan Facility, resulting in unused commitments totaling $2.0 billion in comparison to the maximum capacity of $2.6 billion under these facilities. Committed Facilities, Collateral Financing Arrangement and Reinsurance Financing Arrangement The Company previously had access to an unsecured revolving credit facility and certain committed facilities through the Company’s former parent, MetLife, Inc. These facilities were used for collateral for certain of the Company’s affiliated reinsurance liabilities. In connection with the Reinsurance Merger, effective April 28, 2017, MetLife, Inc.’s then existing affiliated reinsurance subsidiaries that supported the business interests of Brighthouse Financial, Inc. became a part of Brighthouse Financial, Inc. Simultaneously with the Reinsurance Merger, the existing reserve financing arrangements of the affected reinsurance subsidiaries, as well as Brighthouse Financial, Inc.’s access to MetLife Inc.’s revolving credit facility and certain committed facilities, including outstanding letters of credit, were terminated and replaced with a single reinsurance financing arrangement, which is discussed in more detail below. The terminated committed facilities included a $3.5 billion committed facility for the benefit of MetLife Reinsurance Company of South Carolina (“MRSC”) and a $4.3 billion committed facility for the benefit of a designated protected cell of MetLife Reinsurance Company of Vermont. In 2007, MetLife, Inc. and MRSC entered into a 30-year collateral financing arrangement with an unaffiliated financial institution that provided up to $3.5 billion of statutory reserve support for MRSC associated with reinsurance obligations under affiliated reinsurance agreements. At December 31, 2016, the amount outstanding under this collateral financing arrangement was $2.8 billion. On April 28, 2017, MetLife, Inc. and MRSC terminated this collateral financing arrangement. As a result, the $2.8 billion collateral financing arrangement obligation outstanding was extinguished utilizing $2.8 billion of assets held in trust, which had been repositioned into short-term investments and cash equivalents. The remaining assets held in trust of $590 million were returned to MetLife, Inc. and reported as an increase to additional paid-in capital. On April 28, 2017, BRCD entered into a new $10.0 billion financing arrangement with a pool of highly rated third-party reinsurers. This financing arrangement consists of credit-linked notes that each have a term of 20 years. At December 31, 2017, there were no drawdowns and there was $8.3 billion of funding available under this arrangement. See Note 9 of the Notes to the Consolidated and Combined Financial Statements for further information regarding the Company’s committed facilities, collateral financing arrangement and reinsurance financing arrangement. Debt and Facility Covenants Certain of the Company’s debt instruments, credit and committed facilities, and the reinsurance financing arrangement contain administrative, reporting, legal and financial covenants, including requirements to maintain a specified minimum consolidated net worth and to maintain a ratio of indebtedness to total capitalization not in excess of a specified percentage, and limitation on the dollar amount of indebtedness that may be incurred by our subsidiaries, which could restrict our operations and use of funds. The Company is not aware of any non-compliance with these financial covenants at December 31, 2017. Debt Repurchases We may from time to time seek to retire or purchase our outstanding debt through cash purchases and/or exchanges for other securities, in open market purchases, privately negotiated transactions or otherwise. Any such repurchases or exchanges will be dependent upon several factors, including our liquidity requirements, contractual restrictions, general market conditions, and applicable regulatory, legal and accounting factors. Whether or not to repurchase any debt and the size and timing of any such repurchases will be determined at our discretion. Liquidity and Capital Uses In addition to the general description of liquidity and capital uses in “- Primary Sources of Liquidity and Capital,” and “- Contractual Obligations,” the following additional information is provided regarding our primary uses of liquidity and capital: Debt Repayments In April 2017, MetLife, Inc. and MRSC terminated the collateral financing arrangement and, as a result, the $2.8 billion obligation outstanding, under this arrangement was extinguished. Insurance Liabilities Liabilities arising from our insurance activities primarily relate to benefit payments under various life insurance products, and annuity products, as well as payments for policy surrenders, withdrawals and loans. For annuity or deposit type products, surrender or lapse behavior differs somewhat by segment. In the Annuities segment, lapses and surrenders tend to occur in the normal course of business. During the years ended December 31, 2017 and 2016, general account surrenders and withdrawals from annuity products were $1.8 billion and $1.9 billion, respectively. Pledged Collateral We pledge collateral to, and have collateral pledged to us by, counterparties in connection with our derivatives. At December 31, 2017 and 2016, counterparties were obligated to return cash collateral pledged by us of $44 million and $765 million, respectively. At December 31, 2017 and 2016, we were obligated to return cash collateral pledged to us by counterparties of $379 million and $749 million, respectively. See Note 7 of the Notes to the Consolidated and Combined Financial Statements for additional information about pledged collateral. We pledge collateral from time to time in connection with funding agreements. Securities Lending We participate in a securities lending program whereby securities are loaned to third parties, primarily brokerage firms and commercial banks. We obtain collateral, usually cash, from the borrower, which must be returned to the borrower when the loaned securities are returned to us. Under our securities lending program, we were liable for cash collateral under our control of $3.8 billion and $6.6 billion at December 31, 2017 and 2016, respectively. Of these amounts, $1.6 billion and $2.1 billion at December 31, 2017 and 2016, respectively, were on open, meaning that the related loaned security could be returned to us on the next business day requiring the immediate return of cash collateral we hold. The estimated fair value of the securities on loan related to the cash collateral on open at December 31, 2017 was $1.6 billion, all of which were U.S. government and agency securities which, if put to us, could be immediately sold to satisfy the cash requirements to immediately return the cash collateral. See Note 6 of the Notes to the Consolidated and Combined Financial Statements. Litigation Putative or certified class action litigation and other litigation, and claims and assessments against us, in addition to those discussed elsewhere herein and those otherwise provided for in the financial statements, have arisen in the course of our business, including, but not limited to, in connection with our activities as an insurer, employer, investor, investment advisor, and taxpayer. Further, state insurance regulatory authorities and other federal and state authorities regularly make inquiries and conduct investigations concerning our compliance with applicable insurance and other laws and regulations. See Note 15 of the Notes to the Consolidated and Combined Financial Statements. We establish liabilities for litigation and regulatory loss contingencies when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. For material matters where a loss is believed to be reasonably possible but not probable, no accrual is made but we disclose the nature of the contingency and an aggregate estimate of the reasonably possible range of loss in excess of amounts accrued, when such an estimate can be made. It is not possible to predict or determine the ultimate outcome of all pending investigations and legal proceedings. In some of the matters referred to herein, very large and/or indeterminate amounts, including punitive and treble damages, are sought. Although in light of these considerations, it is possible that an adverse outcome in certain cases could have a material adverse effect upon our financial position, based on information currently known by us, in our opinion, the outcome of such pending investigations and legal proceedings are not likely to have such an effect. However, given the large and/or indeterminate amounts sought in certain of these matters and the inherent unpredictability of litigation, it is possible that an adverse outcome in certain matters could, from time to time, have a material adverse effect on our combined net income or cash flows in particular quarterly or annual periods. Contractual Obligations The following table summarizes our major contractual obligations at: Insurance Liabilities Insurance liabilities include future policy benefits and other policy-related balances, which are reported on the balance sheet and are more fully described in Notes 1 and 3 of the Notes to the Consolidated and Combined Financial Statements. The amounts presented reflect future estimated cash payments and (i) are based on mortality, morbidity, lapse and other assumptions comparable with our experience and expectations of future payment patterns; and (ii) consider future premium receipts on current policies in-force. All estimated cash payments presented are undiscounted as to interest, net of estimated future premiums on in-force policies and gross of any reinsurance recoverable. Additionally, the more than five years category includes estimated payments due for periods extending for more than 100 years. The sum of the estimated cash flows shown for all years of $76.5 billion exceeds the liability amounts of $39.6 billion included on the balance sheet principally due to (i) the time value of money, which accounts for a substantial portion of the difference; and (ii) differences in assumptions, most significantly mortality, between the date the liabilities were initially established and the current date; and are partially offset by liabilities related to accounting conventions (such as interest reserves and unearned revenue), or which are not contractually due, which are excluded. Actual cash payments may differ significantly from the liabilities as presented on the balance sheet and the estimated cash payments as presented due to differences between actual experience and the assumptions used in the establishment of these liabilities and the estimation of these cash payments. For the majority of our insurance operations, estimated contractual obligations for future policy benefits and policyholder account balances, as presented, are derived from the annual asset adequacy analysis used to develop actuarial opinions of statutory reserve adequacy for state regulatory purposes. See “- Policyholder Account Balances.” Policyholder Account Balances See Notes 1 and 3 of the Notes to the Consolidated and Combined Financial Statements for a description of the components of policyholder account balances. See “- Insurance Liabilities” regarding the source and uncertainties associated with the estimation of the contractual obligations related to future policy benefits and policyholder account balances. Amounts presented represent the estimated cash payments undiscounted as to interest and including assumptions related to the receipt of future premiums and deposits; withdrawals, including unscheduled or partial withdrawals; policy lapses; surrender charges; annuitization; mortality; future interest credited; policy loans and other contingent events as appropriate for the respective product type. Such estimated cash payments are also presented net of estimated future premiums on policies currently in-force and gross of any reinsurance recoverable. The sum of the estimated cash flows shown for all years of $59.7 billion exceeds the liability amount of $37.8 billion included on the balance sheet principally due to (i) the time value of money, which accounts for a substantial portion of the difference; (ii) differences in assumptions, between the date the liabilities were initially established and the current date; and (iii) liabilities related to accounting conventions (such as interest reserves and embedded derivatives), or which are not contractually due, which are excluded. Payables for Collateral Under Securities Loaned and Other Transactions We have accepted cash collateral in connection with securities lending and derivatives. As the securities lending transactions expire within the next year and the timing of the return of the derivatives collateral is uncertain, the return of the collateral has been included in the one year or less category in the table. We also held non-cash collateral, which is not reflected as a liability on the balance sheet of $397 million at December 31, 2017. Debt The total amount presented for debt differs from the total amount presented on the consolidated and combined balance sheets due to the following: (i) the amounts presented herein do not include premiums or discounts upon issuance; (ii) the amounts presented herein include future interest on such obligations for the period from January 1, 2018 through maturity; and (iii) the amounts presented herein do not include $11 million at December 31, 2017 of long-term debt relating to CSEs - FVO as such debt does not represent our contractual obligation. Future interest on variable rate debt was computed using prevailing rates at December 31, 2017 and, as such, does not consider the impact of future rate movements. Future interest on fixed rate debt was computed using the stated rate on the obligations. Investment Commitments To enhance the return on our investment portfolio, we commit to lend funds under mortgage loans, bank credit facilities and private corporate bond investments and we commit to fund partnership investments. In the table, the timing of the funding of mortgage loans and private corporate bond investments is based on the expiration dates of the corresponding commitments. As it relates to commitments to fund partnerships and bank credit facilities, we anticipate that these amounts could be invested any time over the next five years; however, as the timing of the fulfillment of the obligation cannot be predicted, such obligations are generally presented in the one year or less category. See Note 15 of the Notes to the Consolidated and Combined Financial Statements and “- Off-Balance Sheet Arrangements.” Other Other obligations presented are principally comprised of amounts due under reinsurance agreements, payables related to securities purchased but not yet settled, accrued interest on debt obligations, estimated fair value of derivative obligations, guaranty liabilities, and accruals and accounts payable due under contractual obligations, which are all reported in other liabilities on the balance sheet. If the timing of any of these other obligations is sufficiently uncertain, the amounts are included within the one year or less category. Items reported in other liabilities on the balance sheet that were excluded from the table represent accounting conventions or are not liabilities due under contractual obligations. Unrecognized tax benefits and related accrued interest totaling $25 million was excluded as the timing of payment cannot be reliably determined. Separate account liabilities are excluded as they are fully funded by cash flows from the corresponding separate account assets and are set equal to the estimated fair value of separate account assets. We also enter into agreements to purchase goods and services in the normal course of business; however, such amounts are excluded as these purchase obligations were not material to our results of operations or financial position. Additionally, we have agreements in place for services we conduct, generally at cost, between companies relating to insurance, reinsurance, loans and capitalization. Intercompany transactions have been eliminated in combination. Intercompany transactions among insurance companies and affiliates have been approved by the appropriate insurance regulators as required. GLOSSARY Glossary of Selected Financial Terms Account value The amount of money in a policyholder’s account. The value increases with additional premiums and investment gains, and it decreases with withdrawals, investment losses and fees. Adjusted earnings See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP and Other Financial Disclosures.” Alternative investments General account invested assets in real estate joint ventures, other limited partnership interests and other invested assets. Annualized new premium (“ANP”) A sales term used to compare new business written in a year on a recurring basis. The annualization is determined by using 100% of annual recurring premium and 10% of single premiums or deposits. Assets under management (“AUM”) General account investments and separate account assets. Conditional tail expectation (“CTE”) Calculated as the average amount of total assets required to satisfy obligations over the life of the contract or policy in the worst [x]% of scenarios. Represented as CTE (100 less x). Example: CTE95 represents the five worst percent of scenarios. Credit loss The difference between the amortized cost of the security and the present value of projected future cash flows expected to be collected is recognized as an OTTI in earnings. Deferred acquisition cost (“DAC”) Represents the incremental costs related directly to the successful acquisition of new and renewal insurance and annuity contracts and which have been deferred on the balance sheet as an asset. Deferred sales inducements (“DSI”) Represent amounts that are credited to a policyholder’s account balance that are higher than the expected crediting rates on similar contracts without such an inducement and that are an incentive to purchase a contract and also meet the accounting criteria to be deferred as an asset that is amortized over the life of the contract. Deferred tax asset or deferred tax liability Assets or liabilities that are recorded for the difference between book basis and tax basis of an asset or a liability. General account assets All insurance company assets not allocated to separate accounts. Invested assets General account investments. Includes fixed maturity securities, equity securities, mortgage loans, policy loans, alternative investments and short-term investments. Investment Hedge Adjustments Earned income on derivatives and amortization of premium on derivatives that are hedges of investments or that are used to replicate certain investments, but do not qualify for hedge accounting treatment. Market Value Adjustments Amounts associated with periodic crediting rate adjustments based on the total return of a contractually referenced pool of assets and market value adjustments associated with surrenders or terminations of contracts. Minimum Initial Target Assets Cash and invested assets, including funds withheld. Net amount at risk (“NAR”) Represents the difference between a claim amount payable if a specific event occurs and the amount set aside to support the claim. The calculation of NAR can differ by policy type and/or guarantee. Net investment spread See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP and Other Financial Disclosures.” Reinsurance Insurance that an insurance company buys for its own protection. Reinsurance enables an insurance company to expand its capacity, stabilize its underwriting results, or finance its expanding volume. Risk-based capital (“RBC”) Rules to determine insurance company regulatory capital requirements. It is based on rules published by the National Association of Insurance Commissioners (“NAIC”). Sales See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP and Other Financial Disclosures.” Tax-deferral An investment with earnings such as interest, dividends or capital gains that accumulate tax free until the investor withdraws and takes possession of them. The most common types of tax-deferred investments include those in individual retirement accounts and individual retirement annuities (collectively, “IRAs”) and deferred annuities. Value of business acquired (“VOBA”) Present value of projected future gross profits from in-force policies of acquired businesses. Glossary of Product Terms Accumulation phase The phase of a variable annuity contract during which assets accumulate based on the policyholder’s lump sum or periodic deposits and reinvested interest, capital gains and dividends that are generally tax deferred. Annuitant The person who receives annuity payments or the person whose life expectancy determines the amount of variable annuity payments upon annuitization of a life contingent annuity. Annuities Long-term, tax deferred investments designed to help investors save for retirement. Annuitization The process of converting an annuity investment into a series of periodic income payments, generally for life. Benefit Base A notional amount (not actual cash value) used to calculate the owner’s guaranteed benefits within an annuity contract. The death benefit and living benefit within the same contract may not have the same Benefit Base. Cash surrender value The amount an insurance company pays (minus any surrender charge) to the variable annuity owner when the contract is voluntarily terminated prematurely. Deferred annuity An annuity purchased with premiums paid either over a period of years or as a lump sum, for which savings accumulate prior to annuitization or surrender, and upon annuitization, such savings are exchanged for either a future lump sum or periodic payments for a specific length of time or for a lifetime. Dollar-for-dollar withdrawal A method of calculating the reduction of a variable annuity Benefit Base after a withdrawal in which the benefit is reduced by one dollar for every dollar withdrawn. Enhanced death benefit An optional benefit that locks in investment gains annually, or every few years, or pays a minimum stated interest rate on purchase payments to the beneficiary. Fixed annuity An annuity that guarantees a set annual rate of return with interest at rates we determine, subject to specified minimums. Credited interest rates are guaranteed not to change for certain limited periods of time. Future policy benefits Future policy benefits for the annuities business are comprised mainly of liabilities for life-contingent income annuities, and liabilities for the variable annuity guaranteed minimum benefits accounted for as insurance. Guaranteed minimum accumulation benefits (“GMAB”) An optional benefit (available for an additional cost) which entitles an annuitant to a minimum payment, typically in lump-sum, after a set period of time, typically referred to as the accumulation period. The minimum payment is based on the Benefit Base, which could be greater than the underlying account value. Guaranteed minimum death benefits (“GMDB”) An optional benefit (available for an additional cost) that guarantees an annuitant’s beneficiaries are entitled to a minimum payment based on the Benefit Base, which could be greater than the underlying account value, upon the death of the annuitant. Guaranteed minimum income benefits (“GMIB”) An optional benefit (available for an additional cost) where an annuitant is entitled to annuitize the policy and receive a minimum payment stream based on the Benefit Base, which could be greater than the underlying account value. Guaranteed minimum living benefits (“GMLB”) A reference to all forms of guaranteed minimum living benefits, including GMIBs, GMWBs and GMABs (does not include GMDBs). Guaranteed minimum withdrawal benefit for life (“GMWBL”) An optional benefit (available for an additional cost) where an annuitant is entitled to withdraw a maximum amount of their Benefit Base each year, for the duration of the contract holder’s life, regardless of account performance. Guaranteed minimum withdrawal benefit riders (“GMLB Riders”) Changes in the carrying value of GMLB liabilities, related hedges and reinsurance; the fees earned directly from the GMLB liabilities; and related DAC offsets. Guaranteed minimum withdrawal benefits (“GMWB”) An optional benefit (available for an additional cost) where an annuitant is entitled to withdraw a maximum amount of their Benefit Base each year, for which cumulative payments to the annuitant could be greater than the underlying account value. Guaranteed minimum benefits (“GMxB”) A general reference to all forms of guaranteed minimum benefits, inclusive of living benefits and death benefits. Immediate income annuity A type of annuity for which the owner pays a lump sum and receives periodic payments immediately or soon after purchase. Single premium immediate annuities (“SPIAs”) are single premium annuity products that provide a guaranteed level of income to the owner generally for a specified number of years and/or for the life of the annuitant. Deferred income annuities (“DIAs”) provide a pension-like stream of income payments after a specified deferral period. Index-linked annuities An annuity that provides for asset accumulation and asset distribution needs with an ability to share in the upside from certain financial markets such as equity indices, or an interest rate benchmark. With an index-linked annuity, the customer’s account value can grow or decline due to various external financial market indices performance. Living benefits Optional benefits (available at an additional cost) that guarantee that the owner will get back at least his original investment when the money is withdrawn. Mortality and expense risk fee (“M&E fee”) A fee charged by insurance companies to compensate for the risk they take by issuing variable annuity contracts. Net flows Net change in customer account balances in a period including, but not limited to, new sales, full or partial exits and the net impact of clients utilizing or withdrawing their funds. It excludes the impact of markets on account balances. Period certain annuity Type of annuity that guarantees payment to the annuitant for a specified time period and to the beneficiary if the annuitant dies before the period ends. Policyholder account balances Annuities: Policyholder account balances are held for fixed deferred annuities, the fixed account portion of variable annuities, and non-life contingent income annuities. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. Life Insurance Policies: Policyholder account balances are held for retained asset accounts, universal life policies and the fixed account of universal variable life insurance policies. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. Rider An optional feature or benefit that a variable annuity contract holder can purchase at an additional cost. Roll-up rate The guaranteed percentage that the Benefit Base increases by each year. Separate account An insurance company account, legally segregated from the general account, that holds the contract assets or subaccount investments that can be actively or passively managed and invest in stock, bonds or money market portfolios. Step-up An optional variable annuity feature (available at an additional cost) that can increase the Benefit Base amount if the variable annuity account value is higher than the Benefit Base on specified dates. Surrender charge A fee paid by a contract owner for the early withdrawal of an amount that exceeds a specific percentage or for cancellation of the contract within a specified amount of time after purchase. Term life products Term life products provide a fixed death benefit in exchange for a guaranteed level premium over a specified period of time, usually ten to thirty years. Generally, term life does not include any cash value, savings or investment components. Total adjusted capital (“TAC”) Primarily consists of statutory capital and surplus and the statutory asset valuation reserve. Universal life products Life insurance products that provide a death benefit in return for payment of specified annual policy charges that are generally related to specific costs, which may change over time. To the extent that the policyholder chooses to pay more than the charges required in any given year to keep the policy in-force, the excess premium will be placed into the account value of the policy and credited with a stated interest rate on a monthly basis. Variable annuity A type of annuity that offers guaranteed periodic payments for a defined period of time or for life and gives purchasers the ability to invest in various markets though the underlying investment options, which may result in potentially higher, but variable, returns. Variable universal life Universal life products where the excess amount paid over policy charges can be directed by the policyholder into a variety of separate account investment options. In the separate account investment options, the policyholder bears the entire risk and returns of the investment results. Whole life products Life insurance products that provide a guaranteed death benefit in exchange for a guaranteed level premium for a specified period of time in order to maintain coverage for the life of the insured. Whole life products also have guaranteed minimum cash surrender values. Although the primary purpose is protection, the policyholder can withdraw or borrow against the policy (sometimes on a tax favored basis).

<s>[INST] Page Introduction Executive Summary Industry Trends and Uncertainties Summary of Critical Accounting Estimates NonGAAP and Other Financial Disclosures Economic Capital Results of Operations Effects of Inflation Investments Derivatives OffBalance Sheet Arrangements Policyholder Liabilities Liquidity and Capital Resources Glossary Introduction For purposes of this discussion, “Brighthouse,” the “Company,” “we,” “our” and “us” refer to Brighthouse Financial, Inc. a corporation incorporated in Delaware in 2016, and its subsidiaries. Brighthouse Financial, Inc. was formerly a whollyowned subsidiary of MetLife, Inc. (MetLife, Inc., together with its subsidiaries and affiliates, “MetLife”). Following this summary is a discussion addressing the consolidated results of operations and financial condition of the Company for the periods indicated. This discussion should be read in conjunction with “Note Regarding ForwardLooking Statements,” “Risk Factors,” “Selected Financial Data,” “Quantitative and Qualitative Disclosures About Market Risk” and the Company’s consolidated financial statements included elsewhere herein. The following discussion may contain forwardlooking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in these forwardlooking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this report, particularly in “Note Regarding ForwardLooking Statements” and “Risk Factors.” Presentation Prior to discussing our Results of Operations, we present background information and definitions that we believe are useful to understanding the discussion of our financial results. This information precedes the Results of Operations and is most beneficial when read in the sequence presented. A summary of key informational sections is as follows: “Executive Summary” contains the following subsections: “Overview” provides information regarding our business, reporting segments and results as discussed in the Results of Operations. “Background” presents details of the Company’s legal entity structure and key events that led up to the completion of the Separation. “Industry Trends and Uncertainties” discusses updates and changes to a number of trends and uncertainties that we believe may materially affect our future financial condition, results of operations or cash flows. “Summary of Critical Accounting Estimates” explains the most critical estimates and judgments applied in determining our GAAP results. “NonGAAP and Other Financial Disclosures” defines key financial measures presented in the Results of Operations that are not calculated in accordance with GAAP but are used by management in evaluating company and segment performance. As described in this section, adjusted earnings is presented by key business activities which are derived from, but different than, the line items presented in the GAAP statement of operations. This section also refers to certain other terms used to describe our insurance business and financial and operating metrics, but is not intended to be exhaustive. The Results of Operations section begins with two introductory sections to facilitate an understanding of the results discussion: “Significant Business Actions” defines certain actions that had a significant impact to either or both net income (loss) and adjusted earnings, as defined in “ NonGAAP and Other Financial Disclosures”, which are not indicative of performance in the respective periods. Events defined in this section are referred to in the Results of Operations discussion. “Actuarial Assumption Review” describes the changes in key assumptions applied in 2017 and 2016, respectively, resulting in a favorable impact to net income (loss) in the current period. Executive Summary Overview We are a major provider of annuity products and life insurance in the United States through multiple independent distribution channels and marketing arrangements with a diverse network of distribution partners. For operating purposes, we have established three reporting segments: (i) Annuities, (ii) Life and (iii) Runoff, which consists of operations relating to products we are not actively selling and which are separately managed. In addition, we report certain of our results of operations not included in the segments in Corporate & Other. In the third quarter of 2016, the Company reorganized its businesses in anticipation of the Separation. Also, in the fourth quarter of 2016, the Company moved the universal life policies with secondary guarantees business [/INST] Positive. </s>

Brighthouse Financial, Inc.

2019-02-26

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Index to Management’s Discussion and Analysis of Financial Condition and Results of Operations Page Introduction Executive Summary Industry Trends and Uncertainties Summary of Critical Accounting Estimates Non-GAAP and Other Financial Disclosures Segment Capital Results of Operations Effects of Inflation Investments Derivatives Off-Balance Sheet Arrangements Policyholder Liabilities Liquidity and Capital Resources Glossary Introduction For purposes of this discussion, unless otherwise mentioned or unless the context indicates otherwise, “Brighthouse,” “Brighthouse Financial,” the “Company,” “we,” “our” and “us” refer to Brighthouse Financial, Inc. a corporation incorporated in Delaware in 2016, and its subsidiaries. We use the term “BHF” to refer solely to Brighthouse Financial, Inc., and not to any of its subsidiaries. Until August 4, 2017, BHF was a wholly-owned subsidiary of MetLife, Inc. (together with its subsidiaries and affiliates, “MetLife”). Following this summary is a discussion addressing the consolidated results of operations and financial condition of the Company for the periods indicated. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with “Note Regarding Forward-Looking Statements,” “Risk Factors,” “Selected Financial Data,” “Quantitative and Qualitative Disclosures About Market Risk” and the Company’s consolidated financial statements included elsewhere herein. The term “Separation” refers to the separation of MetLife’s former Brighthouse Financial segment from MetLife’s other businesses and the creation of a separate, publicly traded company, BHF, as well as the distribution on August 4, 2017 of 96,776,670, or 80.8%, of the 119,773,106 shares of BHF common stock outstanding immediately prior to the distribution date by MetLife, Inc. to holders of MetLife, Inc. common stock as of the record date for the distribution. The term “MetLife Divestiture” refers to the disposition by MetLife, Inc. on June 14, 2018 of all its remaining shares of BHF common stock. Effective with the MetLife Divestiture, MetLife, Inc. and its subsidiaries and affiliates are no longer considered related parties to Brighthouse Financial, Inc. and its subsidiaries and affiliates. See Note 1 of the Notes to the Consolidated and Combined Financial Statements. The following discussion may contain forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this report, particularly in “Note Regarding Forward-Looking Statements” and “Risk Factors.” Presentation Prior to discussing our Results of Operations, we present background information and definitions that we believe are useful to understanding the discussion of our financial results. This information precedes the Results of Operations and is most beneficial when read in the sequence presented. A summary of key informational sections is as follows: • “Executive Summary” contains the following sub-sections: • “Overview” provides information regarding our business, segments and results as discussed in the Results of Operations. • “Background” presents details of the Company’s legal entity structure and key events that led up to the completion of the Separation. • “Industry Trends and Uncertainties” discusses updates and changes to a number of trends and uncertainties that we believe may materially affect our future financial condition, results of operations or cash flows. • “Summary of Critical Accounting Estimates” explains the most critical estimates and judgments applied in determining our GAAP results. • “Non-GAAP and Other Financial Disclosures” defines key financial measures presented in the Results of Operations that are not calculated in accordance with GAAP but are used by management in evaluating company and segment performance. As described in this section, adjusted earnings is presented by key business activities which are derived from, but different than, the line items presented in the GAAP statement of operations. This section also refers to certain other terms used to describe our insurance business and financial and operating metrics but is not intended to be exhaustive. • The Results of Operations section begins with two introductory sections to facilitate an understanding of the results discussion: • “Significant Business Actions” defines certain actions that had a significant impact to either or both net income (loss) available to shareholders and adjusted earnings, as defined in “- Non-GAAP and Other Financial Disclosures,” which are not indicative of performance in the respective periods. Events defined in this section are referred to in the Results of Operations discussion. • “Annual Actuarial Review” describes the changes in key assumptions applied in 2018, 2017 and 2016, respectively, resulting in an unfavorable impact to net income (loss) available to shareholders in each period. Certain amounts presented in prior periods within the foregoing discussions of our financial results have been reclassified to conform with the current year presentation. Executive Summary Overview We are one of the largest providers of annuity and life insurance products in the United States through multiple independent distribution channels and marketing arrangements with a diverse network of distribution partners. For operating purposes, we have established three segments: (i) Annuities, (ii) Life and (iii) Run-off, which consists of operations relating to products we are not actively selling, and which are separately managed. In addition, we report certain of our results of operations in Corporate & Other. In the third quarter of 2016, the Company reorganized its businesses in anticipation of the Separation. Also, in the fourth quarter of 2016, the Company moved the universal life policies with secondary guarantees business from the Life segment to the Run-off segment (“ULSG Re-segmentation”). These changes were applied retrospectively and did not have an impact on total consolidated net income (loss) available to shareholders or adjusted earnings in the prior periods. See “Business - Segments and Corporate & Other” and Note 2 of the Notes to the Consolidated and Combined Financial Statements for further information on our segments and Corporate & Other. The table below presents a summary of our net income (loss) available to shareholders and adjusted earnings a non-GAAP financial measure. See “- Non-GAAP and Other Financial Disclosures.” For a detailed discussion of our results see “- Results of Operations.” For the year ended December 31, 2018, we had net income of $865 million and $892 million of adjusted earnings as compared to a net loss of $378 million and $920 million of adjusted earnings for the year ended December 31, 2017. Net income for the year ended December 31, 2018 reflected impacts from lower equity markets which resulted in favorable net changes in derivative instruments in our variable annuity rider business, but lower adjusted earnings driven by lower fee income and higher amortization of DAC. Despite higher adjusted earnings, the net loss for the year ended December 31, 2017 was driven by unfavorable changes in our derivative instruments resulting from strong equity market performance and rising interest rates. In the third quarter of 2017 we recognized a $1.1 billion tax charge in connection with the Separation which was substantially offset by a benefit of $947 million recorded in the fourth quarter of 2017 in connection with changes to the Tax Code. The net loss for the year ended December 31, 2016 was driven by reserve strengthening, including the effect of our 2016 annual actuarial review for our variable annuities business, our second quarter refinement in the actuarial model which we use to calculate the reserves for our in-force book of ULSG products and the loss recognition, mostly in the form of a write down of deferred acquisition costs, triggered by the move of our ULSG products into the Run-off segment in the fourth quarter of 2016. In addition to reserve strengthening, derivative losses on our economic hedges of certain liabilities also contributed to the net loss, primarily due to the impact of the fourth quarter 2016 rise in interest rates without an offset from the liabilities being hedged due to the insensitivity of GAAP liabilities to changes in interest rates. See “- Results of Operations.” Background Brighthouse Financial, Inc., which until the completion of the Separation on August 4, 2017 was a wholly-owned subsidiary of MetLife, Inc., is a holding company incorporated in Delaware on August 1, 2016 to own the legal entities that have historically operated a substantial portion of MetLife’s former Retail segment, as well as certain portions of its former Corporate Benefit Funding segment, which is included in our Run-off segment. This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help the reader understand the results of operations, financial condition and cash flows of Brighthouse for the periods indicated. In addition to Brighthouse Financial, Inc., the companies and businesses included in the results of operations, financial condition and cash flows are: • Brighthouse Life Insurance Company (together with its subsidiaries and affiliates, “BLIC”), formerly MetLife Insurance Company USA, our largest insurance operating entity, domiciled in Delaware and licensed to write business in 49 states; • New England Life Insurance Company (“NELICO”), domiciled in Massachusetts and licensed to write business in all 50 states; • Brighthouse Life Insurance Company of NY (“BHNY”), formerly First MetLife Investors Insurance Company, domiciled in New York and licensed to write business in New York, which is a subsidiary of Brighthouse Life Insurance Company; • Brighthouse Reinsurance Company of Delaware (“BRCD”), our single reinsurance company licensed in Delaware, which is a subsidiary of Brighthouse Life Insurance Company; • Brighthouse Investment Advisers, LLC (“Brighthouse Advisers”), formerly MetLife Advisers, LLC, serving as investment advisor to certain proprietary mutual funds that are underlying investments under our and MetLife’s variable insurance products; • Brighthouse Services, LLC (“Brighthouse Services”), an internal services and payroll company; • Brighthouse Securities, LLC (“Brighthouse Securities”), registered as a broker-dealer with the SEC, approved as a member of FINRA and registered as a broker-dealer and licensed as an insurance agency in all required states; and • Brighthouse Holdings, LLC (“BH Holdings”), a wholly-owned holding company subsidiary of Brighthouse Financial, Inc. domiciled in Delaware. Industry Trends and Uncertainties Throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations, we discuss a number of trends and uncertainties that we believe may materially affect our future financial condition, results of operations or cash flows. Where these trends or uncertainties are specific to a particular aspect of our business, we often include such a discussion under the relevant caption of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, as part of our broader analysis of that area of our business. In addition, the following factors represent some of the key general trends and uncertainties that have influenced the development of our business and our historical financial performance and that we believe will continue to influence our business and results of operations in the future. Changes in Accounting Standards Our financial statements are subject to the application of GAAP, which is periodically revised by the FASB. The FASB exposed several proposed amendments to the accounting for long-duration insurance contracts in 2016, and on August 15, 2018 issued a final ASU effective January 1, 2021. The ASU will result in significant changes to the accounting for long-duration insurance contracts, including a requirement for all guarantees associated with our variable annuity business to be measured at fair value. The Company is in the early stages of evaluating the new guidance and therefore is unable to estimate the impact to its financial statements. The ASU could result in a material adverse effect on our stockholders’ equity and results of operations, including our net income. Financial and Economic Environment Our business and results of operations are materially affected by conditions in the capital markets and the economy generally. Stressed conditions, volatility and disruptions in the capital markets, particular markets, or financial asset classes can have an adverse effect on us. The impact on capital markets and the economy generally of the priorities and policies of the Trump administration is uncertain. See “Risk Factors - Economic Environment and Capital Markets-Related Risks - If difficult conditions in the capital markets and the U.S. economy generally persist or are perceived to persist, they may materially adversely affect our business and results of operations.” Equity market performance can affect our profitability for variable annuities and other separate account products as a result of the effects it has on product demand, revenues, expenses, reserves and our risk management effectiveness. The level of long-term interest rates and the shape of the yield curve can have a negative effect on the demand for, and the profitability of, spread-based products such as fixed annuities, index-linked annuities and universal life insurance. Low interest rates and risk premium, including credit spread, affect new money rates on invested assets and the cost of product guarantees. Insurance premium growth and demand for our products is impacted by the general health of U.S. economic activity. The above factors affect our expectations regarding future margins, which in turn, affect the amortization of certain of our intangible assets such as DAC and VOBA. Significantly lower expected margins may cause us to accelerate the amortization of DAC and VOBA, thereby reducing net income in the affected reporting period. We review our long-term assumptions about capital market returns and interest rates, along with other assumptions such as contract holder behavior, as part of our annual actuarial review. As additional company specific and/or industry information on contract holder behavior becomes available, related assumptions may change and may potentially have a material impact on liability valuations and net income. In addition, the change in accounting estimate relating to the liability valuations that occurred in the second quarter of 2016 may result in greater income statement volatility in the future. Demographics We believe that demographic trends in the U.S. population, the increase in under-insured individuals, the potential risk to governmental social safety net programs and the shifting of responsibility for retirement planning and financial security from employers and other institutions to individuals, highlight the need of individuals to plan for their long-term financial security and will create opportunities to generate significant demand for our products. By focusing our product development and marketing efforts to meeting the needs of certain targeted customer segments identified as part of our strategy, we will be able to focus on offering a smaller number of products that we believe are appropriately priced given current economic conditions, which we believe will benefit our expense ratio thereby increasing our profitability. Competitive Environment The life insurance industry remains highly fragmented and competitive. See “Business - Segments and Corporate & Other” for each of our segments. In particular, we believe that financial strength and financial flexibility are highly relevant differentiators from the perspective of customers and distributors. We believe we are adequately positioned to compete in this environment. Regulatory Developments Our life insurance companies are regulated primarily at the state level, with some products and services also subject to federal regulation. In addition, Brighthouse Financial, Inc. and its insurance subsidiaries are subject to regulation under the insurance holding company laws of various U.S. jurisdictions. Furthermore, some of our operations, products and services are subject to ERISA, consumer protection laws, securities, broker-dealer and investment advisor regulations, and environmental and unclaimed property laws and regulations. See “Business - Regulation” and “Risk Factors - Regulatory and Legal Risks.” In addition, Regulation 187 adopts a “best interest” standard for the sale of life insurance and annuity products in New York, which may have adverse effects on our business by imposing greater compliance, oversight, disclosure and notification requirements on us. The NAIC, other states and the SEC are also considering or have proposed similar regulations. Summary of Critical Accounting Estimates The preparation of financial statements in conformity with GAAP requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported on the Consolidated and Combined Financial Statements. The most critical estimates include those used in determining: i. liabilities for future policy benefits; ii. accounting for reinsurance; iii. capitalization and amortization of DAC and the amortization of VOBA; iv. estimated fair values of investments in the absence of quoted market values; v. investment impairments; vi. estimated fair values of freestanding derivatives and the recognition and estimated fair value of embedded derivatives requiring bifurcation; vii. measurement of income taxes and the valuation of deferred tax assets; and viii. liabilities for litigation and regulatory matters. In applying our accounting policies, we make subjective and complex judgments that frequently require estimates about matters that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance and financial services industries; others are specific to our business and operations. Actual results could differ from these estimates. The above critical accounting estimates are described below and in Note 1 of the Notes to the Consolidated and Combined Financial Statements. Liability for Future Policy Benefits Future policy benefits for traditional long-duration insurance contracts (term, whole-life insurance and income annuities) are payable over an extended period of time and the related liabilities are equal to the present value of future expected benefits to be paid, reduced by the present value of future expected net premiums. Assumptions used to measure the liability are based on the Company’s experience and include a margin for adverse deviation. The principal assumptions used in the establishment of liabilities for future policy benefits are mortality, morbidity, benefit utilization and withdrawals, policy lapse, retirement, disability incidence, disability terminations, investment returns, inflation, expenses and other contingent events as appropriate to the respective product type. These assumptions, intended to estimate the experience for the period the policy benefits are payable, are established at the time the policy is issued and are not updated unless a premium deficiency exists. Utilizing these assumptions, liabilities are established for each line of business. If experience is less favorable than assumed and a premium deficiency exists, DAC may be reduced, and/or additional insurance liabilities established, resulting in a reduction in earnings. Future policy benefit liabilities for GMDBs and certain GMIBs relating to variable annuity contracts are based on estimates of the expected value of benefits in excess of the projected account balance, recognizing the excess ratably over the accumulation period based on total expected assessments. Liabilities for universal and variable life insurance secondary guarantees are determined by estimating the expected value of death benefits payable when the account balance is projected to be zero using a range of scenarios and recognizing those benefits ratably over the contract period based on total expected assessments. The Company also maintains a profit followed by losses reserve on universal life insurance with secondary guarantees. The assumptions of investment performance and volatility for variable products are consistent with historical experience of the underlying separate account funds. We regularly review our assumptions supporting our estimates of actuarial liabilities for future policy benefits. For universal life and annuity product guarantees, assumptions are updated periodically, whereas for traditional long-duration insurance contracts, assumptions are established at inception and not updated unless a premium deficiency exists. We also review our liability projections to determine if profits are projected in earlier years followed by losses projected in later years, which could require us to establish an additional liability. We aggregate insurance contracts by product and segment in assessing whether a premium deficiency or profits followed by losses exists. Differences between actual experience and the assumptions used in pricing our policies and guarantees, as well as adjustments to the related liabilities, result in changes to earnings. See Note 1 of the Notes to the Consolidated and Combined Financial Statements for additional information on our accounting policy relating to variable annuity guarantees and liability for future policy benefits. Reinsurance Accounting for reinsurance requires extensive use of assumptions and estimates, particularly related to the future performance of the underlying business and the potential impact of counterparty credit risk with respect to reinsurance receivables. We periodically review actual and anticipated experience compared to the aforementioned assumptions used to establish assets and liabilities relating to ceded and assumed reinsurance and evaluate the financial strength of counterparties to our reinsurance agreements using criteria similar to those evaluated in our security impairment process. See “- Investment Impairments.” Additionally, for each of our reinsurance agreements, we determine whether the agreement provides indemnification against loss or liability relating to insurance risk, in accordance with applicable accounting standards. We review all contractual features, including those that may limit the amount of insurance risk to which the reinsurer is subject or features that delay the timely reimbursement of claims. We evaluate present values of projected future cash flows on blocks of policies subject to new reinsurance agreements in light of all such contractual features to determine whether our reinsurance counterparties are exposed to a reasonable possibility of significant loss. Such analysis involves management estimates as to the cash flow projections, as well as management judgment as to what constitutes a reasonable possibility of significant loss. If we determine that a reinsurance agreement does not expose the reinsurer to a reasonable possibility of a significant loss from insurance risk, we record the agreement using the deposit method of accounting. See Note 1 of the Notes to the Consolidated and Combined Financial Statements for additional information on our accounting policy relating to reinsurance and Note 5 of the Notes to the Consolidated and Combined Financial Statements for additional information on our reinsurance programs. Deferred Policy Acquisition Costs and Value of Business Acquired We incur significant costs in connection with acquiring new and renewal insurance business. Costs that relate directly to the successful acquisition or renewal of insurance contracts are deferred as DAC. VOBA represents the excess of book value over the estimated fair value of acquired insurance, annuity and investment-type contracts in force at the acquisition date. The recovery of both DAC and VOBA is dependent upon the future profitability of the related business. DAC and VOBA related to deferred annuities, universal and variable life insurance contracts are amortized based on expected future gross profits. DAC and VOBA balances and amortization for variable contracts can be significantly impacted by changes in expected future gross profits related to projected separate account rates of return. Our practice of determining changes in projected separate account returns assumes that long-term appreciation in equity markets is not changed by short-term market fluctuations but is only changed when sustained interim deviations are expected. We monitor these events and only change the assumption when our long-term expectation changes. The effect of an increase (decrease) by 100 basis points in the assumed future rate of return is reasonably likely to result in a decrease (increase) in the DAC and VOBA amortization with an offset to our unearned revenue liability which nets to approximately $215 million. We use a mean reversion approach to separate account returns where the mean reversion period is five years with a long-term separate account return after the five-year reversion period is over. The current long-term rate of return assumption for variable annuity and variable universal life contracts insurance contracts is in the 6-7% range. We also generally review other long-term assumptions underlying the projections of expected future gross profits on an annual basis. These assumptions primarily relate to general account investment returns, interest crediting rates, mortality, in-force or persistency, benefit elections and withdrawals, and expenses to administer business. Assumptions used in the calculation of expected future gross profits which have significantly changed are updated annually. If the update of assumptions causes expected future gross profits to increase, DAC and VOBA amortization will generally decrease, resulting in a current period increase to earnings. The opposite result occurs when the assumption update causes expected future gross profits to decrease. Our DAC balances are also impacted by replacing expected future gross profits with actual gross profits in each reporting period, including changes in annuity embedded derivatives and the related nonperformance risk. When the change in expected future gross profits principally relates to the difference between actual and estimates in the current period, an increase in profits will generally result in an increase in amortization and a decrease in profits will generally result in a decrease in amortization. See Note 1 and Note 4 of the Notes to the Consolidated and Combined Financial Statements for additional information relating to DAC and VOBA accounting policy and amortization. Estimated Fair Value of Investments In determining the estimated fair value of our investments, fair values are based on unadjusted quoted prices for identical investments in active markets that are readily and regularly obtainable. When such quoted prices are not available, fair values are based on quoted prices in markets that are not active, quoted prices for similar but not identical investments, or other observable inputs. If these inputs are not available, or observable inputs are not determinable, unobservable inputs and/or adjustments to observable inputs requiring management judgment are used to determine the estimated fair value of investments. The methodologies, assumptions and inputs utilized are described in Note 8 of the Notes to the Consolidated and Combined Financial Statements. Financial markets are susceptible to severe events evidenced by rapid depreciation in asset values accompanied by a reduction in asset liquidity. Our ability to sell investments, or the price ultimately realized for investments, depends upon the demand and liquidity in the market and increases the use of judgment in determining the estimated fair value of certain investments. Investment Impairments One of the significant estimates related to AFS securities is our impairment evaluation. The assessment of whether an other-than-temporary impairment (“OTTI”) occurred is based on our case-by-case evaluation of the underlying reasons for the decline in estimated fair value on a security-by-security basis. Our review of each fixed maturity security for OTTI includes an analysis of gross unrealized losses by three categories of severity and/or age of gross unrealized loss. An extended and severe unrealized loss position may not have any impact on the ability of the issuer to service all scheduled interest and principal payments. Accordingly, such an unrealized loss position may not impact our evaluation of recoverability of all contractual cash flows or the ability to recover an amount at least equal to its amortized cost based on the present value of the expected future cash flows to be collected. Additionally, we consider a wide range of factors about the security issuer and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in our evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Factors we consider in the OTTI evaluation process are described in Note 6 of the Notes to the Consolidated and Combined Financial Statements. The determination of the amount of allowances and impairments on the remaining invested asset classes is highly subjective and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. See Notes 1 and 6 of the Notes to the Consolidated and Combined Financial Statements for additional information relating to our determination of the amount of allowances and impairments. Derivatives We use freestanding derivative instruments to hedge various capital market risks in our products, including: (i) certain guarantees, some of which are reported as embedded derivatives; (ii) current or future changes in the fair value of our assets and liabilities; and (iii) current or future changes in cash flows. All derivatives, whether freestanding or embedded, are required to be carried on the balance sheet at fair value with changes reflected in either net income (loss) available to shareholders or in OCI, depending on the type of hedge. Below is a summary of critical accounting estimates by type of derivative. Freestanding Derivatives The determination of the estimated fair value of freestanding derivatives, when quoted market values are not available, is based on market standard valuation methodologies and inputs that management believes are consistent with what other market participants would use when pricing such instruments. Derivative valuations can be affected by changes in interest rates, foreign currency exchange rates, financial indices, credit spreads, default risk, nonperformance risk, volatility, liquidity and changes in estimates and assumptions used in the pricing models. See Note 7 of the Notes to the Consolidated and Combined Financial Statements for additional information on significant inputs into the OTC derivative pricing models and credit risk adjustment. Embedded Derivatives in Variable Annuity Guarantees We issue variable annuity products with guaranteed minimum benefits, some of which are embedded derivatives measured at estimated fair value separately from the host variable annuity product, with changes in estimated fair value reported in net derivative gains (losses). The estimated fair values of these embedded derivatives are determined based on the present value of projected future benefits minus the present value of projected future fees attributable to the guarantee. The projections of future benefits and future fees require capital markets and actuarial assumptions, including expectations concerning policyholder behavior. A risk neutral valuation methodology is used under which the cash flows from the guarantees are projected under multiple capital market scenarios using observable risk-free rates and implied equity volatilities. Market conditions, including, but not limited to, changes in interest rates, equity indices, market volatility and variations in actuarial assumptions, including policyholder behavior, mortality and risk margins related to non-capital market inputs, as well as changes in our nonperformance risk may result in significant fluctuations in the estimated fair value of the guarantees that could have a material impact on net income. Changes to actuarial assumptions, principally related to contract holder behavior such as annuitization utilization and withdrawals associated with GMIB riders, can result in a change of expected future cash outflows of a guarantee between the accrual-based model for insurance liabilities and the fair-value based model for embedded derivatives. See Note 1 of the Notes to the Consolidated and Combined Financial Statements for additional information relating to the determination of the accounting model. Risk margins are established to capture the non-capital market risks of the instrument which represent the additional compensation a market participant would require to assume the risks related to the uncertainties in certain actuarial assumptions. The establishment of risk margins requires the use of significant management judgment, including assumptions of the amount and cost of capital needed to cover the guarantees. Assumptions for embedded derivatives are reviewed at least annually, and if they change significantly, the estimated fair value is adjusted by a cumulative charge or credit to net income. See Note 7 and Note 8 of the Notes to the Consolidated and Combined Financial Statements for additional information on our embedded derivatives and the determination of their fair values. Embedded Derivatives in Index-Linked Annuities The Company issues and assumes through reinsurance index-linked annuities that contain equity crediting rates accounted for as an embedded derivative. The crediting rates are measured at estimated fair value which is determined using a combination of an option pricing methodology and an option-budget approach. The estimated fair value includes capital market and actuarial policyholder behavior and biometric assumptions, including expectations for renewals at the end of the term period. Market conditions, including interest rates and implied volatilities, and variations in actuarial assumptions and risk margins as well as changes in our nonperformance risk adjustment may result in significant fluctuations in the estimated fair value that could have a material impact on net income. Nonperformance Risk Adjustment The valuation of our embedded derivatives includes an adjustment for the risk that we fail to satisfy our obligations, which we refer to as our nonperformance risk. The nonperformance risk adjustment, which is captured as a spread over the risk-free rate in determining the discount rate to discount the cash flows of the liability, was previously determined by taking into consideration publicly available information relating to spreads in the secondary market for MetLife, Inc.’s debt, including related credit default swaps. In the third quarter of 2017, in connection with the Separation, we updated our assumptions for determining the credit spread underlying the nonperformance risk adjustment to be based on Brighthouse Financial, Inc.’s creditworthiness instead of that of MetLife, Inc. Our credit spread is determined by taking into consideration publicly available information relating to spreads in the secondary market for Brighthouse Financial, Inc.’s debt. These observable spreads are then adjusted, as necessary, to reflect the financial strength ratings of the issuing insurance subsidiaries as compared to the credit rating of Brighthouse Financial, Inc. The impact of this change in methodology resulted in an increase in net income (loss) available to shareholders before provision for income tax of $521 million ($339 million, net of income tax). The following table illustrates the impact that a range of reasonably likely variances in credit spreads would have on our consolidated and combined balance sheet, excluding the effect of income tax, related to the embedded derivative valuation on certain variable annuity products measured at estimated fair value. Even when credit spreads do not change, the impact of the nonperformance risk adjustment on fair value will change when the cash flows within the fair value measurement change. The table only reflects the impact of changes in credit spreads on the balance sheet and not these other potential changes. In determining the ranges, we have considered current market conditions, as well as the market level of spreads that can reasonably be anticipated over the near term. Income Taxes We provide for federal and state income taxes currently payable, as well as those deferred due to temporary differences between the financial reporting and tax bases of assets and liabilities. Our accounting for income taxes represents our best estimate of various events and transactions. Tax laws are often complex and may be subject to differing interpretations by the taxpayer and the relevant governmental taxing authorities. In establishing a provision for income tax expense, we must make judgments and interpretations about the application of tax laws. We must also make estimates about when in the future certain items will affect taxable income in the various taxing jurisdictions. In establishing a liability for unrecognized tax benefits, assumptions may be made in determining whether, and to what extent, a tax position may be sustained. Once established, unrecognized tax benefits are adjusted when there is more information available or when events occur requiring a change. Valuation allowances are established against deferred tax assets, particularly those arising from carryforwards, when management determines, based on available information, that it is more likely than not that deferred income tax assets will not be realized. The realization of deferred tax assets related to carryforwards depends upon the existence of sufficient taxable income within the carryforward periods under the tax law in the applicable tax jurisdiction. Significant judgment is required in projecting future taxable income to determine whether valuation allowances should be established, as well as the amount of such allowances. See Note 1 of the Notes to the Consolidated and Combined Financial Statements for additional information relating to our determination of such valuation allowances. We may be required to change our provision for income taxes when estimates used in determining valuation allowances on deferred tax assets significantly change, or when new information indicates the need for adjustment in valuation allowances. Additionally, future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the financial statements in the year these changes occur. See Notes 1 and 13 of the Notes to the Consolidated and Combined Financial Statements for additional information on our income taxes. Litigation Contingencies We are a party to a number of legal actions and may be involved in a number of regulatory investigations. Given the inherent unpredictability of these matters, it is difficult to estimate the impact on our financial position. Liabilities are established when it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. On a quarterly and annual basis, we review relevant information with respect to liabilities for litigation, regulatory investigations and litigation-related contingencies to be reflected in our results of operations and financial condition. See Note 15 of the Notes to the Consolidated and Combined Financial Statements for additional information regarding our assessment of litigation contingencies. Non-GAAP and Other Financial Disclosures Our definitions of the non-GAAP and other financial measures may differ from those used by other companies. Non-GAAP Financial Disclosures Adjusted Earnings In this report, we present adjusted earnings, which excludes net income (loss) attributable to noncontrolling interests, as a measure of our performance that is not calculated in accordance with GAAP. We believe that this non-GAAP financial measure highlights our results of operations and the underlying profitability drivers of our business, as well as enhances the understanding of our performance by the investor community. However, adjusted earnings should not be viewed as a substitute for net income (loss) available to Brighthouse Financial, Inc.’s common shareholders, which is the most directly comparable financial measure calculated in accordance with GAAP. See “- Results of Operations” for a reconciliation of adjusted earnings to net income (loss) available to Brighthouse Financial, Inc.’s common shareholders. Adjusted earnings, which may be positive or negative, is used by management to evaluate performance, allocate resources and facilitate comparisons to industry results. This financial measure focuses on our primary businesses principally by excluding (i) the impact of market volatility, which could distort trends, and (ii) businesses that have been or will be sold or exited by us, referred to as divested businesses. The following are significant items excluded from total revenues, net of income tax, in calculating adjusted earnings: • Net investment gains (losses); • Net derivative gains (losses) except earned income on derivatives and amortization of premium on derivatives that are hedges of investments or that are used to replicate certain investments, but do not qualify for hedge accounting treatment (“Investment Hedge Adjustments”); and • Amortization of unearned revenue related to net investment gains (losses) and net derivative gains (losses) and certain variable annuity GMIB fees (“GMIB Fees”). The following are significant items excluded from total expenses, net of income tax, in calculating adjusted earnings: • Amounts associated with benefits and hedging costs related to GMIBs (“GMIB Costs”); • Amounts associated with periodic crediting rate adjustments based on the total return of a contractually referenced pool of assets and market value adjustments associated with surrenders or terminations of contracts (“Market Value Adjustments”); and • Amortization of DAC and VOBA related to (i) net investment gains (losses), (ii) net derivative gains (losses), (iii) GMIB Fees and GMIB Costs and (iv) Market Value Adjustments. The tax impact of the adjustments mentioned is calculated net of the statutory tax rate, which could differ from our effective tax rate. We present adjusted earnings in a manner consistent with management’s view of the primary business activities that drive the profitability of our core businesses. The following table illustrates how each component of adjusted earnings is calculated from the GAAP statement of operations line items: _______________ (1) Italicized items indicate GAAP statement of operations line items. Consistent with GAAP guidance for segment reporting, adjusted earnings is also our GAAP measure of segment performance. Accordingly, we report adjusted earnings by segment in Note 2 of the Notes to the Consolidated and Combined Financial Statements. Adjusted Net Investment Income We present adjusted net investment income, which is not calculated in accordance with GAAP. We present adjusted net investment income to measure our performance for management purposes, and we believe it enhances the understanding of our investment portfolio results. Adjusted net investment income represents net investment income including investment hedge adjustments. For a reconciliation of adjusted net investment income to net investment income, the most directly comparable GAAP measure, see footnote 3 to the summary yield table located in “- Investments - Current Environment - Investment Portfolio Results.” Other Financial Disclosures The following additional information is relevant to an understanding of our performance results: • We sometimes refer to sales activity for various products. Statistical sales information for life sales are calculated using the LIMRA definition of sales for core direct sales, excluding company-sponsored internal exchanges, corporate-owned life insurance, bank-owned life insurance, and private placement variable universal life insurance. Annuity sales consist of 10% of direct statutory premiums, excluding company sponsored internal exchanges. These sales statistics do not correspond to revenues under GAAP but are used as relevant measures of business activity. • Allocated equity is the portion of common stockholders’ equity that management allocated to each of its segments prior to 2018. See “- Segment Capital” and Note 2 of the Notes to the Consolidated and Combined Financial Statements for further information. • Similar to adjusted net investment income, we present net investment income yields as a performance measure we believe enhances the understanding of our investment portfolio results. Net investment income yields are calculated on adjusted net investment income as a percent of average quarterly asset carrying values. Asset carrying values exclude unrealized gains (losses), collateral received in connection with our securities lending program, freestanding derivative assets, collateral received from derivative counterparties. Segment Capital Beginning in the first quarter of 2018, we changed the methodology for how capital is allocated to segments and, in some cases, products. Segment investment and capitalization targets are now based on statutory oriented risk principles and metrics. Segment invested assets backing liabilities are based on net statutory liabilities plus excess capital. For our variable annuity business, the excess capital held is based on the target statutory total asset requirement consistent with our variable annuity risk management strategy. See “Business - Risk Management Strategies - Variable Annuity Statutory Reserving Requirements and Exposure Management.” For insurance businesses other than variable annuities, excess capital held is based on a percentage of required statutory RBC. Assets in excess of those allocated to the segments, if any, are held in Corporate & Other. Segment net investment income reflects the performance of each segment’s respective invested assets. We refer to this change in methodology as the “Portfolio Realignment.” While this change had no effect on our consolidated net income (loss) or adjusted earnings, it did, and we expect will continue to, impact segment results. Prior period segment results were not recast for this change in methodology as the inventory of assets has changed over time. Therefore, it is not reasonably possible to replicate the asset transfers as of prior periods and estimating such would not provide a meaningful comparison. In the future, management will evaluate, on a periodic basis, the excess capital held by each segment and may rebalance or move capital between segments based on market changes or changes in our statutory metrics. Previously, invested assets held in the segments were based on net GAAP liabilities. Excess capital was retained in Corporate & Other and allocated to segments based on an internally developed statistics-based capital model intended to capture the material risks to which we were exposed (referred to as “allocated equity”). Surplus assets in excess of the combined allocations to the segments were held in Corporate & Other with net investment income being credited back to the segments at a predetermined rate. Any excess or shortfall in net investment income from surplus assets was recognized in Corporate & Other. Management is responsible for the periodic review and enhancement of the capital allocation model to ensure it remains consistent with the Company’s overall objectives and emerging industry practices. Results of Operations Index to Results of Operations Page Significant Business Actions Annual Actuarial Review Consolidated Results for the Years Ended December 31, 2018, 2017, and 2016 Reconciliation of Net Income (Loss) to Adjusted Earnings Consolidated Results for the Years Ended December 31, 2018, 2017 and 2016 - Adjusted Earnings Segments and Corporate & Other - Adjusted Earnings for the Years Ended December 31, 2018, 2017 and 2016 GMLB Riders for the Years Ended December 31, 2018, 2017 and 2016 Significant Business Actions The following table presents the effect on income (loss) before provision for income tax and pre-tax adjusted earnings from certain business actions undertaken by management that resulted in significant earnings impacts but are not indicative of underlying business performance in the period. These actions do not include the results from the AAR used in determining our insurance liabilities, which are separately discussed, nor other significant impacts to earnings from events that may occur as a result of normal business operations, such as market factors or regulatory changes. Items discussed in this section are referred to in the discussion of our results of operations and are intended to facilitate an understanding of that discussion. ULSG Model Change. In the second quarter of 2016, we refined our actuarial model which calculates the reserves for our ULSG products (the “ULSG Model Change”). The new model treats projected premiums and death claims differently than the previous model. This change resulted in a one-time charge to both income (loss) before provision for income tax and pre-tax adjusted earnings of $652 million for the year ended December 31, 2016. Of this one-time charge, $262 million resulted directly from the model refinements, as follows: • a $231 million increase in insurance-related liabilities; • a $24 million decrease in amortization of unearned revenue; and • a $7 million increase in amortization of DAC. The above impacts from the model change also resulted in a reduction of expected future gross profits, which drove our loss recognition margins negative, resulting in a further DAC write-off of $358 million and an increase in insurance-related liabilities of $32 million for the year ended December 31, 2016. In addition to the one-time charges, as a result of the lower expected future gross profits, we have recognized ongoing increases in insurance-related liabilities of $218 million and $132 million for the years ended December 31, 2017 and 2016, respectively, that are not included in the preceding table. We expect to recognize similar ongoing increases in future periods. ULSG Re-segmentation. In the fourth quarter of 2016, we moved the ULSG products out of the Life segment and into the Run-off segment. The move was triggered by the decision in late 2016 to cease sales of all ULSG products in early 2017 and to manage this business separately from the rest of the Life business. In accordance with our accounting policies, the move to a different segment required us to separately evaluate and test the ULSG products for loss recognition without being able to offset losses with future earnings from the variable and universal life products remaining in the Life segment. This re-segmentation driven loss recognition resulted in a decrease in both income (loss) before provision for income tax and pre-tax adjusted earnings of $614 million, of which $562 million was from the write-off of DAC and $52 million was from an increase in insurance-related liabilities. SPDA Recaptures. In 2016, in contemplation of the Separation, we recaptured certain blocks of single premium deferred annuities ceded to MLIC, a subsidiary of MetLife, on a 90% coinsurance basis (together, the “SPDA Recaptures”). The SPDA Recaptures resulted in a benefit to both income (loss) before provision for income tax and pre-tax adjusted earnings of $413 million for the year ended December 31, 2016, comprised of higher fee income of $303 million due to a net favorable settlement and a recovery of DAC amortization of $110 million. The SPDA Recaptures were primarily settled with market-adjusted assets-in-kind, which increased the invested asset base but also resulted in lower yields as compared to the yield used in determining the interest income recognized on the reinsurance receivable balances prior to the recaptures. Together these changes had additional impacts to net investment spread on a comparative basis which are not reflected in the preceding table. VA Recaptures. Effective January 1, 2017, certain ceded and assumed variable annuity reinsurance agreements with MLIC were recaptured (“VA Recaptures”). The initial settlement of these transactions resulted in a charge in the first quarter of 2017 which decreased income (loss) before provision for income tax by $277 million. Of this amount, $265 million was included in GMLB Riders, recognized in net derivative gains (losses). The remaining $12 million was included in pre-tax adjusted earnings, recognized in other expenses, net of DAC capitalization, partially offset by lower amortization of DAC and VOBA. Upon final settlement in the second quarter of 2017, we recognized a benefit of $137 million, of which $110 million was included in GMLB Riders in net derivative gains (losses), and $27 million was included in adjusted earnings in other revenue. ULSG Actions. In the fourth quarter of 2017, several actions involving our USLG business resulted in a net decrease to both income (loss) before provision for income tax and pre-tax adjusted earnings of $82 million. These actions included the following: • the recapture of certain Unaffiliated Third-Party Reinsurance agreements which resulted in net charges totaling $147 million; partially offset by • refinements to the actuarial valuation model, resulting in a net favorable impact of $65 million. Annual Actuarial Review Generally, in the third quarter of each year we conduct an annual actuarial review (the “AAR”). The 2018 AAR for our variable annuity business reflected the alignment to the statutory variable annuity capital reform framework. See “Business - Risk Management Strategies - Variable Annuity Statutory Reserving Requirements and Exposure Management.” These changes included lower lapse and utilization assumptions, consistent with updated Brighthouse policyholder experience and industry participants, as well as updates to the equity market scenario generator as reflected in the framework. We also updated the tax rate to reflect the statutory tax rate change due to the Tax Act. In our life business, we updated assumptions related to market returns, policyholder behavior and expenses. As a result of the 2017 AAR related to our variable annuity business, we made certain changes to policyholder behavior, harmonized models and assumptions between GAAP and statutory and reflected Brighthouse specific variables after the completion of the Separation from our former parent. Updates to assumptions for our life businesses were related to realized experience in terms of mortality, lapses and premium payment patterns. Additionally, while we did not revise our long-term general account rate setting methodology inherited from our former parent in the prior year, we did experience positive impacts from differentiating the blended general account earned rates between the Life and Run-off segments. As a result of the 2016 AAR related to our variable annuity business, we made certain changes to policyholder behavior and long-term economic assumptions, primarily relating to annuitization utilization, as well as withdrawals and risk margins. The 2016 review included an analysis of a larger body of actual experience than was previously available which, when combined with relevant industry-wide data that had recently become available, we believed provided greater insight into anticipated policyholder behavior for variable annuity contracts that are in-the-money. This experience included a statistically significant amount of our GMIB policies passing the ten year waiting period required to allow contract holders to use certain benefits and a longer period of experience in a low interest rate environment. The following table presents the impact on pre-tax adjusted earnings and net income (loss) before provision for income tax from the AARs for the years ended December 31, 2018, 2017 and 2016. The impact related to GMLBs is included in net income (loss) but is not included in pre-tax adjusted earnings. See “- Non-GAAP and Other Financial Disclosures.” Consolidated Results for the Years Ended December 31, 2018, 2017, and 2016 Business Overview. We continue to evaluate our product offerings with the goal to provide new products that are simpler, more transparent and provide value to our advisors, clients and shareholders. New business efforts in both 2017 and 2018 centered on the sale of our suite of structured annuities consisting of products marketed under various names (collectively, Shield Annuities), in addition to the introduction of several new fixed annuity products launched in the second half of 2017 and late 2018, driving a 36% increase in annuity sales compared to the year ended December 31, 2017. Unless otherwise noted, all amounts in the following discussions of our results of operations are stated before income tax except for adjusted earnings, which are presented net of income tax. The following table presents the components of net income (loss) available to shareholders, in addition to pre-tax adjusted earnings: GMLB Riders. The GMLB Riders reflect (i) changes in the carrying value of GMLB liabilities, including GMIBs, GMWBs and GMABs, and Shield Annuities; (ii) changes in the fair value of the related hedges as well as any ceded reinsurance of the liabilities; (iii) the fees earned from the GMLB liabilities; and (iv) the effects of DAC and VOBA amortization related to the preceding components. Other Derivative Instruments. We have other derivative instruments, in addition to the hedges and embedded derivatives included in the GMLB Riders, for which changes in fair value are recognized in net derivative gains (losses). Freestanding Derivatives. We have freestanding derivatives that economically hedge certain invested assets and insurance liabilities. The majority of this hedging activity is focused in the following areas: • use of interest rate swaps and swaptions in connection with the ULSG Hedge Program; • use of interest rate swaps when we have duration mismatches where suitable assets with maturities similar to those of our long-dated liabilities are not readily available in the market; and • use of foreign currency swaps when we hold fixed maturity securities denominated in foreign currencies that are matching insurance liabilities denominated in U.S. dollars. The market impacts on the hedges are accounted for in net income (loss) while the offsetting economic impact on the items they are hedging are either not recognized or recognized through OCI in equity. Embedded Derivatives. Certain ceded reinsurance agreements in our Life and Run-off segments are written on a coinsurance with funds withheld basis. The funds withheld component is accounted for as an embedded derivative with changes in the fair value recognized in net income (loss) in the period in which they occur. In addition, the changes in liability values of our index-linked annuity products that result from changes in the underlying equity index are accounted for as embedded derivatives. In connection with the transition to our variable annuity hedging program, changes in the fair value of the Shield Annuities were included in GMLB Riders beginning in the third quarter of 2017. Pre-tax Adjusted Earnings. As more fully described in “- Non-GAAP and Other Financial Disclosures,” we use adjusted earnings, which does not equate to net income (loss) available to shareholders, as determined in accordance with GAAP. We believe that the presentation of adjusted earnings, as we measure it for management purposes, enhances the understanding of our performance by highlighting the results of operations and the underlying profitability drivers of the business. Adjusted earnings and other financial measures based on adjusted earnings allow analysis of our performance relative to our business plan and facilitate comparisons to industry results. Adjusted earnings should not be viewed as a substitute for net income (loss). Year Ended December 31, 2018 Compared with the Year Ended December 31, 2017 Net income available to shareholders before provision for income tax was $984 million ($865 million, net of income tax), an increase of $1.6 billion ($1.2 billion, net of income tax) from a loss before provision for income tax of $615 million ($378 million, net of income tax) in the prior period. The increase was driven by the following key favorable items: • GMLB Riders, discussed in detail in “- GMLB Riders for the Years Ended December 31, 2018, 2017 and 2016;” • lower policyholder benefits and claims resulting from the adjustment for market performance related to participating products in the Run-off segment; and • a loss on the Shield Annuities embedded derivatives recognized in the prior period. The increase in income before provision for income tax was partially offset by the following key unfavorable items: • lower adjusted earnings, which is discussed in greater detail below; • higher net investment losses reflecting: ◦ higher current period net losses on sales of U.S. Treasuries due to portfolio repositioning actions and ◦ current period net losses on equity securities compared to prior period net gains; partially offset by ◦ higher current period net gains on real estate joint ventures; • changes in the fair value of other freestanding derivatives including: ◦ current period losses on interest rate swaps and swaptions in our ULSG Hedge Program from rising long-term interest rates; and ◦ the unfavorable impact on credit default swaps from credit spreads widening in the current period and narrowing in the prior period; partially offset by, ◦ the U.S. dollar strengthening in the current period and weakening in the prior period, favorably impacting foreign currency swaps. The provision for income tax in the current period led to an effective tax rate of 12%, compared to 39% in the prior period, and primarily differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. In the prior period we recognized a $1.1 billion non-cash tax charge in connection with the Separation, which was partially offset by a tax benefit of $725 million related to the Tax Act. Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Our net loss available to shareholders before provision for income tax was $615 million ($378 million, net of income tax), which improved by $4.1 billion ($2.6 billion, net of income tax), from a net loss before provision for income tax of $4.7 billion ($2.9 billion, net of income tax) in the prior period. The improvement was driven by the following key favorable items: • changes in the fair value of other freestanding derivatives including: ◦ the favorable changes in interest rates on the fair value of our interest rate swaps; partially offset by ◦ unfavorable changes in our foreign currency swaps due to the U.S. dollar weakening against key foreign currencies in the current period when compared to the prior period. • GMLB Riders, discussed in detail in “- GMLB Riders for the Years Ended December 31, 2018, 2017 and 2016;” • higher adjusted earnings discussed in detail below; • charges in the prior period for an impairment of goodwill in our Run-off segment; • the write-off of previously capitalized items in Corporate & Other in connection with the sale of MPCG to MassMutual; • lower net investment losses reflecting: ◦ higher impairments in the prior period on real estate joint ventures and fixed maturity securities; ◦ higher current period net gains on sales of equity securities; and ◦ lower current period net losses on sales of fixed maturity securities; partially offset by ◦ current period net losses compared to prior period net gains on foreign currency transactions and ◦ current period net losses on commercial mortgage loans compared to prior period net gains. The increase in income before provision for income tax was partially offset by the change in fair value of the Shield Annuities embedded derivatives. The provision for income tax in the current period led to an effective tax rate of 39%, compared to 38% in the prior period, and primarily differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. In the current period we recognized a $1.1 billion non-cash tax charge in connection with the Separation, which was partially offset by a tax benefit of $725 million related to the Tax Act. Reconciliation of Net Income (Loss) Available to Shareholders to Adjusted Earnings The following tables reconcile net income (loss) available to shareholders to adjusted earnings: Consolidated Results for the Years Ended December 31, 2018, 2017, and 2016 - Adjusted Earnings The following table presents the components of adjusted earnings: Year Ended December 31, 2018 Compared with the Year Ended December 31, 2017 Adjusted earnings decreased $28 million. Key unfavorable impacts were: • lower fee income due to: ◦ a benefit from tax-related adjustments recognized in other revenues in the prior period, which had a partial offset in tax expense in Corporate & Other; ◦ lower asset-based fees resulting from lower average separate account balances in our Annuities segment; and ◦ the comparative impacts in the AAR, mostly due to mortality and maintenance expense assumptions in our Life segment; partially offset by ◦ higher retained fees from the recapture of reinsurance agreements in the current period in our ULSG business. • higher amortization of DAC and VOBA due to: ◦ net unfavorable impacts from the AAR in the current period than the prior period and ◦ negative equity market performance. • higher other expenses from: ◦ higher establishment costs related to planned technology and branding expenses and ◦ increased operating costs as a stand-alone company. • net costs from insurance-related activities increased due to: ◦ reserve growth and unfavorable mortality in our ULSG business; partially offset by ◦ lower GMDB liabilities resulting from the AAR in our Annuities segment and ◦ higher retained premiums, from the ongoing impacts of a reinsurance recapture in the prior period in our Life segment. The decrease in adjusted earnings was partially offset by an increase in net investment spread. The provision for income tax in the current period led to an effective tax rate of 13%, compared to 42% in the prior period. In the prior period we recognized a $1.1 billion non-cash tax charge in connection with the Separation, which was partially offset by a tax benefit of $725 million related to the Tax Act. Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Adjusted earnings increased $234 million. Key favorable impacts were: • lower amortization of DAC and VOBA due to: ◦ charges recognized in the prior period from loss recognition triggered by the ULSG Model Change in our Run-off segment and ◦ refinements to the amortization period as a result of the current period AAR in our Annuities segment; • net costs of insurance-related activities decreased due to: ◦ charges recognized in the prior period, net of additional charges in the current period, related to the ULSG Model Change and associated loss recognition in our Run-off segment and ◦ a favorable change in the fair value of underlying ceded separate account assets related to a reinsurance agreement for certain variable annuity contracts. The increase in adjusted earnings was partially offset by the following unfavorable impacts: • higher other expenses increased from: ◦ higher establishment costs related to planned technology and branding expenses; ◦ increased operating costs as a stand-alone company; and ◦ higher asset-based expenses in our Annuities segment; • net investment spread decreased reflecting lower net investment income in our Annuities segment and Corporate & Other, which is discussed in greater detail below; • lower fee income decreased due to: ◦ a decline in our annuities segment related to the SPDA recaptures; partially offset by ◦ higher asset-based fees and ◦ a benefit from tax-related adjustments recognized in other revenues in the current period, which had a partial offset in tax expense in Corporate & Other. The provision for income tax in the current period led to an effective tax rate of 42%, compared to 21% in the prior year. In the current period we recognized a $1.1 billion non-cash tax charge in connection with the Separation, which was partially offset by a tax benefit of $725 million related to the Tax Act. Segments and Corporate & Other - Adjusted Earnings for the Years Ended December 31, 2018, 2017, and 2016 Annuities The following table presents the components of adjusted earnings for our Annuities segment: A significant portion of our adjusted earnings is driven by separate account balances related to our variable annuity business. Most directly, these balances determine asset-based fee income, but they also impact DAC amortization and asset-based commissions. Separate account balances are driven by sales, market movements, surrenders, withdrawals, benefit payments, policy charges and transfers. Below is a rollforward of our variable annuities separate account balances. Variable annuities separate account balances decreased in 2018 driven by the weak equity market performance and negative net flows. Year Ended December 31, 2018 Compared with the Year Ended December 31, 2017 Adjusted earnings increased $6 million. Key favorable impacts were: • higher net investment income driven by: ◦ a higher net invested asset base due to the Portfolio Realignment; ◦ repositioning of the investment portfolio into higher yielding assets; ◦ higher income on other limited partnership interests from improved equity performance; and ◦ higher average invested assets resulting from positive net flows in the general account; • lower costs associated with insurance-related activities due to: ◦ a decrease in GMDB liability balances resulting from the AAR, partially offset by; ◦ a less favorable adjustment to deferred sales inducements (“DSI”) from the AAR in the current period than in the prior period. The increase in adjusted earnings was partially offset by the following key unfavorable items: • higher DAC and VOBA amortization driven by: ◦ less favorable impacts from the AAR in the current period than the prior period and ◦ negative equity market performance in the current period; • lower fee income due to: ◦ lower asset-based fees resulting from lower average separate account balances and ◦ a net benefit recognized in the prior period as a result of reinsurance activity; • higher other expenses due to: ◦ increased operating costs as a stand-alone company and ◦ higher variable annuity pass-through expenses due to changes in arrangements with third-parties for investment management and revenue sharing fees in connection with the Separation; partially offset by ◦ the exit of various transition services agreements with MetLife in the current period. The provision for income tax in the current period led to an effective tax rate of 17%, compared to 27% in the prior period. Our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Adjusted earnings decreased by $135 million. Key unfavorable impacts were: • higher other expenses reflecting ◦ increased operating costs as a stand-alone company and ◦ higher variable annuity pass-through expenses due to changes in arrangements with third-parties for investment management and revenue sharing fees in connection with the Separation; • lower fee income including ◦ a benefit recorded in the prior period in connection with the SPDA Recapture and ◦ a deferred gain related to the VA Recaptures recognized in the prior period; partially offset by ◦ increased revenue sharing fees which are passed through to third parties and have an offset in other expenses and ◦ higher asset-based fees from higher average separate account balances; • lower net investment income reflecting ◦ lower derivative income resulting from the termination of interest rate swaps; ◦ lower reinvestment yields on fixed maturities; and ◦ lower prepayment fees; partially offset by ◦ positive general account net flows. The decrease in adjusted earnings was partially offset by the following key favorable items: • lower amortization of DAC and VOBA reflecting ◦ refinements to the amortization period in connection with the AAR in the current period; partially offset by ◦ a prior period recovery in connection with the SPDA Recaptures; • lower net costs from insurance-related activities due to ◦ a favorable change in the fair value of ceded separate account assets under a reinsurance agreement for certain variable annuity contracts and ◦ lower amortization of DSI mostly from refinements to the amortization period as part of the AAR in the current period. The provision for income tax in the current period led to an effective tax rate of 27%, compared to 30% in the prior period. Our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. Life The following table presents the components of adjusted earnings for our Life segment: Year Ended December 31, 2018 Compared with the Year Ended December 31, 2017 Adjusted earnings increased by $212 million. Key favorable items were: • higher net investment income reflecting ◦ a higher net invested asset base due to the Portfolio Realignment and ◦ repositioning of the investment portfolio into higher yielding assets; • lower amortization of DAC and VOBA resulting from comparative impacts in the AAR, mostly due to mortality assumptions; • lower costs of insurance-related activities, due to the ongoing impacts in the current period for the yearly renewable term reinsurance recapture (the “YRT Recapture”) in the prior year; • lower other expenses reflecting ◦ the exit in the current period of various transition services agreements with MetLife, partially offset by ◦ a change in allocation between segments. These favorable impacts were partially offset by: • lower fee income including ◦ the comparative impacts in the AAR, mostly due to mortality and maintenance expense assumptions and ◦ lower ceded fees resulting from the recapture of various reinsurance agreements in 2017 and 2018. The provision for income tax in the current period led to an effective tax rate of 20%. Our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividend received deduction. Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Adjusted earnings decreased $10 million. The decrease was primarily driven by the following unfavorable items: • higher costs of insurance-related activities including ◦ higher paid claims, net of reinsurance and ◦ a net increase in costs resulting from reinsurance recapture transactions in both periods; • lower net investment spread reflecting ◦ lower reinvestment yields on fixed maturities; ◦ lower funds withheld assets as a result of reinsurance activity; and ◦ a reduction in interest on allocated equity as a result of reduced interest credited and allocated equity assets; partially offset by ◦ higher returns on other limited partnership interests from improved equity market performance; The decrease in adjusted earnings was partially offset by lower amortization of DAC and VOBA reflecting: ◦ prior year recapture transactions and ◦ the impact on gross profits from higher policyholder benefits and claims in the current period; partially offset by ◦ assumptions regarding mortality and maintenance expenses in connection with the AAR. The provision for income tax in the current period led to an effective tax rate that is not meaningful in the current period. There was no income tax expense in the prior year. Run-off The following table presents the components of adjusted earnings for our Run-off segment: Year Ended December 31, 2018 Compared with the Year Ended December 31, 2017 Adjusted earnings decreased by $147 million. The decrease was primarily driven by the following unfavorable items: • higher costs associated with insurance-related activities due to: ◦ ULSG reserve growth and unfavorable mortality and ◦ the net impact of recapture transactions in both periods; partially offset by ◦ net impact of the changes to pension risk transfer reserves; • lower net investment income reflecting: ◦ a lower net invested asset base due to the Portfolio Realignment; ◦ lower income on interest rate derivatives; and ◦ lower securities lending income as a result of lower margins due to the impact of a flatter yield curve and a reduction in program size; partially offset by ◦ higher income on other limited partnership interests from improved equity market performance. The decrease in adjusted earnings was partially offset by the following favorable items: • higher fee income including: ◦ lower ceded fees from the recapture of reinsurance agreements in the current period; partially offset by ◦ a benefit recognized in the prior period from changes to assumptions, primarily long-term earned rates, maintenance expenses and premiums in connection with the AAR; • lower other expenses reflecting: ◦ lower costs related to reinsurance financing arrangements that were terminated in the second quarter of 2017. The provision for income tax in the current period led to an effective tax rate of 24%, compared to 29% in the prior period. Our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividends received deductions. Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Adjusted earnings increased $643 million. Key favorable impacts were: • lower amortization of DAC and VOBA resulting from the write-off of the DAC asset in the prior period due to loss recognition triggered by the ULSG Model Change and ULSG Re-segmentation, which also resulted in no amortization in the current year; • lower costs of insurance-related activities due to: ◦ a net charge recognized in the prior period in connection with the ULSG Model Change; partially offset by ◦ an increase in net costs associated with ULSG from ULSG actions, recurring impacts of the ULSG Re-segmentation and additional loss recognition in the current period and ◦ an increase in pension risk transfer reserves; • lower fee income including: ◦ a refinement in allocation of ceded reinsurance fees between the Run-off and Life Segments, partially offset by ◦ changes in connection with the AAR regarding premium persistency and mortality assumptions. The provision for income tax in the current period led to an effective tax rate of 29%, compared to 35% from income tax expense in the prior period. Our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividend received deductions. Corporate & Other The following table presents the components of adjusted earnings for Corporate & Other: Year Ended December 31, 2018 Compared with the Year Ended December 31, 2017 Adjusted earnings decreased $99 million. Key unfavorable impacts were: • lower fee income due to a benefit from tax-related adjustments recognized in other revenues in the prior period, which had a partial offset in tax expense; • lower net investment income reflecting: ◦ a lower net invested asset base due to the Portfolio Realignment and ◦ lower income on derivatives from the termination of interest rate swaps; • higher establishment costs related to planned technology and branding expenses. In the prior period we recognized a $1.1 billion non-cash tax charge in connection with the Separation, which was partially offset by a tax benefit of $725 million related to the Tax Act. These adjustments resulted in an effective tax rate percentage that is not meaningful for comparison purposes and accordingly has not been included. Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Adjusted earnings decreased $264 million. Key unfavorable impacts were driven primarily by: • higher other expenses from higher establishment costs related to planned technology and branding expenses; • lower net investment income reflecting: ◦ a reduction in the invested asset base from a reduction in economic capital managed by the segment as a result of the termination of certain collateral financing arrangements in connection with the formation of BRCD and a cash distribution paid to MetLife in the current period in connection with the Separation; ◦ lower returns on other limited partnerships; and ◦ lower income from our securities lending program as a result of a reduction in program size, as well as lower margins resulting from a flatter yield curve. The decrease in adjusted earnings was partially offset by higher fee income due to a benefit from tax-related adjustments recognized in other revenues in the current period, which had a partial offset in tax expense. In the current period we recognized a $1.1 billion non-cash tax charge in connection with the Separation, which was partially offset by a tax benefit of $725 million related to the Tax Act. These adjustments resulted in effective tax rate percentages that are not meaningful for comparison purposes and accordingly have not been included. GMLB Riders for the Years Ended December 31, 2018, 2017 and 2016 The following table presents the overall impact on income (loss) before provision for income tax from the performance of GMLB Riders for (i) changes in carrying value of the GAAP liabilities, (ii) the mark-to-market of hedges and reinsurance, (iii) fees, and (iv) associated DAC amortization. ______________ (1) Includes cumulative changes in fair value of the Shield Annuities embedded derivatives of $358 million and ($305) million for the years ended December 31, 2018 and 2017, respectively. Changes in the fair value of the Shield Annuities embedded derivatives were not included in the GMLB results for the first and second quarters of 2017 and the year ended December 31, 2016. (2) Certain hedges of GMIB insurance liabilities were historically reported in policyholder benefits and claims. Amounts reported in policyholder benefits and claims were ($324) million and ($278) million for the years ended December 31, 2017 and 2016, respectively. Consistent with the hedge strategy now focused on a statutory target, with less emphasis on matching GAAP liabilities, all hedge program amounts were recorded in net derivative gains (losses) beginning in 2018. (3) Excludes living benefit fees, included as a component of adjusted earnings, of $69 million, $71 million and $76 million for the years ended December 31, 2018, 2017 and 2016, respectively. GMLB Liabilities. Liabilities reported as part of GMLB Riders (“GMLB Liabilities”) include (i) guarantee rider benefits accounted for as embedded derivatives, (ii) guarantee rider benefits accounted for as insurance and (iii) Shield Annuities embedded derivatives. Liabilities related to guarantee rider benefits represent our obligation to protect policyholders against the possibility that a downturn in the markets will reduce the specified benefits that can be claimed under the base annuity contract. Any periods of significant and/or sustained downturns in equity markets, increased equity volatility, or reduced interest rates could result in an increase in the valuation of these liabilities. An increase in these liabilities would result in a decrease to our net income (loss) available to shareholders, which could be significant. Shield Annuities currently offered provide the ability for the contract holder to participate in the appreciation of certain financial markets up to a stated level, while offering protection from a portion of declines in the applicable indices or benchmark. We believe that Shield Annuities may provide us with risk offset to liabilities related to guarantee rider benefits. GMLB Hedging Program and Reinsurance. We enter into freestanding derivatives to hedge the market risks inherent in the GMLB Liabilities. Generally, the same market factors that impact the fair value of the guarantee rider embedded derivatives impact the value of the hedges, though in the opposite direction. However, the changes in value of the GMLB Liabilities and related hedges may not be symmetrical and the divergence could be significant due to certain factors, such as the guarantee riders accounted for as insurance are not recognized at fair value and there are unhedged risks within the GMLB Liabilities. We may also use reinsurance to manage our exposure related to the GMLB Liabilities. GMLB Fees. We earn fees from the guarantee rider benefits, which are calculated based on the policyholder’s Benefit Base. Fees calculated based on the Benefit Base are more stable in market downturns, compared to fees based on the account value because the Benefit Base excludes the impact of a decline in the market value of the policyholder’s account value. We use the fees directly earned from the guarantee riders to fund the reserves, future claims and costs associated with the hedges of market risks inherent in these liabilities. For guarantee rider embedded derivatives, the future fees are included in the fair value of the embedded derivative liabilities, with changes recorded in net derivative gains (losses). For guarantee rider benefits accounted for as insurance, while the related fees do affect the valuation of these liabilities, they are not included in the resulting liability values, but are recorded separately in universal life and investment-type policy fees. GMLB DAC. Changes in the fair value of GMLB Liabilities that are accounted for as embedded derivatives result in a corresponding recognition of DAC amortization that generally has an inverse effect on net income (loss), which we refer to as the DAC offset. While the DAC offset is generally the most significant driver of GMLB DAC, it can be impacted by other adjustments including amortization related to guarantee benefit riders accounted for as insurance. Year Ended December 31, 2018 Compared with the Year Ended December 31, 2017 Comparative results from GMLB Riders were favorable by $2.3 billion. Of this amount, a favorable change of $2.4 billion was recorded in net derivative gains (losses). This change was mostly driven by a decrease in equity market performance, particularly in the fourth quarter of 2018, which impacted the following: • a favorable change in the fair value of equity derivatives in our GMLB Hedging Program and • a favorable change in the fair value of the Shield Annuities embedded derivatives; partially offset by • an increase in the liability reserves for the guarantee rider embedded derivatives, net of the favorable change in non-performance risk driven by a widening of credit spreads in the current period. These net favorable effects from the decline in equity markets were partially offset by an unfavorable change in comparative results related to GMLB DAC reflecting: • an unfavorable change in the offset related to the cumulative historical losses in the GMLB Hedging Program and • an unfavorable change in the offset related to the change in non-performance risk associated with the guarantee rider embedded derivatives; partially offset by • higher amortization recognized in the prior period in connection with the AAR, primarily from changes in the amortization period and the use of Brighthouse’s post-separation credit spread, instead of that of MetLife, in the calculation of the non-performance risk adjustment. Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016 Comparative results from GMLB Riders were favorable by $1.3 billion. Of this amount, a favorable change of $2.6 billion was recorded in net derivative gains (losses). This change was mostly driven by: • a favorable change from increases in guarantee rider embedded derivatives, recognized in the prior period, related to changes in assumptions for policyholder behavior and risk margins in connection with the AAR, which also resulted in an unfavorable change in GMLB DAC; partially offset by • unfavorable changes resulting from market factors as higher equity market performance more than offset the effects of interest rates increasing less in the current period than in the prior period; and • an unfavorable change in the fair value of the Shield Annuities embedded derivatives recognized in the current period. The market factors noted above resulted in an unfavorable comparative change in our GMLB Hedging Program which was partially offset by favorable changes in the GMLB Liabilities and GMLB DAC. Effects of Inflation Management believes that inflation has not had a material effect on the Company’s results of operations, except insofar as inflation may affect interest rates. An increase in inflation could affect our business in several ways. During inflationary periods, the value of fixed income investments falls which could increase realized and unrealized losses. Inflation also increases expenses for labor and other materials, potentially putting pressure on profitability if such costs cannot be passed through in our product prices. Prolonged and elevated inflation could adversely affect the financial markets and the economy generally and dispelling it may require governments to pursue a restrictive fiscal and monetary policy, which could constrain overall economic activity, inhibit revenue growth and reduce the number of attractive investment opportunities. Investments Investment Risks Our primary investment objective is to optimize risk-adjusted net investment income and risk-adjusted total return while appropriately matching assets and liabilities. In addition, the investment process is designed to ensure that the portfolio has an appropriate level of liquidity, quality and diversification. We are exposed to the following primary sources of investment risks: • credit risk, relating to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest; • interest rate risk, relating to the market price and cash flow variability associated with changes in market interest rates. Changes in market interest rates will impact the net unrealized gain or loss position of our fixed income investment portfolio and the rates of return we receive on both new funds invested and reinvestment of existing funds; • market valuation risk, relating to the variability in the estimated fair value of investments associated with changes in market factors such as credit spreads and equity market levels. A widening of credit spreads will adversely impact the net unrealized gain (loss) position of the fixed income investment portfolio, will increase losses associated with credit-based non-qualifying derivatives while we assume credit exposure, and, if credit spreads widen significantly or for an extended period of time, will likely result in higher OTTI. Credit spread tightening will reduce net investment income associated with new purchases of fixed maturity securities and will favorably impact the net unrealized gain (loss) position of the fixed income investment portfolio; • liquidity risk, relating to the diminished ability to sell certain investments, in times of strained market conditions; • real estate risk, relating to commercial, agricultural and residential real estate, and stemming from factors, which include, but are not limited to, market conditions, including the demand and supply of leasable commercial space, creditworthiness of borrowers and their tenants and joint venture partners, capital markets volatility and inherent interest rate movements; • currency risk, relating to the variability in currency exchange rates for foreign denominated investments; and • financial and operational integration risks while we transition to a multiple manager investment platform, and following such transition, we will continue to be subject to the risks related to using external investment managers. We manage these risks through asset-type allocation and industry and issuer diversification. Risk limits are also used to promote diversification by asset sector, avoid concentrations in any single issuer and limit overall aggregate credit and equity risk exposure. Real estate risk is managed through geographic and property type and product type diversification. We manage interest rate risk as part of our Asset Liability Management (“ALM”) strategies. Product design, such as the use of market value adjustment features and surrender charges, is also utilized to manage interest rate risk. These strategies include maintaining an investment portfolio with diversified maturities that targets a weighted average duration that reflects the duration of our estimated liability cash flow profile. For certain of our liability portfolios, it is not possible to invest assets to the full liability duration, thereby creating some asset/liability mismatch. We also use certain derivatives in the management of currency, credit, interest rate, and equity market risks. Investment Management Agreements Following the Separation, MLIA managed our investment portfolio pursuant to several investment management agreements. On February 5, 2019, we terminated several existing investment management agreements with MLIA and entered into the new Investment Management Agreement with MLIA, pursuant to which MLIA will, on a sub-advisory basis, manage the investment of the assets comprising the general account portfolio, as well as certain separate account assets of our insurance subsidiaries, as well as assets of BHF and our non-insurance subsidiaries. As part of the termination of the prior investment management agreements, we brought our derivatives trading, which had previously been managed by MLIA, in-house. The Investment Management Agreement marks one of the initial steps in the transition of our investment portfolio to a multi-manager platform, which is expected to occur in stages throughout 2019. Accordingly, the Investment Management Agreement allows us flexibility to partially terminate investment management services for specified investments upon prior notice to MLIA, which we intend to do as we engage a select group of experienced external asset management firms to provide services previously provided under the Investment Management Agreement. Current Environment Our business and results of operations are materially affected by conditions in capital markets and the economy, generally. As a U.S. insurance company, we are affected by the monetary policy of the Federal Reserve Board in the United States. In December 2018, the Federal Open Market Committee increased the federal funds rate, the fourth such increase in 2018. The Federal Reserve may take further actions to influence interest rates in the future, which may have an impact on the pricing levels of risk-bearing investments and may adversely impact the level of product sales. We are also affected by the monetary policy of central banks around the world due to the diversification of our investment portfolio. See “- Industry Trends and Uncertainties - Financial and Economic Environment.” Selected Investments On January 29, 2019, PG&E Corporation (“PG&E”) filed for bankruptcy related to potential liabilities from wildfires in California. We have direct exposure to PG&E in fixed maturity securities with an estimated fair value and amortized cost of $35 million and $43 million, respectively, at December 31, 2018. The estimated fair value and amortized cost of our indirect exposure to PG&E through fixed maturity securities was $59 million and $61 million, respectively, at December 31, 2018. In addition, we hold a lease equity position with indirect exposure to PG&E with a carrying value of $65 million at December 31, 2018. Investment Portfolio Results The table below presents the yield and adjusted net investment income for our investment portfolio. As described below, this table reflects certain differences from the presentation of net investment income presented in the GAAP statement of operations. This summary yield table presentation is consistent with how we measure our investment performance for management purposes, and we believe it enhances understanding of our investment portfolio results. _______________ (1) Yields are calculated as investment income as a percent of average quarterly asset carrying values. Investment income excludes recognized gains and losses and reflects the adjustments presented in Note 3 below to arrive at adjusted net investment income. Asset carrying values exclude unrealized gains (losses), collateral received in connection with our securities lending program, freestanding derivative assets and collateral received from derivative counterparties. (2) Adjusted net investment income included in yield calculations includes Investment Hedge Adjustments. (3) Adjusted net investment income presented in the yield table varies from the most directly comparable GAAP measure due to certain reclassifications, as presented below. See “- Results of Operations - Consolidated Results - Year Ended December 31, 2018 Compared with the Year Ended December 31, 2017” and “- Results of Operations - Consolidated Results -Year Ended December 31, 2017 Compared with the Year Ended December 31, 2016,” for an analysis of the year over year changes in net investment income. Fixed Maturity Securities AFS The following table presents fixed maturity securities AFS by type (public or private) held at: Valuation of Securities. See Note 8 of the Notes to the Consolidated Financial Statements for further information on our valuation controls and procedures including our formal process to challenge any prices received from independent pricing services that are not considered representative of estimated fair value. Fixed Maturity Securities AFS See Notes 1 and 6 of the Notes to the Consolidated Financial Statements for information about fixed maturity securities AFS by sector, contractual maturities and continuous gross unrealized losses. Fixed Maturity Securities Credit Quality - Ratings Rating agency ratings are based on availability of applicable ratings from rating agencies on the NAIC credit rating provider list, including Moody’s Investors Service, Inc. (“Moody’s”), S&P, Fitch, Dominion Bond Rating Service, A.M. Best, Kroll Bond Rating Agency, Egan Jones Ratings Company and Morningstar, Inc. (“Morningstar”). If no rating is available from a rating agency, then an internally developed rating is used. The NAIC has methodologies to assess credit quality for certain Structured Securities comprised of non-agency RMBS, CMBS and asset backed securities (“ABS”). The NAIC’s objective with these methodologies is to increase the accuracy in assessing expected losses, and to use the improved assessment to determine a more appropriate capital requirement for such Structured Securities. The methodologies reduce regulatory reliance on rating agencies and allow for greater regulatory input into the assumptions used to estimate expected losses from Structured Securities. We apply the NAIC methodologies to Structured Securities held by our insurance subsidiaries. The NAIC’s present methodology is to evaluate Structured Securities held by insurers on an annual basis. If our insurance subsidiaries acquire Structured Securities that have not been previously evaluated by the NAIC but are expected to be evaluated by the NAIC in the upcoming annual review, an internally developed designation is used until a final designation becomes available. The following table presents total fixed maturity securities by NRSRO rating and the applicable NAIC designation from the NAIC published comparison of NRSRO ratings to NAIC designations, except for certain Structured Securities, which are presented using the revised NAIC methodologies, as well as the percentage, based on estimated fair value that each NAIC designation is comprised of at: The following tables present total fixed maturity securities, based on estimated fair value, by sector classification and by NRSRO rating and the applicable NAIC designations from the NAIC published comparison of NRSRO ratings to NAIC designations, except for certain Structured Securities, which are presented using the NAIC methodologies as described above: U.S. and Foreign Corporate Fixed Maturity Securities We maintain a diversified portfolio of corporate fixed maturity securities across industries and issuers. This portfolio does not have any exposure to any single issuer in excess of 1% of total investments and the top ten holdings in aggregate comprise 2% of total investments at both December 31, 2018 and 2017. The tables below present our U.S. and foreign corporate securities holdings by industry at: Structured Securities We held $15.9 billion and $13.2 billion of Structured Securities, at estimated fair value, at December 31, 2018 and 2017, respectively, as presented in the RMBS, CMBS and ABS sections below. RMBS The following table presents our RMBS holdings at: Historically, we have managed our exposure to sub-prime RMBS holdings by focusing primarily on senior tranche securities, stress testing the portfolio with severe loss assumptions and closely monitoring the performance of the portfolio. Our sub-prime RMBS portfolio consists predominantly of securities that were purchased after 2012 at significant discounts to par value and discounts to the expected principal recovery value of these securities. The vast majority of these securities are investment grade under the NAIC designations (e.g., NAIC 1 and NAIC 2). The estimated fair value of our sub-prime RMBS holdings purchased since 2012 was $883 million and $976 million at December 31, 2018 and 2017, respectively, with unrealized gains (losses) of $50 million and $65 million at December 31, 2018 and 2017, respectively. CMBS Our CMBS holdings are diversified by vintage year. The following tables present our CMBS holdings by vintage year at: CMBS rated Aaa using rating agency ratings were $3.5 billion, or 66.9% of total CMBS, and designated NAIC 1 were $5.2 billion, or 98.8% of total CMBS, at December 31, 2018. CMBS Aaa rating agency ratings were $2.3 billion, or 65.8% of total CMBS, and designated NAIC 1 were $3.4 billion, or 100.0% of total CMBS at December 31, 2017. ABS Our ABS are diversified both by collateral type and by issuer. The following table presents our ABS holdings at: Evaluation of AFS Securities for OTTI and Temporary Impairment See Note 6 of the Notes to the Consolidated Financial Statements for information about the evaluation of fixed maturity securities AFS for OTTI and temporary impairment. Securities Lending We participate in a securities lending program whereby securities are loaned to third parties, primarily brokerage firms and commercial banks. We obtain collateral, usually cash, in an amount generally equal to 102% of the estimated fair value of the securities loaned, which is obtained at the inception of a loan and maintained at a level greater than or equal to 100% for the duration of the loan. We monitor the estimated fair value of the securities loaned on a daily basis with additional collateral obtained as necessary throughout the duration of the loan. Securities loaned under such transactions may be sold or repledged by the transferee. We are liable to return to our counterparties the cash collateral under our control. Security collateral received from counterparties may not be sold or repledged, unless the counterparty is in default, and is not reflected in the financial statements. These transactions are treated as financing arrangements and the associated cash collateral liability is recorded at the amount of the cash received. See “- Liquidity and Capital Resources - The Company - Liquidity and Capital Uses - Securities Lending” and Note 6 of the Notes to the Consolidated Financial Statements for information regarding our securities lending program. Mortgage Loans Our mortgage loans are principally collateralized by commercial, agricultural and residential properties. Mortgage loans and the related valuation allowances are summarized as follows at: We diversify our mortgage loan portfolio by both geographic region and property type to reduce the risk of concentration. Of our commercial and agricultural mortgage loan portfolios, at both December 31, 2018 and 2017, 97% were collateralized by properties located in the U.S. and the remainder was collateralized by properties located outside of the U.S. The carrying value as a percentage of total commercial and agricultural mortgage loans for the top three states in the U.S. is as follows at: Additionally, we manage risk when originating commercial and agricultural mortgage loans by generally lending up to 75% of the estimated fair value of the underlying real estate collateral. We manage our residential mortgage loan portfolio in a similar manner to reduce risk of concentration. All residential mortgage loans were collateralized by properties located in the U.S. at both December 31, 2018 and 2017. The carrying value as a percentage of total residential mortgage loans for the top three states in the U.S. is as follows at: Commercial Mortgage Loans by Geographic Region and Property Type. Commercial mortgage loans are the largest component of the mortgage loan invested asset class. The tables below present the diversification across geographic regions and property types of commercial mortgage loans at: Mortgage Loan Credit Quality - Monitoring Process. Our investment manager monitors our mortgage loan investments on an ongoing basis, including a review of loans that are current, past due, restructured and under foreclosure. Quarterly, we conduct a formal review of the portfolio with our manager. See Note 6 of the Notes to the Consolidated and Combined Financial Statements for information on mortgage loans by credit quality indicator, past due and nonaccrual mortgage loans, as well as impaired mortgage loans. Our investment manager reviews our commercial mortgage loans on an ongoing basis. These reviews may include an analysis of the property financial statements and rent roll, lease rollover analysis, property inspections, market analysis, estimated valuations of the underlying collateral, loan-to-value ratios, debt service coverage ratios and tenant creditworthiness. The monitoring process focuses on higher risk loans, which include those that are classified as restructured, delinquent or in foreclosure, as well as loans with higher loan-to-value ratios and lower debt service coverage ratios. The monitoring process for agricultural mortgage loans is generally similar, with a focus on higher risk loans, such as loans with higher loan-to-value ratios, including reviews on a geographic and sector basis. We review our residential mortgage loans on an ongoing basis. See Note 6 of the Notes to the Consolidated and Combined Financial Statements for information on our evaluation of residential mortgage loans and related valuation allowance methodology. Loan-to-value ratios and debt service coverage ratios are common measures in the assessment of the quality of commercial mortgage loans. Loan-to-value ratios are a common measure in the assessment of the quality of agricultural mortgage loans. Loan-to-value ratios compare the amount of the loan to the estimated fair value of the underlying collateral. A loan-to-value ratio greater than 100% indicates that the loan amount is greater than the collateral value. A loan-to-value ratio of less than 100% indicates an excess of collateral value over the loan amount. Generally, the higher the loan-to-value ratio, the higher the risk of experiencing a credit loss. The debt service coverage ratio compares a property’s net operating income to amounts needed to service the principal and interest due under the loan. Generally, the lower the debt service coverage ratio, the higher the risk of experiencing a credit loss. For our commercial mortgage loans, our average loan-to-value ratio was 52% and 51% at December 31, 2018 and 2017, respectively, and our average debt service coverage ratio was 2.2x and 2.3x at December 31, 2018 and 2017, respectively. The debt service coverage ratio, as well as the values utilized in calculating the ratio, is updated annually on a rolling basis, with a portion of the portfolio updated each quarter. In addition, the loan-to-value ratio is routinely updated for all but the lowest risk loans as part of our ongoing review of our commercial mortgage loan portfolio. For our agricultural mortgage loans, our average loan-to-value ratio was 46% and 43% at December 31, 2018 and 2017, respectively. The values utilized in calculating the agricultural mortgage loan loan-to-value ratio are developed in connection with the ongoing review of the agricultural loan portfolio and are routinely updated. Mortgage Loan Valuation Allowances. See Notes 6 and 8 of the Notes to the Consolidated and Combined Financial Statements for information about how valuation allowances are established and monitored, activity in and balances of the valuation allowance, and the estimated fair value of impaired mortgage loans and related impairments included within net investment gains (losses) at and for the years ended December 31, 2018 and 2017. Real Estate Joint Ventures Real estate joint ventures are comprised primarily of limited partner interests in real estate funds, and to a lesser extent joint ventures with interests in projects with varying strategies ranging from the development of properties to the operation of income-producing properties. The estimated fair value of the real estate joint venture investment portfolios was $572 million and $594 million at December 31, 2018 and 2017, respectively. Other Limited Partnership Interests Other limited partnership interests are comprised of private equity funds and hedge funds. The carrying value of other limited partnership interests was $1.8 billion and $1.7 billion at December 31, 2018 and 2017, respectively, which included $98 million and $104 million of hedge funds at December 31, 2018 and 2017, respectively. Cash distributions on these investments are generated from investment gains, operating income from the underlying investments of the funds and liquidation of the underlying investments of the funds. We estimate that the underlying investments of the funds will typically be liquidated over the next 10 to 20 years. Other Invested Assets The following table presents the carrying value of our other invested assets by type at: _______________ (1) The Company reclassified Federal Home Loan Bank (“FHLB”) stock in prior periods from equity securities to other invested assets. Derivatives Derivative Risks We are exposed to various risks relating to our ongoing business operations, including interest rate, foreign currency exchange rate, credit and equity market. We use a variety of strategies to manage these risks, including the use of derivatives. See Note 7 of the Notes to the Consolidated and Combined Financial Statements: • A comprehensive description of the nature of our derivatives, including the strategies for which derivatives are used in managing various risks. • Information about the gross notional amount, estimated fair value, and primary underlying risk exposure of our derivatives by type of hedge designation, excluding embedded derivatives held at December 31, 2018 and 2017. • The statement of operations effects of derivatives in cash flow, fair value, or nonqualifying hedge relationships for the years ended December 31, 2018, 2017 and 2016. See “Business - Segments and Corporate & Other - Annuities” and “Business - Risk Management Strategies - ULSG Market Risk Exposure Management” for more information about our use of derivatives by major hedge programs, as well as “- Results of Operations - Annual Actuarial Review.” Fair Value Hierarchy See Note 7 of the Notes to the Consolidated and Combined Financial Statements for derivatives measured at estimated fair value on a recurring basis and their corresponding fair value hierarchy. The valuation of Level 3 derivatives involves the use of significant unobservable inputs and generally requires a higher degree of management judgment or estimation than the valuations of Level 1 and Level 2 derivatives. Although Level 3 inputs are unobservable, management believes they are consistent with what other market participants would use when pricing such instruments and are considered appropriate given the circumstances. The use of different inputs or methodologies could have a material effect on the estimated fair value of Level 3 derivatives and could materially affect net income. Derivatives categorized as Level 3 at December 31, 2018 include: credit default swaps priced using unobservable credit spreads, or that are priced through independent broker quotations; equity variance swaps with unobservable volatility inputs; foreign currency swaps with certain unobservable inputs and equity index options with unobservable correlation inputs. See Note 8 of the Notes to Consolidated and Combined Financial Statements for a roll-forward of the fair value measurements for derivatives measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs. Credit Risk See Note 7 of the Notes to the Consolidated and Combined Financial Statements for information about how we manage credit risk related to derivatives and for the estimated fair value of our net derivative assets and net derivative liabilities after the application of master netting agreements and collateral. Our policy is not to offset the fair value amounts recognized for derivatives executed with the same counterparty under the same master netting agreement. This policy applies to the recognition of derivatives on the balance sheets and does not affect our legal right of offset. Credit Derivatives The following table presents the gross notional amount and estimated fair value of credit default swaps at: The maximum amount at risk related to our written credit default swaps is equal to the corresponding gross notional amount. In a replication transaction, we pair an asset on our balance sheet with a written credit default swap to synthetically replicate a corporate bond, a core asset holding of life insurance companies. Replications are entered into in accordance with the guidelines approved by state insurance regulators and the NAIC and are an important tool in managing the overall corporate credit risk within the Company. In order to match our long-dated insurance liabilities, we seek to buy long-dated corporate bonds. In some instances, these may not be readily available in the market, or they may be issued by corporations to which we already have significant corporate credit exposure. For example, by purchasing Treasury bonds (or other high-quality assets) and associating them with written credit default swaps on the desired corporate credit name, we, can replicate the desired bond exposures and meet our ALM needs. This can expose the Company to changes in credit spreads as the written credit default swap tenor is shorter than the maturity of Treasury bonds. Embedded Derivatives See Note 8 of the Notes to the Consolidated and Combined Financial Statements for information about embedded derivatives measured at estimated fair value on a recurring basis and their corresponding fair value hierarchy. See Note 8 of the Notes to the Consolidated and Combined Financial Statements for a rollforward of the fair value measurements for net embedded derivatives measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs. See Note 7 of the Notes to the Consolidated and Combined Financial Statements for information about the nonperformance risk adjustment included in the valuation of guaranteed minimum benefits accounted for as embedded derivatives. See “- Summary of Critical Accounting Estimates - Derivatives” for further information on the estimates and assumptions that affect embedded derivatives. Off-Balance Sheet Arrangements Collateral for Securities Lending and Derivatives We have a securities lending program for the purpose of enhancing the total return on our investment portfolio. Periodically we receive non-cash collateral for securities lending from counterparties, which cannot be sold or repledged, and which is not recorded on our consolidated balance sheets. The amount of this collateral was $55 million and $29 million at estimated fair value at December 31, 2018 and 2017, respectively. See Note 6 of the Notes to the Consolidated and Combined Financial Statements, as well as “- Investments - Securities Lending” for discussion of our securities lending program, the classification of revenues and expenses, and the nature of the secured financing arrangement and associated liability. We enter into derivatives to manage various risks relating to our ongoing business operations. We have non-cash collateral from counterparties for derivatives, which can be sold or repledged subject to certain constraints, and which has not been recorded on our consolidated balance sheets. The amount of this non-cash collateral was $145 million and $368 million at December 31, 2018 and 2017, respectively. See Note 7 of the Notes to the Consolidated and Combined Financial Statements for information regarding the earned income on and the gross notional amount, estimated fair value of assets and liabilities and primary underlying risk exposure of our derivatives. Guarantees See “Guarantees” in Note 15 of the Notes to the Consolidated and Combined Financial Statements. Other Additionally, we enter into commitments for the purpose of enhancing the total return on our investment portfolio: mortgage loan commitments and commitments to fund partnership investments, bank credit facilities and private corporate bond investments. See Note 6 of the Notes to the Consolidated and Combined Financial Statements for information on the investment income, investment expense, gains and losses from such investments. See also “- Investments - Fixed Maturity and Equity Securities AFS” and “- Investments - Mortgage Loans” for information on our investments in fixed maturity securities and mortgage loans. See “- Investments - Real Estate Joint Ventures” and “- Investments - Other Limited Partnership Interests” for information on our partnership investments. Other than the commitments disclosed in Note 15 of the Notes to the Consolidated and Combined Financial Statements, there are no other material obligations or liabilities arising from the commitments to fund mortgage loans, partnership investments, bank credit facilities and private corporate bond investments. For further information on commitments to fund partnership investments, mortgage loans, bank credit facilities and private corporate bond investments. See “- Liquidity and Capital Resources - The Company - Contractual Obligations.” Policyholder Liabilities We establish, and carry as liabilities, actuarially determined amounts that are calculated to meet policy obligations or to provide for future annuity payments. Amounts for actuarial liabilities are computed and reported in the financial statements in conformity with GAAP. For more details on policyholder liabilities, see “- Summary of Critical Accounting Estimates.” Due to the nature of the underlying risks and the uncertainty associated with the determination of actuarial liabilities, we cannot precisely determine the amounts that will ultimately be paid with respect to these actuarial liabilities, and the ultimate amounts may vary from the estimated amounts, particularly when payments may not occur until well into the future. We periodically review the assumptions supporting our estimates of actuarial liabilities for future policy benefits. We revise estimates, to the extent permitted or required under GAAP, if we determine that future expected experience differs from assumptions used in the development of actuarial liabilities. We charge or credit changes in our liabilities to expenses in the period the liabilities are established or re-estimated. If the liabilities originally established for future benefit payments prove inadequate, we must increase them. Such an increase could adversely affect our earnings and have a material adverse effect on our business, results of operations and financial condition. We have experienced, and will likely in the future experience, catastrophe losses and possibly acts of terrorism, as well as turbulent financial markets that may have an adverse impact on our business, results of operations, and financial condition. Due to their nature, we cannot predict the incidence, timing, severity or amount of losses from catastrophes and acts of terrorism, but we make broad use of catastrophic and non-catastrophic reinsurance to manage risk from these perils. Future Policy Benefits We establish liabilities for amounts payable under insurance policies. See “- Summary of Critical Accounting Estimates - Liability for Future Policy Benefits” and Notes 1 and 3 of the Notes to the Consolidated and Combined Financial Statements. A discussion of future policy benefits by segment, as well as Corporate & Other follows. Annuities Future policy benefits for the annuities business are comprised mainly of liabilities for life-contingent income annuities, and liabilities for the variable annuity guaranteed minimum benefits accounted for as insurance. Life Future policy benefits for the life business are comprised mainly of liabilities for traditional life and for universal and variable life insurance contracts. In order to manage risk, we have often reinsured a portion of the mortality risk on life insurance policies. The reinsurance programs are routinely evaluated, and this may result in increases or decreases to existing coverage. We have entered into various derivative positions, primarily interest rate swaps, to mitigate the risk that investment of premiums received and reinvestment of maturing assets over the life of the policy will be at rates below those assumed in the original pricing of these contracts. Run-off Future policy benefits primarily include liabilities for structured settlement annuities and pension risk transfers. There is no interest rate crediting flexibility on the liabilities for payout annuities. As a result, a sustained low interest rate environment could negatively impact earnings; however, we mitigate our risks by applying various ALM strategies, including the use of derivative positions, primarily interest rate swaps, to mitigate the risks associated with such a scenario. Corporate & Other Future policy benefits primarily include liabilities for certain run-off long-term care and workers’ compensation business. Additionally, future policy benefits historically included liabilities for variable annuity guaranteed minimum benefits assumed from a former operating joint venture in Japan that were accounted for as insurance prior to 2014. Policyholder Account Balances Policyholder account balances are generally equal to the account value, which includes accrued interest credited, but excludes the impact of any applicable charge that may be incurred upon surrender. See “- Variable Annuity Guarantees” and “Quantitative and Qualitative Disclosures About Market Risk - Market Risk - Fair Value Exposures - Interest Rates.” See Notes 1 and 3 of the Notes to the Consolidated and Combined Financial Statements for additional information. A discussion of policyholder account balances by segment, as well as Corporate & Other, follows. Annuities Policyholder account balances for annuities are held for fixed deferred annuities, the fixed account portion of variable annuities, and non-life contingent income annuities. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. A sustained low interest rate environment could negatively impact earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We have various derivative positions, including interest rate floors, to partially mitigate the risks associated with such a scenario. Additionally, policyholder account balances are held for variable annuity guaranteed minimum living benefits that are accounted for as embedded derivatives. The following table presents the breakdown of account value subject to minimum guaranteed crediting rates for Annuities at: ______________ (1) These amounts are not adjusted for policy loans. As a result of acquisitions, we establish additional liabilities known as excess interest reserves for policies with credited rates in excess of market rates as of the applicable acquisition dates. Excess interest reserves for Annuities were $285 million and $297 million at December 31, 2018 and 2017, respectively. Life Life policyholder account balances are held for retained asset accounts, universal life policies and the fixed account of universal variable life insurance policies. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. A sustained low interest rate environment could negatively impact earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We have various derivative positions, including interest rate floors, to partially mitigate the risks associated with such a scenario. The following table presents the breakdown of account value subject to minimum guaranteed crediting rates for Life at: _______________ (1) These amounts are not adjusted for policy loans. As a result of acquisitions, we establish additional liabilities known as excess interest reserves for policies with credited rates in excess of market rates as of the applicable acquisition dates. Excess interest reserves for Life were $22 million and $28 million at December 31, 2018 and 2017, respectively. Run-off Policyholder account balances in Run-off are comprised of funding agreements and COLI. Interest crediting rates vary by type of contract and can be fixed or variable. Variable interest crediting rates are generally tied to an external index, most commonly (one-month or three-month) LIBOR. We are exposed to interest rate risks, when guaranteeing payment of interest and return on principal at the contractual maturity date. We may invest in floating rate assets or enter into receive-floating rate swaps, also tied to external indices, as well as caps, to mitigate the impact of changes in market interest rates. We also mitigate our risks by applying various ALM strategies. The following table presents the breakdown of account value subject to minimum guaranteed crediting rates for Run-off as of: _______________ (1) These amounts are not adjusted for policy loans. As a result of acquisitions, we establish additional liabilities known as excess interest reserves for policies with credited rates in excess of market rates as of the applicable acquisition dates. Excess interest reserves for Run-off were $62 million and $64 million at December 31, 2018 and 2017, respectively. Corporate & Other Policyholder account balances were historically held for variable annuity guaranteed minimum benefits assumed from a former operating joint venture in Japan that were accounted for as embedded derivatives prior to 2014. Variable Annuity Guarantees We issue directly and assume from an affiliate through reinsurance certain variable annuity products with guaranteed minimum benefits that provide the policyholder a minimum return based on their initial deposit (i.e., the Benefit Base) less withdrawals. In some cases, the Benefit Base may be increased by additional deposits, bonus amounts, accruals or optional market value step-ups. Certain of our variable annuity guarantee features are accounted for as insurance liabilities and recorded in future policy benefits while others are accounted for at fair value as embedded derivatives and recorded in policyholder account balances. Generally speaking, a guarantee is accounted for as an insurance liability if the guarantee is paid only upon either (i) the occurrence of a specific insurable event, or (ii) annuitization. Alternatively, a guarantee is accounted for as an embedded derivative if a guarantee is paid without requiring (i) the occurrence of specific insurable event, or (ii) the policyholder to annuitize, that is, the policyholder can receive the guarantee on a net basis. In certain cases, a guarantee may have elements of both an insurance liability and an embedded derivative and in such cases the guarantee is split and accounted for under both models. Further, changes in assumptions, principally involving behavior, can result in a change of expected future cash outflows of a guarantee between portions accounted for as insurance liabilities and portions accounted for as embedded derivatives. Guarantees accounted for as insurance liabilities in future policy benefits include GMDBs, the life contingent portion of the GMWBs and the portion of the GMIBs that require annuitization, as well as the life contingent portion of the expected annuitization when the policyholder is forced into an annuitization upon depletion of their account value. These insurance liabilities are accrued over the accumulation phase of the contract in proportion to actual and future expected policy assessments based on the level of guaranteed minimum benefits generated using multiple scenarios of separate account returns. The scenarios are based on best estimate assumptions consistent with those used to amortize DAC. When current estimates of future benefits exceed those previously projected or when current estimates of future assessments are lower than those previously projected, liabilities will increase, resulting in a current period charge to net income. The opposite result occurs when the current estimates of future benefits are lower than those previously projected or when current estimates of future assessments exceed those previously projected. At each reporting period, we update the actual amount of business remaining in-force, which impacts expected future assessments and the projection of estimated future benefits resulting in a current period charge or increase to earnings. See Note 3 of the Notes to the Consolidated and Combined Financial Statements for additional details of guarantees accounted for as insurance liabilities. Guarantees accounted for as embedded derivatives in policyholder account balances include the non-life contingent portion of GMWBs, GMABs, and for GMIBs the non-life contingent portion of the expected annuitization when the policyholder is forced into an annuitization upon depletion of their account value, as well as the Guaranteed Principal Option. The estimated fair values of guarantees accounted for as embedded derivatives are determined based on the present value of projected future benefits minus the present value of projected future fees. At policy inception, we attribute to the embedded derivative a portion of the projected future guarantee fees to be collected from the policyholder equal to the present value of projected future guaranteed benefits. Any additional fees represent “excess” fees and are reported in universal life and investment-type product policy fees. In valuing the embedded derivative, the percentage of fees included in the fair value measurement is locked-in at inception. The projections of future benefits and future fees require capital market and actuarial assumptions including expectations concerning policyholder behavior. A risk neutral valuation methodology is used to project the cash flows from the guarantees under multiple capital market scenarios to determine an economic liability. The reported estimated fair value is then determined by taking the present value of these risk-free generated cash flows using a discount rate that incorporates a spread over the risk-free rate to reflect our nonperformance risk and adding a risk margin. For more information on the determination of estimated fair value. See Note 8 of the Notes to the Consolidated and Combined Financial Statements. Liquidity and Capital Resources Overview Our business and results of operations are materially affected by conditions in the global capital markets and the economy generally. Stressed conditions, volatility or disruptions in global capital markets, particular markets or financial asset classes can impact us adversely, in part because we have a large investment portfolio and our insurance liabilities and derivatives are sensitive to changing market factors. Changing conditions in the global capital markets and the economy may affect our financing costs and market interest rates for our debt or equity securities. For further information regarding market factors that could affect our ability to meet liquidity and capital needs, see “- Industry Trends and Uncertainties” and “- Investments - Current Environment.” Liquidity and Capital Management Based upon our capitalization, expectations regarding maintaining our ratings, business mix and funding sources available to us, we believe we have sufficient liquidity to meet business requirements under current market conditions and certain stress scenarios. Our Board of Directors and senior management are directly involved in the governance of the capital management process, including proposed changes to the annual capital plan and capital targets. We are targeting a debt-to-capital ratio commensurate with our parent company credit ratings and our insurance subsidiaries’ financial strength ratings. We continuously monitor and adjust our liquidity and capital plans in light of market conditions, as well as changing needs and opportunities. We maintain a substantial short-term liquidity position, which was $2.2 billion and $1.6 billion at December 31, 2018 and 2017, respectively. Short-term liquidity is comprised of cash and cash equivalents and short-term investments, excluding assets that are pledged or otherwise committed. Assets pledged or otherwise committed include amounts received in connection with securities lending, derivatives and assets held on deposit or in trust. An integral part of our liquidity management includes managing our level of liquid assets, which was $36.5 billion and $38.3 billion at December 31, 2018 and 2017. Liquid assets are comprised of cash and cash equivalents, short-term investments and publicly-traded securities, excluding assets that are pledged or otherwise committed. Assets pledged or otherwise committed include amounts received in connection with securities lending, derivatives and assets held on deposit or in trust. The Company Liquidity Liquidity refers to our ability to generate adequate cash flows from our normal operations to meet the cash requirements of our operating, investing and financing activities. We determine our liquidity needs based on a rolling 12-month forecast by portfolio of invested assets which we monitor daily. We adjust the general account asset and derivatives mix and general account asset maturities based on this rolling 12-month forecast. To support this forecast, we conduct cash flow and stress testing, which reflect the impact of various scenarios, including (i) the potential increase in our requirement to pledge additional collateral or return collateral to our counterparties, (ii) a reduction in new business sales, and (iii) the risk of early contract holder and policyholder withdrawals, as well as lapses and surrenders of existing policies and contracts. We include provisions limiting withdrawal rights on many of our products, under which certain of these provisions deter the customer from making withdrawals prior to the maturity date of the product. In the event of significant cash requirements beyond anticipated liquidity needs, we have various alternatives available depending on market conditions and the amount and timing of the liquidity need. These potential available alternative sources of liquidity include cash flows from operations, sales of liquid assets and funding sources including secured funding agreements, unsecured credit facilities and secured committed facilities. Under certain adverse market and economic conditions, our access to liquidity may deteriorate, or the cost to access liquidity may increase. See “Risk Factors - Economic Environment and Capital Markets-Related Risks - Adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs and our access to capital.” Capital We manage our capital position to maintain our financial strength and credit ratings. Our capital position is supported by our ability to generate cash flows within our insurance companies, our ability to effectively manage the risk of our businesses and our expected ability to borrow funds and raise additional capital to meet operating and growth needs in the event of adverse market and economic conditions. We target to maintain a debt-to-capital ratio of approximately 25%, which we monitor using an average of our key leverage ratios as calculated by A.M. Best, Fitch, Moody’s and S&P. As such, we may opportunistically look to pursue additional financing over time, which may include the incurrence of additional term loans, borrowings under credit facilities, the issuance of debt, equity or hybrid securities or the refinancing of existing indebtedness. There can be no assurance that we will be able to complete any such financing transactions on terms and conditions favorable to us or at all. Additionally, we intend to maintain a funding of assets in excess of CTE98 to support our variable annuity contracts during normal market conditions and assets in excess of CTE95 in stressed market conditions. At December 31, 2018, we held assets in excess of CTE98. In August 2018, our Board of Directors authorized the repurchase of up to $200 million of our common stock. Repurchases made under such authorization may be made through open market purchases, pursuant to 10b5-1 plans, or pursuant to accelerated stock repurchase plans from time to time at management’s discretion in accordance with applicable federal securities laws. Common stock repurchases are dependent upon several factors, including our capital position, liquidity, financial strength and credit ratings, general market conditions, the market price of our common stock compared to management’s assessment of the stock’s underlying value and applicable regulatory approvals, as well as other legal and accounting factors. We do not currently anticipate declaring or paying cash dividends on our common stock. Any future declaration and payment of dividends or other distributions or returns of capital will be at the discretion of our Board of Directors and will depend on and be subject to our financial condition, results of operations, cash needs, regulatory and other constraints, capital requirements (including capital requirements of our subsidiaries), contractual restrictions and any other factors that our Board of Directors deems relevant in making such a determination. Therefore, there can be no assurance that we will pay any dividends or make other distributions or returns of capital on our common stock, or as to the amount of any such dividends, distributions or returns of capital. Rating Agencies The following financial strength ratings represent each rating agency’s current opinion of our principal insurance subsidiaries’ ability to pay obligations under insurance policies and contracts in accordance with their terms and are not evaluations directed toward the protection of investors in our securities. Financial strength ratings are not statements of fact nor are they recommendations to purchase, hold or sell any security, contract or policy. Each rating should be evaluated independently of any other rating. Our financial strength ratings as of the date of this filing are indicated in the following table. All financial strength ratings have a stable outlook unless otherwise indicated. _______________ NR = Not rated (1) Negative outlook. Our long-term issuer credit ratings as of the date of this filing are indicated in the following table. All long-term issuer credit ratings have a stable outlook unless otherwise indicated. _______________ (1) Long-term Issuer Credit Rating refers to issuer credit rating, issuer default rating, long-term issuer rating and long-term counterparty credit rating for A.M. Best, Fitch, Moody’s and S&P, respectively. (2) Negative outlook. Additional information about financial strength ratings and credit ratings can be found on the respective websites of the rating agencies. Rating agencies may continue to review and adjust our ratings. See “Risk Factors - Risks Related to Our Business - A downgrade or a potential downgrade in our financial strength or credit ratings could result in a loss of business and materially adversely affect our financial condition and results of operations” for an in-depth description of the impact of a ratings downgrade. Sources and Uses of Liquidity and Capital Our primary sources and uses of liquidity and capital are summarized as follows: Cash Flows from Operating Activities The principal cash inflows from our insurance activities come from insurance premiums, annuity considerations and net investment income. The principal cash outflows are the result of various annuity and life insurance products, operating expenses and income tax, as well as interest expense. The primary liquidity concern with respect to these cash flows is the risk of early contract holder and policyholder withdrawal. Cash Flows from Investing Activities The principal cash inflows from our investment activities come from repayments of principal, proceeds from maturities and sales of investments, as well as settlements of freestanding derivatives. The principal cash outflows relate to purchases of investments and settlements of freestanding derivatives. We typically can have a net cash outflow from investing activities because cash inflows from insurance operations are reinvested in accordance with our ALM discipline to fund insurance liabilities. We closely monitor and manage these risks through our comprehensive investment risk management process. The primary liquidity concerns with respect to these cash flows are the risk of default by debtors and market disruption. Cash Flows from Financing Activities The principal cash inflows from our financing activities come from issuances of debt, deposits of funds associated with policyholder account balances and lending of securities. The principal cash outflows come from repayments of debt, common stock repurchases, withdrawals associated with policyholder account balances and the return of securities on loan. The primary liquidity concerns with respect to these cash flows are market disruption and the risk of early policyholder withdrawal. Primary Sources of Liquidity and Capital In addition to the summary description of liquidity and capital sources discussed in “- Sources and Uses of Liquidity and Capital,” the following additional information is provided regarding our primary sources of liquidity and capital: Funding Sources Liquidity is provided by a variety of funding sources, including secured funding agreements, unsecured credit facilities and secured committed facilities. Capital is provided by a variety of funding sources, including issuances of long-term debt and borrowings under our credit facilities. The diversity of our funding sources enhances our funding flexibility, limits dependence on any one market or source of funds and generally lowers the cost of funds. Our primary funding sources include: Federal Home Loan Bank Funding Agreements, Reported in Policyholder Account Balances In July 2018, Brighthouse Life Insurance Company became a member of FHLB of Atlanta and, shortly thereafter, discontinued its membership in FHLB of Pittsburgh. At both December 31, 2018 and 2017, Brighthouse Life Insurance Company had obligations outstanding under funding agreements with certain FHLBs of $595 million. During the years ended December 31, 2018, 2017 and 2016, Brighthouse Life Insurance Company issued $0, $25 million and $4.7 billion, respectively, and repaid $0, $75 million and $5.9 billion, respectively, under such funding agreements. Activity related to these funding agreements is reported in the Run-off segment. Farmer Mac Funding Agreements In February 2019, Brighthouse Life Insurance Company entered into a funding agreement program with the Federal Agricultural Mortgage Corporation and its affiliate Farmer Mac Mortgage Securities Corporation (“Farmer Mac”), pursuant to which the parties may agree to enter into funding agreements in an aggregate amount of up to $500 million. The funding agreement program has a term ending on December 1, 2023. Funding agreements are issued to Farmer Mac in exchange for cash. In connection with each funding agreement, Farmer Mac will be granted liens on certain assets, including agricultural loans, to collateralize Brighthouse Life Insurance Company’s obligations under the funding agreements. Upon any event of default by Brighthouse Life Insurance Company, Farmer Mac’s recovery on the collateral is limited to the amount of Brighthouse Life Insurance Company’s liabilities to Farmer Mac. At February 26, 2019, there were no borrowings under this funding agreement program. Long-term Debt Issued In September 2018, BHF issued $375 million of 6.25% unsecured junior subordinated debentures due 2058. In June 2017, BHF issued $3.0 billion of unsecured senior notes consisting of (i) $1.5 billion of 3.70% senior notes due 2027 and (ii) $1.5 billion of 4.70% senior notes due 2047. Credit Facilities As of December 31, 2018, we maintained a $2.0 billion unsecured revolving credit facility maturing December 2, 2021 (the “Revolving Credit Facility”), all of which may be used for letters of credit and up to $1.0 billion may be used for loans, and a $600 million unsecured delayed draw term loan facility maturing December 2, 2019 (the “2017 Term Loan Facility”). At December 31, 2018, there were no borrowings under the Revolving Credit Facility. In August 2017, we borrowed $600 million under the 2017 Term Loan Facility, all of which remained outstanding at December 31, 2018. On February 1, 2019, BHF entered into a new term loan agreement with respect to a new $1.0 billion five-year unsecured term loan facility (the “2019 Term Loan Facility”). On February 1, 2019, BHF borrowed $1.0 billion under the 2019 Term Loan Facility, terminated the 2017 Term Loan Facility without penalty and repaid $600 million of borrowings outstanding under the 2017 Term Loan Facility, with the remainder to be used for general corporate purposes. Committed Facilities Repurchase Facility In April 2018, Brighthouse Life Insurance Company entered into a secured committed repurchase facility (the “Repurchase Facility”) with a financial institution, pursuant to which Brighthouse Life Insurance Company may enter into repurchase transactions in an aggregate amount up to $2.0 billion. The Repurchase Facility has a term of three years, beginning on July 31, 2018 and maturing on July 31, 2021. Under the Repurchase Facility, Brighthouse Life Insurance Company may sell certain eligible securities at a purchase price based on the market value of the securities less an applicable margin based on the types of securities sold, with a concurrent agreement to repurchase such securities at a predetermined future date (ranging from two weeks to three months) and at a price which represents the original purchase price plus interest. At December 31, 2018, there were no borrowings under the Repurchase Facility. Reinsurance Financing Arrangement Our reinsurance subsidiary, BRCD, was formed to manage our capital and risk exposures and to support our term and ULSG businesses through the use of affiliated reinsurance arrangements and related reserve financing. At December 31, 2018, BRCD had a $10.0 billion financing arrangement with a pool of highly rated third-party reinsurers. This financing arrangement consists of credit-linked notes that each mature in 2037. At December 31, 2018, there were no borrowings under this facility, and there was $9.8 billion of funding available under this financing arrangement. BRCD is capitalized with cash and invested assets, including funds withheld (“Minimum Initial Target Assets”) at a level that is sufficient to satisfy its future cash obligations assuming a permanent level yield curve, consistent with NAIC cash flow testing scenarios. BRCD utilizes the above referenced financing arrangement to cover the difference between full required statutory assets (i.e., XXX/AXXX reserves plus target risk margin appropriate to meet capital needs) and Minimum Initial Target Assets. An admitted deferred tax asset, if any, would also serve to reduce the amount of funding required under the above referenced financing arrangement. Outstanding Long-term Debt The following table summarizes our outstanding long-term debt at: _______________ (1) Includes unamortized debt issuance costs and debt discount totaling $46 million and $34 million at December 31, 2018 and 2017, respectively, for senior notes and junior subordinated debentures on a combined basis. (2) Represents non-recourse debt for which creditors have no access, subject to customary exceptions, to the general assets of the Company other than recourse to certain investment companies. Debt and Facility Covenants The Company’s debt instruments and credit and committed facilities contain certain administrative, reporting and legal covenants. Additionally, the Company’s credit facilities contain financial covenants, including requirements to maintain a specified minimum adjusted consolidated net worth, to maintain a ratio of total indebtedness to total capitalization not in excess of a specified percentage and that place limitations on the dollar amount of indebtedness that may be incurred by the Company, which could restrict our operations and use of funds. At December 31, 2018, the Company was in compliance with these financial covenants. Primary Uses of Liquidity and Capital In addition to the summarized description of liquidity and capital uses discussed in “- Sources and Uses of Liquidity and Capital,” and “- Contractual Obligations,” the following additional information is provided regarding our primary uses of liquidity and capital: Common Stock Repurchases As of December 31, 2018, we had repurchased 2,628,167 shares of our common stock through open market purchases, pursuant to 10b5-1 plans, for $105 million. In 2019, through February 22, 2019, BHF repurchased an additional 879,701 shares of its common stock through open market purchases, pursuant to 10b5-1 plans, for $31 million. Debt Repurchases We may from time to time seek to retire or purchase our outstanding indebtedness through cash purchases and/or exchanges for other securities, purchases in the open market, privately negotiated transactions or otherwise. Any such repurchases or exchanges will be dependent upon several factors, including our liquidity requirements, contractual restrictions, general market conditions, and applicable regulatory, legal and accounting factors. Whether or not we repurchase any debt and the size and timing of any such repurchases will be determined at our discretion. Collateral Financing Arrangement Repaid In April 2017, MetLife, Inc. and MetLife Reinsurance Company of South Carolina (which was subsequently merged into BRCD) terminated a collateral financing arrangement and, as a result, the $2.8 billion obligation outstanding under this arrangement was extinguished. Insurance Liabilities Liabilities arising from our insurance activities primarily relate to benefit payments under various annuity and life insurance products, as well as payments for policy surrenders, withdrawals and loans. Surrender or lapse behavior differs somewhat by product but tends to occur in the ordinary course of business. During the years ended December 31, 2018 and 2017, general account surrenders and withdrawals totaled $3.0 billion and $2.2 billion, respectively, of which $2.4 billion and $1.8 billion, respectively, were attributable to products within the Annuities segment. Pledged Collateral We pledge collateral to, and have collateral pledged to us by, counterparties in connection with our derivatives. At December 31, 2018 and 2017, counterparties were obligated to return cash collateral pledged by us of $64 million and $44 million, respectively. At December 31, 2018 and 2017, we were obligated to return cash collateral pledged to us by counterparties of $1.4 billion and $379 million, respectively. See Note 7 of the Notes to the Consolidated and Combined Financial Statements for additional information about pledged collateral. We also pledge collateral from time to time in connection with funding agreements. Securities Lending We have a securities lending program whereby securities are loaned to third parties, primarily brokerage firms and commercial banks. We obtain collateral, usually cash, from the borrower, which must be returned to the borrower when the loaned securities are returned to us. Under our securities lending program, we were liable for cash collateral under our control of $3.6 billion and $3.8 billion at December 31, 2018 and 2017, respectively. Of these amounts, $1.5 billion and $1.6 billion at December 31, 2018 and 2017, respectively, were on open, meaning that the related loaned security could be returned to us on the next business day requiring the immediate return of cash collateral we hold. The estimated fair value of the securities on loan related to the cash collateral on open at December 31, 2018 was $1.4 billion, all of which were U.S. government and agency securities which, if put back to us, could be immediately sold to satisfy the cash requirement. See Note 6 of the Notes to the Consolidated and Combined Financial Statements. Litigation Putative or certified class action litigation and other litigation, and claims and assessments against us, in addition to those discussed elsewhere herein and those otherwise provided for in the financial statements, have arisen in the course of our business, including, but not limited to, in connection with our activities as an insurer, employer, investor, investment advisor, and taxpayer. Further, state insurance regulatory authorities and other federal and state authorities regularly make inquiries and conduct investigations concerning our compliance with applicable insurance and other laws and regulations. See Note 15 of the Notes to the Consolidated and Combined Financial Statements. Contractual Obligations The following table summarizes our major contractual obligations at December 31, 2018: Insurance Liabilities and Policyholder Account Balances Insurance liabilities reflect future estimated cash flows and (i) are based on mortality, morbidity, lapse and other assumptions comparable with our experience and expectations of future payment patterns; and (ii) consider future premium receipts on current policies in-force. Additionally, the more than five years category includes estimated payments due for periods extending for more than 100 years. The total amount presented for insurance liabilities of $89.9 billion exceeds the liability amounts of $39.2 billion presented on the consolidated balance sheet principally due to (i) the time value of money, which accounts for a substantial portion of the difference; and (ii) differences in assumptions, most significantly mortality, between the date the liabilities were initially established and the current date; and are partially offset by liabilities related to accounting conventions (such as interest reserves and unearned revenue), or which are not contractually due, which are excluded. Policyholder account balances generally represent the estimated cash payments on customer deposits and are based on assumptions related to withdrawals, including unscheduled or partial withdrawals; policy lapses; surrender charges; annuitization; mortality; future interest credited; policy loans and other contingent events as appropriate for the respective product type. The total amount presented for policyholder account balances of $52.1 billion exceeds the liability amount of $40.1 billion presented on the consolidated balance sheet principally due to (i) the time value of money, which accounts for a substantial portion of the difference; (ii) differences in assumptions between the date the liabilities were initially established and the current date; and (iii) liabilities related to accounting conventions (such as interest reserves and embedded derivatives), or which are not contractually due, which are excluded. Actual cash payments on insurance liabilities and policyholder account balances may differ significantly from the liabilities as presented on the consolidated balance sheet and the estimated cash payments as presented due to differences between actual experience and the assumptions used in the establishment of these liabilities and the estimation of these cash payments. All estimated cash payments are presented gross of any reinsurance recoverable. Payables for Collateral Under Securities Loaned and Other Transactions We have accepted cash collateral in connection with securities lending and derivatives. As the securities lending transactions expire within the next year and the timing of the return of the derivatives collateral is uncertain, the return of the collateral has been included in the one year or less category in the table. We also held non-cash collateral, which is not reflected as a liability on the consolidated balance sheet of $200 million at December 31, 2018. Long-term Debt The total amount presented for long-term debt differs from the total amount presented on the consolidated balance sheet as the amounts presented herein do not include unamortized premiums or discounts and debt issuance costs incurred upon issuance and include future interest on such obligations for the period from January 1, 2019 through maturity. Future interest on variable rate debt was computed using prevailing rates at December 31, 2018 and, as such, does not consider the impact of future rate movements. Future interest on fixed rate debt was computed using the stated rate on the obligations. Investment Commitments Investment commitments include commitments to lend funds under mortgage loans, bank credit facilities, private corporate bond investments and partnership investments. The timing of the funding of mortgage loans and private corporate bond investments is based on the expiration dates of the corresponding commitments. As it relates to commitments to fund partnerships and bank credit facilities, we anticipate that these amounts could be invested any time over the next five years; however, as the timing of the fulfillment of the obligation cannot be predicted, such obligations are generally presented in the one year or less category. See Note 15 of the Notes to the Consolidated and Combined Financial Statements and “- Off-Balance Sheet Arrangements.” Other Other obligations are principally comprised of (i) the estimated fair value of derivative obligations, (ii) amounts due under reinsurance agreements, (iii) obligations under deferred compensation arrangements, (iv) payables related to securities purchased but not yet settled and (v) other accruals and accounts payable for which the Company is contractually liable, which are reported in other liabilities on the consolidated balance sheet. If the timing of any of these other obligations is sufficiently uncertain, the amounts are included within the one year or less category. Separate account liabilities are excluded as they are fully funded by cash flows from the corresponding separate account assets and are set equal to the estimated fair value of separate account assets. The Parent Company Liquidity and Capital In evaluating liquidity, it is important to distinguish the cash flow needs of the parent company from the cash flow needs of the combined group of companies. BHF is largely dependent on cash flows from its insurance subsidiaries to meet its obligations. Constraints on BHF’s liquidity may occur as a result of operational demands and/or as a result of compliance with regulatory requirements. See “Risk Factors - Risks Related to our Business - Our analyses of scenarios and sensitivities utilized in connection with our variable annuity risk management strategies involve significant estimates based on assumptions that may result in material differences in actual outcomes compared to the sensitivities calculated under such scenarios.” Short-term Liquidity and Liquid Assets At December 31, 2018 and 2017, BHF and certain of its non-insurance subsidiaries had short-term liquidity of $520 million and $419 million, respectively. Short-term liquidity is comprised of cash and cash equivalents and short-term investments. At December 31, 2018 and 2017, BHF and certain of its non-insurance subsidiaries had liquid assets of $752 million and $656 million, respectively, of which $693 million and $563 million, respectively, was held by BHF Liquid assets are comprised of cash and cash equivalents, short-term investments and publicly-traded securities. Statutory Capital and Dividends The NAIC and state insurance departments have established regulations that provide minimum capitalization requirements based on RBC formulas for insurance companies. RBC is based on a formula calculated by applying factors to various asset, premium, claim, expense and statutory reserve items. The formula takes into account the risk characteristics of the insurer, including asset risk, insurance risk, interest rate risk, market risk and business risk and is calculated on an annual basis. The formula is used as an early warning regulatory tool to identify possible inadequately capitalized insurers for purposes of initiating regulatory action, and not as a means to rank insurers generally. State insurance laws provide insurance regulators the authority to require various actions by, or take various actions against, insurers whose TAC does not meet or exceed certain RBC levels. As of the date of the most recent annual statutory financial statements filed with insurance regulators, the TAC of each of our insurance subsidiaries subject to these requirements was in excess of each of those RBC levels. The amount of dividends that our insurance subsidiaries can ultimately pay to BHF through their various parent entities provides an additional margin for risk protection and investment in our businesses. Such dividends are constrained by the amount of surplus our insurance subsidiaries hold to maintain their ratings, which is generally higher than minimum RBC requirements. We proactively take actions to maintain capital consistent with these ratings objectives, which may include adjusting dividend amounts and deploying financial resources from internal or external sources of capital. Certain of these activities may require regulatory approval. Furthermore, the payment of dividends and other distributions by our insurance subsidiaries is governed by insurance laws and regulations. See “- Primary Sources of Liquidity and Capital - Dividends and Returns of Capital from Insurance Subsidiaries” and Note 10 of the Notes to the Consolidated and Combined Financial Statements. Adjusted Statutory Earnings Adjusted statutory earnings is a measure of our insurance companies’ generation of statutory distributable cash flows. It reflects the impact of the effectiveness or ineffectiveness of our variable annuity exposure management program. Adjusted statutory earnings is calculated as statutory pre-tax income less the change in the variable annuities reserve methodology (AG 43) while including the change in both the reserve and capital methodology based CTE95 calculation, as well as unrealized gains (losses) associated with the variable annuities risk management strategy. Adjusted statutory earnings may be further adjusted for certain unanticipated items that impacted our results in order to help management and investors better understand, evaluate and forecast those results. The following table presents the components of adjusted statutory earnings at December 31, 2018. Primary Sources of Liquidity and Capital The principal sources of funds available to BHF include distributions from BH Holdings, dividends and returns of capital from its insurance subsidiaries, capital markets issuances, as well as its own cash and cash equivalents and short-term investments. These sources of funds may also be supplemented by alternate sources of liquidity either directly or indirectly through our insurance subsidiaries. For example, we have established internal liquidity facilities to provide liquidity within and across our regulated and non-regulated entities to support our businesses. In addition to the liquidity and capital sources discussed in “- The Company - Primary Sources of Liquidity and Capital,” the following additional information is provided regarding BHF’s primary sources of liquidity and capital: Distributions from BH Holdings During the years ended December 31, 2018 and 2017, BHF received cash distributions of $52 million and $50 million from BH Holdings. On January 14, 2019, BHF received a cash distribution of $195 million from BH Holdings. Dividends and Returns of Capital from Insurance Subsidiaries Our business is primarily conducted through our insurance subsidiaries. The insurance subsidiaries are subject to regulatory restrictions on the payment of dividends and other distributions imposed by the regulators of their respective state domiciles. See “Business - Regulation - Insurance Regulation - Holding Company Regulation.” Any requested payment of dividends by Brighthouse Life Insurance Company and NELICO to BH Holdings, or by BHNY to Brighthouse Life Insurance Company, in excess of the 2019 limit on the permitted payment of dividends without approval would be considered an extraordinary dividend and would require prior approval from the Delaware Department of Insurance or the Massachusetts Division of Insurance, and the NYDFS, respectively. The table below sets forth the dividends permitted to be paid by our insurance subsidiaries without insurance regulatory approval and the respective dividends paid. _______________ (1) Reflects dividend amounts that may be paid during 2019 without prior regulatory approval. However, because dividend tests may be based on dividends previously paid over rolling 12-month periods, if paid before a specified date during 2019, some or all of such dividends may require regulatory approval. (2) Reflects all amounts paid, including those requiring regulatory approval. (3) Reflects dividend amounts that could have been paid during the relevant year without prior regulatory approval. (4) Dividends paid by BLIC in 2016 were paid to its former parent, MetLife, Inc. (5) Dividends paid by NELICO in 2016, including a $295 million extraordinary cash dividend, were paid to its former parent, MetLife, Inc. Dividends paid by NELICO in 2018, including a $65 million ordinary cash dividend and a $335 million extraordinary dividend comprised of $135 million of cash and a $200 million surplus note, were paid to its parent, BH Holdings. (6) Dividends are not anticipated to be paid by BHNY in 2019. Short-term Intercompany Loans On October 23, 2017, BHF, as borrower, entered into a short-term intercompany loan agreement with certain of its non-insurance subsidiaries, as lenders, for the purposes of facilitating the management of the available cash of the borrower and the lenders on a consolidated basis. Each loan entered into under this intercompany loan agreement has a term not more than 364 days and bears interest on the unpaid principal amount at a variable rate, payable monthly. During the years ended December 31, 2018 and 2017, BHF borrowed $478 million and $136 million, respectively, from certain of its non-insurance subsidiaries under short-term intercompany loan agreements and had total obligations outstanding of $303 million and $136 million under such agreements at December 31, 2018 and 2017, respectively. See Note 3 of the Schedule II - Condensed Financial Information (Parent Company Only). Intercompany Liquidity Facilities At December 31, 2018, we maintained intercompany liquidity facilities with certain of our insurance and non-insurance company subsidiaries to provide short-term liquidity within and across the combined group of companies. Under these facilities, which are comprised of a series of revolving loan agreements among BHF and its participating subsidiaries, each company may lend to or borrow from each other, subject to certain maximum limits for a term not more than 364 days. During the year ended December 31, 2018, BHF borrowed $40 million from NELICO under an intercompany liquidity facility and had no obligations under such facilities at December 31, 2018. See Note 3 of the Schedule II - Condensed Financial Information (Parent Company Only). Primary Uses of Liquidity and Capital The primary uses of liquidity of BHF include debt service including interest expense and debt repayments, capital contributions to subsidiaries, common stock repurchases and payment of general operating expenses. Based on our analysis and comparison of our current and future cash inflows from the dividends we receive from subsidiaries that are permitted to be paid without prior insurance regulatory approval, our investment portfolio and other cash flows and anticipated access to the capital markets, we believe there will be sufficient liquidity and capital to enable BHF to make payments on debt, contribute capital to its subsidiaries, repurchase its common stock, pay all general operating expenses and meet its cash needs. In addition to the liquidity and capital uses discussed in “- The Company - Primary Uses of Liquidity and Capital” and “- The Company - Contractual Obligations” the following additional information is provided regarding Brighthouse Financial, Inc.’s primary uses of liquidity and capital: Capital Contributions to BH Holdings BHF made cash capital contributions of $208 million and $1.3 billion to BH Holdings during the years ended December 31, 2018 and 2017, respectively. Affiliated Short-term Debt Repaid During the year ended December 31, 2018, BHF repaid $311 million to non-insurance company subsidiaries under short-term intercompany loan agreements and $40 million to NELICO under an intercompany liquidity facility. On January 14, 2019, BHF repaid $195 million of short-term intercompany loans due to BH Holdings. GLOSSARY Glossary of Selected Financial Terms Account value The amount of money in a policyholder’s account. The value increases with additional premiums and investment gains, and it decreases with withdrawals, investment losses and fees. Actuarial Guideline 43 (“AG 43”) See “Business - Risk Management Strategies - Variable Annuity Statutory Reserving Requirements and Exposure Management.” Adjusted earnings See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP and Other Financial Disclosures.” Adjusted statutory earnings A measure of our insurance companies' generation of statutory distributable cash flows on a combined basis. It reflects the impact of the effectiveness or ineffectiveness of our variable annuity exposure management program. Adjusted statutory earnings is calculated as statutory pre-tax income less the change in the variable annuities reserve methodology (AG 43) while including the change in both the reserve and capital methodology based CTE95 calculation, as well as unrealized gains (losses) associated with the variable annuities risk management strategy. Adjusted statutory earnings may be further adjusted for certain unanticipated items that impacted our results in order to help management and investors better understand, evaluate and forecast those results. Alternative investments General account invested assets in real estate joint ventures, other limited partnership interests and other invested assets. Annualized new premium (“ANP”) A sales term used to compare new business written in a year on a recurring basis. The annualization is determined by using 100% of annual recurring premium and 10% of single premiums or deposits. Assets under management (“AUM”) General account investments and separate account assets. Conditional tail expectation (“CTE”) Calculated as the average amount of total assets required to satisfy obligations over the life of the contract or policy in the worst “x%” of scenarios. Represented as CTE (100 less x). Example: CTE95 represents the five worst percent of scenarios. Credit loss The difference between the amortized cost of the security and the present value of projected future cash flows expected to be collected is recognized as an OTTI in earnings. Deferred acquisition cost (“DAC”) Represents the incremental costs related directly to the successful acquisition of new and renewal insurance and annuity contracts and which have been deferred on the balance sheet as an asset. Deferred sales inducements (“DSI”) Represent amounts that are credited to a policyholder’s account balance that are higher than the expected crediting rates on similar contracts without such an inducement and that are an incentive to purchase a contract and also meet the accounting criteria to be deferred as an asset that is amortized over the life of the contract. Deferred tax asset or deferred tax liability Assets or liabilities that are recorded for the difference between book basis and tax basis of an asset or a liability. General account assets All insurance company assets not allocated to separate accounts. Invested assets General account investments. Includes fixed maturity securities, equity securities, mortgage loans, policy loans, alternative investments and short-term investments. Investment Hedge Adjustments Earned income on derivatives and amortization of premium on derivatives that are hedges of investments or that are used to replicate certain investments, but do not qualify for hedge accounting treatment. Market Value Adjustments Amounts associated with periodic crediting rate adjustments based on the total return of a contractually referenced pool of assets and market value adjustments associated with surrenders or terminations of contracts. Minimum Initial Target Assets Cash and invested assets, including funds withheld. Net amount at risk (“NAR”) Represents the difference between a claim amount payable if a specific event occurs and the amount set aside to support the claim. The calculation of NAR can differ by policy type and/or guarantee. Net investment spread See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP and Other Financial Disclosures.” Reinsurance Insurance that an insurance company buys for its own protection. Reinsurance enables an insurance company to expand its capacity, stabilize its underwriting results, or finance its expanding volume. Risk-based capital (“RBC”) Rules to determine insurance company regulatory capital requirements. It is based on rules published by the National Association of Insurance Commissioners (“NAIC”). When referred to as “combined,” represents that of our insurance subsidiaries as a whole. Sales See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP and Other Financial Disclosures.” Total adjusted capital (“TAC”) Primarily consists of statutory capital and surplus and the statutory asset valuation reserve. When referred to as “combined,” represents that of our insurance subsidiaries as a whole. Tax-deferral An investment with earnings such as interest, dividends or capital gains that accumulate tax free until the investor withdraws and takes possession of them. The most common types of tax-deferred investments include those in individual retirement accounts and individual retirement annuities (collectively, “IRAs”) and deferred annuities. Value of business acquired (“VOBA”) Present value of projected future gross profits from in-force policies of acquired businesses. Glossary of Product Terms Accumulation phase The phase of a variable annuity contract during which assets accumulate based on the policyholder’s lump sum or periodic deposits and reinvested interest, capital gains and dividends that are generally tax deferred. Annuitant The person who receives annuity payments or the person whose life expectancy determines the amount of variable annuity payments upon annuitization of a life contingent annuity. Annuities Long-term, tax deferred investments designed to help investors save for retirement. Annuitization The process of converting an annuity investment into a series of periodic income payments, generally for life. Benefit Base A notional amount (not actual cash value) used to calculate the owner’s guaranteed benefits within an annuity contract. The death benefit and living benefit within the same contract may not have the same Benefit Base. Cash surrender value The amount an insurance company pays (minus any surrender charge) to the variable annuity owner when the contract is voluntarily terminated prematurely. Deferred annuity An annuity purchased with premiums paid either over a period of years or as a lump sum, for which savings accumulate prior to annuitization or surrender, and upon annuitization, such savings are exchanged for either a future lump sum or periodic payments for a specific length of time or for a lifetime. Dollar-for-dollar withdrawal A method of calculating the reduction of a variable annuity Benefit Base after a withdrawal in which the benefit is reduced by one dollar for every dollar withdrawn. Enhanced death benefit An optional benefit that locks in investment gains annually, or every few years, or pays a minimum stated interest rate on purchase payments to the beneficiary. Fixed annuity An annuity that guarantees a set annual rate of return with interest at rates we determine, subject to specified minimums. Credited interest rates are guaranteed not to change for certain limited periods of time. Future policy benefits Future policy benefits for the annuities business are comprised mainly of liabilities for life-contingent income annuities, and liabilities for the variable annuity guaranteed minimum benefits accounted for as insurance. Guaranteed minimum accumulation benefits (“GMAB”) An optional benefit (available for an additional cost) which entitles an annuitant to a minimum payment, typically in lump-sum, after a set period of time, typically referred to as the accumulation period. The minimum payment is based on the Benefit Base, which could be greater than the underlying account value. Guaranteed minimum death benefits (“GMDB”) An optional benefit (available for an additional cost) that guarantees an annuitant’s beneficiaries are entitled to a minimum payment based on the Benefit Base, which could be greater than the underlying account value, upon the death of the annuitant. Guaranteed minimum income benefits (“GMIB”) An optional benefit (available for an additional cost) where an annuitant is entitled to annuitize the policy and receive a minimum payment stream based on the Benefit Base, which could be greater than the underlying account value. Guaranteed minimum living benefits (“GMLB”) A reference to all forms of guaranteed minimum living benefits, including GMIBs, GMWBs and GMABs (does not include GMDBs). Guaranteed minimum withdrawal benefit for life (“GMWBL”) An optional benefit (available for an additional cost) where an annuitant is entitled to withdraw a maximum amount of their Benefit Base each year, for the duration of the contract holder’s life, regardless of account performance. Guaranteed minimum withdrawal benefit riders (“GMLB Riders”) Changes in the carrying value of GMLB liabilities, related hedges and reinsurance; the fees earned directly from the GMLB liabilities; and related DAC offsets. Guaranteed minimum withdrawal benefits (“GMWB”) An optional benefit (available for an additional cost) where an annuitant is entitled to withdraw a maximum amount of their Benefit Base each year, for which cumulative payments to the annuitant could be greater than the underlying account value. Guaranteed minimum benefits (“GMxB”) A general reference to all forms of guaranteed minimum benefits, inclusive of living benefits and death benefits. Immediate income annuity A type of annuity for which the owner pays a lump sum and receives periodic payments immediately or soon after purchase. Single premium immediate annuities (“SPIAs”) are single premium annuity products that provide a guaranteed level of income to the owner generally for a specified number of years and/or for the life of the annuitant. Deferred income annuities (“DIAs”) provide a pension-like stream of income payments after a specified deferral period. Index-linked annuities An annuity that provides for asset accumulation and asset distribution needs with an ability to share in the upside from certain financial markets such as equity indices, or an interest rate benchmark. With an index-linked annuity, the customer’s account value can grow or decline due to various external financial market indices performance. Living benefits Optional benefits (available at an additional cost) that guarantee that the owner will get back at least his original investment when the money is withdrawn. Mortality and expense risk fee (“M&E fee”) A fee charged by insurance companies to compensate for the risk they take by issuing variable annuity contracts. Net flows Net change in customer account balances in a period including, but not limited to, new sales, full or partial exits and the net impact of clients utilizing or withdrawing their funds. It excludes the impact of markets on account balances. Period certain annuity Type of annuity that guarantees payment to the annuitant for a specified time period and to the beneficiary if the annuitant dies before the period ends. Policyholder account balances Annuities: Policyholder account balances are held for fixed deferred annuities, the fixed account portion of variable annuities, and non-life contingent income annuities. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. Life Insurance Policies: Policyholder account balances are held for retained asset accounts, universal life policies and the fixed account of universal variable life insurance policies. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. Rider An optional feature or benefit that a variable annuity contract holder can purchase at an additional cost. Roll-up rate The guaranteed percentage that the Benefit Base increases by each year. Separate account An insurance company account, legally segregated from the general account, that holds the contract assets or subaccount investments that can be actively or passively managed and invest in stock, bonds or money market portfolios. Step-up An optional variable annuity feature (available at an additional cost) that can increase the Benefit Base amount if the variable annuity account value is higher than the Benefit Base on specified dates. Surrender charge A fee paid by a contract owner for the early withdrawal of an amount that exceeds a specific percentage or for cancellation of the contract within a specified amount of time after purchase. Term life products Term life products provide a fixed death benefit in exchange for a guaranteed level premium over a specified period of time, usually ten to thirty years. Generally, term life does not include any cash value, savings or investment components. Universal life products Life insurance products that provide a death benefit in return for payment of specified annual policy charges that are generally related to specific costs, which may change over time. To the extent that the policyholder chooses to pay more than the charges required in any given year to keep the policy in-force, the excess premium will be placed into the account value of the policy and credited with a stated interest rate on a monthly basis. Variable annuity A type of annuity that offers guaranteed periodic payments for a defined period of time or for life and gives purchasers the ability to invest in various markets though the underlying investment options, which may result in potentially higher, but variable, returns. Variable universal life Universal life products where the excess amount paid over policy charges can be directed by the policyholder into a variety of separate account investment options. In the separate account investment options, the policyholder bears the entire risk and returns of the investment results. Whole life products Life insurance products that provide a guaranteed death benefit in exchange for a guaranteed level premium for a specified period of time in order to maintain coverage for the life of the insured. Whole life products also have guaranteed minimum cash surrender values. Although the primary purpose is protection, the policyholder can withdraw or borrow against the policy (sometimes on a tax favored basis).

<s>[INST] Page Introduction Executive Summary Industry Trends and Uncertainties Summary of Critical Accounting Estimates NonGAAP and Other Financial Disclosures Segment Capital Results of Operations Effects of Inflation Investments Derivatives OffBalance Sheet Arrangements Policyholder Liabilities Liquidity and Capital Resources Glossary Introduction For purposes of this discussion, unless otherwise mentioned or unless the context indicates otherwise, “Brighthouse,” “Brighthouse Financial,” the “Company,” “we,” “our” and “us” refer to Brighthouse Financial, Inc. a corporation incorporated in Delaware in 2016, and its subsidiaries. We use the term “BHF” to refer solely to Brighthouse Financial, Inc., and not to any of its subsidiaries. Until August 4, 2017, BHF was a whollyowned subsidiary of MetLife, Inc. (together with its subsidiaries and affiliates, “MetLife”). Following this summary is a discussion addressing the consolidated results of operations and financial condition of the Company for the periods indicated. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with “Note Regarding ForwardLooking Statements,” “Risk Factors,” “Selected Financial Data,” “Quantitative and Qualitative Disclosures About Market Risk” and the Company’s consolidated financial statements included elsewhere herein. The term “Separation” refers to the separation of MetLife’s former Brighthouse Financial segment from MetLife’s other businesses and the creation of a separate, publicly traded company, BHF, as well as the distribution on August 4, 2017 of 96,776,670, or 80.8%, of the 119,773,106 shares of BHF common stock outstanding immediately prior to the distribution date by MetLife, Inc. to holders of MetLife, Inc. common stock as of the record date for the distribution. The term “MetLife Divestiture” refers to the disposition by MetLife, Inc. on June 14, 2018 of all its remaining shares of BHF common stock. Effective with the MetLife Divestiture, MetLife, Inc. and its subsidiaries and affiliates are no longer considered related parties to Brighthouse Financial, Inc. and its subsidiaries and affiliates. See Note 1 of the Notes to the Consolidated and Combined Financial Statements. The following discussion may contain forwardlooking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in these forwardlooking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this report, particularly in “Note Regarding ForwardLooking Statements” and “Risk Factors.” Presentation Prior to discussing our Results of Operations, we present background information and definitions that we believe are useful to understanding the discussion of our financial results. This information precedes the Results of Operations and is most beneficial when read in the sequence presented. A summary of key informational sections is as follows: “Executive Summary” contains the following subsections: “Overview” provides information regarding our business, segments and results as discussed in the Results of Operations. “Background” presents details of the Company’s legal entity structure and key events that led up to the completion of the Separation. “Industry Trends and Uncertainties” discusses updates and changes to a number of trends and uncertainties that we believe may materially affect our future financial condition, results of operations or cash flows. “Summary of Critical Accounting Estimates” explains the most critical estimates and judgments applied in determining our GAAP results. “NonGAAP and Other Financial Disclosures” defines key financial measures presented in the Results of Operations that are not calculated in accordance with GAAP but are used by management in evaluating company and segment performance. As described in this section, adjusted earnings is presented by key business activities which are derived from, but different than, the line items presented in the GAAP statement of operations. This section also refers to certain other terms used to describe our insurance business and financial and operating metrics but is not intended to be exhaustive. The [/INST] Negative. </s>

Brighthouse Financial, Inc.

2020-02-26

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Index to Management’s Discussion and Analysis of Financial Condition and Results of Operations Page Introduction Executive Summary Risk Management Strategies Industry Trends and Uncertainties Summary of Critical Accounting Estimates Non-GAAP and Other Financial Disclosures Results of Operations Effects of Inflation Investments Derivatives Off-Balance Sheet Arrangements Policyholder Liabilities Liquidity and Capital Resources Glossary Introduction For purposes of this discussion, unless otherwise mentioned or unless the context indicates otherwise, “Brighthouse,” “Brighthouse Financial,” the “Company,” “we,” “our” and “us” refer to Brighthouse Financial, Inc. a corporation incorporated in Delaware in 2016, and its subsidiaries. We use the term “BHF” to refer solely to Brighthouse Financial, Inc., and not to any of its subsidiaries. Until August 4, 2017, BHF was a wholly-owned subsidiary of MetLife, Inc. (together with its subsidiaries and affiliates, “MetLife”). Following this summary is a discussion addressing the consolidated results of operations and financial condition of the Company for the periods indicated. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with “Note Regarding Forward-Looking Statements,” “Risk Factors,” “Selected Financial Data,” “Quantitative and Qualitative Disclosures About Market Risk” and the Company’s consolidated financial statements included elsewhere herein. The term “Separation” refers to the separation of MetLife’s former Brighthouse Financial segment from MetLife’s other businesses and the creation of a separate, publicly-traded company, BHF, as well as the distribution on August 4, 2017 of 96,776,670, or 80.8%, of the 119,773,106 shares of BHF common stock outstanding immediately prior to the distribution date by MetLife, Inc. to holders of MetLife, Inc. common stock as of the record date for the distribution. The term “MetLife Divestiture” refers to the disposition by MetLife, Inc. on June 14, 2018 of all its remaining shares of BHF common stock. Effective with the MetLife Divestiture, MetLife, Inc. and its subsidiaries and affiliates are no longer considered related parties to BHF and its subsidiaries and affiliates. See Note 1 of the Notes to the Consolidated Financial Statements. The following discussion may contain forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this report, particularly in “Note Regarding Forward-Looking Statements” and “Risk Factors.” Presentation Prior to discussing our Results of Operations, we present background information and definitions that we believe are useful to understanding the discussion of our financial results. This information precedes the Results of Operations and is most beneficial when read in the sequence presented. A summary of key informational sections is as follows: • “Executive Summary” contains the following sub-sections: • “Overview” provides information regarding our business, segments and results as discussed in the Results of Operations. • “Background” presents details of the Company’s legal entity structure. • “Risk Management Strategies” describes the Company’s risk management strategy to protect against capital market risks specific to our variable annuity and ULSG businesses. • “Industry Trends and Uncertainties” discusses updates and changes to a number of trends and uncertainties that we believe may materially affect our future financial condition, results of operations or cash flows. • “Summary of Critical Accounting Estimates” explains the most critical estimates and judgments applied in determining our GAAP results. • “Non-GAAP and Other Financial Disclosures” defines key financial measures presented in the Results of Operations that are not calculated in accordance with GAAP but are used by management in evaluating company and segment performance. As described in this section, adjusted earnings is presented by key business activities which are derived from, but different than, the line items presented in the GAAP statement of operations. This section also refers to certain other terms used to describe our insurance business and financial and operating metrics but is not intended to be exhaustive. • The Results of Operations section begins with a discussion of our “Annual Actuarial Review.” Annual actuarial review (the “AAR”) describes the changes in key assumptions applied in 2019 and 2018, respectively, resulting in an unfavorable impact to net income (loss) available to shareholders in each period. Our Results of Operations discussion and analysis presents a review for the years ended December 31, 2019 and 2018 and year-to-year comparisons between these years. Our results of operations discussion and analysis for the year ended December 31, 2017, including a review of the 2017 AAR and year-to-year comparisons between the years ended December 31, 2018 and 2017 can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations” in our Annual Report on Form 10-K for the year ended December 31, 2018 (our “2018 Annual Report”), which was filed with the SEC on February 26, 2019, and such discussions are incorporated herein by reference. Executive Summary Overview We are one of the largest providers of annuity and life insurance products in the United States through multiple independent distribution channels and marketing arrangements with a diverse network of distribution partners. For operating purposes, we have established three segments: (i) Annuities, (ii) Life and (iii) Run-off, which consists of operations relating to products we are not actively selling, and which are separately managed. In addition, we report certain of our results of operations in Corporate & Other. See “Business - Segments and Corporate & Other” and Note 2 of the Notes to the Consolidated Financial Statements for further information on our segments and Corporate & Other. The table below presents a summary of our net income (loss) available to shareholders and adjusted earnings a non-GAAP financial measure. See “- Non-GAAP and Other Financial Disclosures.” For a detailed discussion of our results see “- Results of Operations.” For the year ended December 31, 2019, we had a net loss of $761 million and adjusted earnings of $599 million, as compared to net income of $865 million and adjusted earnings of $892 million for the year ended December 31, 2018. The net loss for the year ended December 31, 2019 reflected impacts from higher equity markets which resulted in unfavorable net changes in derivative instruments in our variable annuity business, partially offset by the impact of lower interest rates on interest rate hedges in both our variable annuity and ULSG businesses. Background This Management’s Discussion and Analysis of Financial Condition and Results of Operations is intended to help the reader understand the results of operations, financial condition and cash flows of Brighthouse for the periods indicated. In addition to Brighthouse Financial, Inc., the companies and businesses included in the results of operations, financial condition and cash flows are: • Brighthouse Life Insurance Company (together with its subsidiaries and affiliates, “BLIC”), our largest insurance operating entity, domiciled in Delaware and licensed to write business in 49 states; • New England Life Insurance Company (“NELICO”), domiciled in Massachusetts and licensed to write business in all 50 states; • Brighthouse Life Insurance Company of NY (“BHNY”), domiciled in New York and licensed to write business in New York, which is a subsidiary of Brighthouse Life Insurance Company; • Brighthouse Reinsurance Company of Delaware (“BRCD”), our single reinsurance company licensed in Delaware, which is a subsidiary of Brighthouse Life Insurance Company; • Brighthouse Investment Advisers, LLC (“Brighthouse Advisers”), serving as investment advisor to certain proprietary mutual funds that are underlying investments under our and MetLife’s variable insurance products; • Brighthouse Services, LLC (“Brighthouse Services”), an internal services and payroll company; • Brighthouse Securities, LLC (“Brighthouse Securities”), registered as a broker-dealer with the SEC, approved as a member of FINRA and registered as a broker-dealer and licensed as an insurance agency in all required states; and • Brighthouse Holdings, LLC (“BH Holdings”), a wholly-owned holding company subsidiary of Brighthouse Financial, Inc. domiciled in Delaware. Risk Management Strategies The Company employs risk management strategies to protect against capital market risks. These strategies are specific to our variable annuity and ULSG businesses, and also include a macro hedge strategy to manage the Company’s exposure to interest rate risk. CTE95 and CTE98 referred to below are defined in “- Glossary.” Interest Rate Hedging The Company is exposed to interest rate risk in most of its products with the more significant longer dated exposure residing in our in-force variable annuity guarantees and ULSG. Historically, we individually managed the interest rate risk in these two blocks with hedge targets based on statutory metrics designed principally to protect the capital of our largest operating insurance company, BLIC. With the adoption of VA Reform, the capital metric of combined RBC ratio now aligns with our management metrics and more holistically captures interest rate risk. We began to more actively manage the interest rate risk in our variable annuity and ULSG businesses together, although individual hedge targets still exist for variable annuities and ULSG. Accordingly, the related portfolio of interest rate derivatives will be managed in the aggregate with rebalancing and trade executions determined by the net exposure. By managing the interest rate exposure on a net basis, we expect to more efficiently manage the derivative portfolio, better protect capital and reduce costs. We refer to this aggregated approach to managing interest rate risk as our macro interest rate hedging program. The table below presents the gross notional amount and estimated fair value of the derivatives held in our macro interest rate hedging program. The aggregate interest rate derivatives are then allocated to the variable annuity guarantee and ULSG businesses based on the hedge targets of the respective programs as of the balance sheet date. Allocations are primarily for purposes of calculating certain product specific metrics needed to run the business which in some cases are still individually measured and to facilitate the quarterly settlement of reinsurance activity associated with BRCD. Variable Annuity Exposure Risk Management With our early adoption of VA Reform, our management of and hedging strategy associated with our variable annuity business aligns with the new regulatory framework. Given this alignment and the fact that we have a large non-variable annuity business, we have shifted our focus on capital metrics from a CTE target to a combined RBC ratio target. In support of our target combined RBC ratio between 400% and 450%, we expect to continue to maintain a capital and exposure risk management program that targets total assets supporting our variable annuity contracts at or above the CTE98 level in normal market conditions. We refer to our target level of assets as our “Variable Annuity Target Funding Level.” While total assets supporting our variable annuity capital may exceed the CTE98 level, under stressed conditions we intend to allow such assets supporting our variable annuities to range between a target floor level of CTE95 and CTE98. At December 31, 2019, we held approximately $11.1 billion of total assets supporting our variable annuity contracts, which equals approximately $1.7 billion above CTE98 and $3.3 billion above CTE95. Our exposure risk management program seeks to mitigate the potential adverse effects of changes in capital markets, specifically equity markets and interest rates, on our Variable Annuity Target Funding Level, as well as on our statutory distributable earnings. We utilize a combination of short-term and longer-term derivative instruments to establish a layered maturity of protection, which we believe will reduce rollover risk during periods of market disruption or higher volatility. When setting our hedge target, we consider the fact that our obligations under Shield Annuity contracts decrease in falling equity markets when variable annuity guarantee obligations increase, and increase in rising equity markets when variable annuity guarantee obligations decrease. We continually review our hedging strategy in the context of our overall capitalization targets as well as monitor the capital markets for opportunities to adjust our derivative positions to manage our variable annuity exposure, as appropriate. Our hedging strategy since the Separation focused on option-based derivatives protecting against larger market movements and reducing hedge losses in rising market scenarios. As a part of this strategy, we historically guided toward a first loss of up to $2.0 billion. The first loss position is relative to our Variable Annuity Target Funding Level such that the impact to reserves and thus total adjusted capital could be greater than the first loss position, however under such a scenario there would be a substantial offset in required statutory capital. Given recent robust equity market returns and the related increase in our statutory capital, we re-assessed our hedging strategy in late 2019. As a result of this review, we revised our hedging strategy to reduce the use of options and move to more swap-based instruments to better protect statutory capital against smaller market moves. With this revised strategy, we plan to operate with a first loss position of no more than $500 million. This revised strategy preserves distributable earnings across more market scenarios and protects the capital generated from the market upside experienced since Separation. We expect to have significantly lower time decay expense as a result of this revised strategy. However, we also expect to incur larger hedge mark-to-market losses in rising equity markets as compared to our previous strategy. We expect this strategy shift will be substantially complete by the end of the first quarter of 2020. We believe the increased capital protection in down markets increases our financial flexibility and supports deploying capital for growing long-term, sustainable shareholder value. However, because our hedging strategy places a low priority on offsetting changes to GAAP liabilities, GAAP net income volatility will likely result when markets are volatile and over time potentially impact stockholders’ equity. See “Risk Factors - Risks Related to Our Business - Our variable annuity exposure risk management strategy may not be effective, may result in significant volatility in our profitability measures and may negatively affect our statutory capital” and “- Summary of Critical Accounting Estimates.” The table below presents the gross notional amount and estimated fair value of the derivatives held in our variable annuity hedging program as well as the interest rate hedges allocated from our macro interest rate hedging program. _______________ (1) Subsequent to December 31, 2019, the instrument types presented in this table are expected to be significantly different as part of our strategy shift described above. The absolute notional amounts presented do not necessarily represent the relative economic coverage provided by option instruments because certain positions were closed out by entering into offsetting positions that are not netted in the above table. ULSG Market Risk Exposure Management The ULSG block includes the business that resides in our operating insurance companies and the portion of it that is ceded to BRCD for providing redundant, non-economic reserve financing support. The primary market risk associated with our ULSG block is the uncertainty around the future levels of U.S. interest rates and bond yields. To help ensure we have sufficient assets to meet future ULSG policyholder obligations, we have employed an actuarial approach based upon NY Regulation 126 Cash Flow Testing (“ULSG CFT”) as the basis for setting our ULSG asset requirement target for BRCD, which reinsures the majority of the ULSG business written by our operating insurance companies. For the business that remains in the operating insurance companies, we set our ULSG asset requirement target to equal the actuarially determined statutory reserves, which, taken together with our ULSG asset requirement target of BRCD, comprises our total ULSG asset requirement target (“ULSG Target”). Under the ULSG CFT approach, we assume that interest rates remain flat or lower than current levels and our actuarial assumptions include a provision for adverse deviation. These underlying assumptions used in ULSG CFT are more conservative than those required under GAAP, which assumes a long-term upward mean reversion of interest rates and best estimate actuarial assumptions without additional provisions for adverse deviation. We seek to mitigate interest rate exposures associated with these liabilities by holding ULSG Assets to closely match our ULSG Target under different interest rate environments. “ULSG Assets” are defined as (i) total general account assets supporting statutory reserves and capital in the ULSG portfolios of the operating insurance companies and BRCD and (ii) interest rate derivative instruments allocated from the macro interest rate hedging program to mitigate ULSG interest rate exposures. The net statutory reserves for the ULSG business in our operating insurance companies and BRCD (which is in part supported by reserve financings) were $21.2 billion and $20.3 billion for the years ended December 31, 2019 and 2018, respectively. The net GAAP reserves were $11.3 billion and $10.1 billion or the years ended December 31, 2019 and 2018, respectively. Our ULSG Target is sensitive to the actual and future expected level of long-term U.S. interest rates. If interest rates fall, our ULSG Target increases. Likewise, if interest rates rise, our ULSG Target declines. The interest rate derivatives allocated to ULSG Assets prioritizes the ULSG Target (comprised of ULSG CFT and statutory considerations), with less emphasis on mitigating GAAP net income volatility. This could increase the period-to-period volatility of net income and equity due to differences in the sensitivity of the ULSG Target and GAAP liabilities to the changes in interest rates. This mitigation strategy enables us to better protect BRCD’s statutory capitalization from potential losses due to an increase in our ULSG Target under lower interest rate conditions. Conversely, in order to limit the cost of this risk mitigation strategy, we may allow for lower realization of gains as the ULSG Target declines in moderately rising interest rate environments. We intend to maintain an adequate amount of liquid investments in our investment portfolio supporting our ULSG book to support any contingent collateral posting requirements from our macro interest rate hedging program. We closely monitor the sensitivity of our ULSG Assets and ULSG Target to changes in interest rates. We seek to maintain ULSG Assets above the ULSG Target across a wide range of interest rate scenarios. At December 31, 2019, BRCD assets exceeded the ULSG CFT requirement. In addition, our macro interest rate hedging program is designed to help us maintain ULSG Assets above the ULSG Target when interest rates decline. Maintaining ULSG Assets that closely match our ULSG Target supports our target combined RBC ratio of between 400% and 450% for the Company. Industry Trends and Uncertainties Throughout this Management’s Discussion and Analysis of Financial Condition and Results of Operations, we discuss a number of trends and uncertainties that we believe may materially affect our future financial condition, results of operations or cash flows. Where these trends or uncertainties are specific to a particular aspect of our business, we often include such a discussion under the relevant caption of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, as part of our broader analysis of that area of our business. In addition, the following factors represent some of the key general trends and uncertainties that have influenced the development of our business and our historical financial performance and that we believe will continue to influence our business and results of operations in the future. Changes in Accounting Standards Our financial statements are subject to the application of GAAP, which is periodically revised by the FASB. The FASB issued an accounting standards update (“ASU”) on August 15, 2018 that will result in significant changes to the accounting for long-duration insurance contracts, including a requirement for all guarantees associated with our variable annuity business to be measured at fair value. The Company is evaluating the new guidance and therefore is unable to estimate the impact to its financial statements. The ASU will have a significant impact on our results of operations, including our net income, and at current market interest rate levels could ultimately result in a material decrease in our stockholders’ equity. Financial and Economic Environment Our business and results of operations are materially affected by conditions in the capital markets and the economy generally. Stressed conditions, volatility and disruptions in the capital markets, particular markets, or financial asset classes can have an adverse effect on us. The impact on capital markets and the economy generally of the priorities and policies of the Trump administration is uncertain. See “Risk Factors - Economic Environment and Capital Markets-Related Risks - If difficult conditions in the capital markets and the U.S. economy generally persist or are perceived to persist, they may materially adversely affect our business and results of operations.” Equity market performance can affect our profitability for variable annuities and other separate account products as a result of the effects it has on product demand, revenues, expenses, reserves and our risk management effectiveness. The level of long-term interest rates and the shape of the yield curve can have a negative effect on the demand for, and the profitability of, spread-based products such as fixed annuities, index-linked annuities and universal life insurance. Low interest rates and risk premium, including credit spread, affect new money rates on invested assets and the cost of product guarantees. Insurance premium growth and demand for our products is impacted by the general health of U.S. economic activity. The above factors affect our expectations regarding future margins, which in turn, affect the amortization of certain of our intangible assets such as DAC. Significantly lower expected margins may cause us to accelerate the amortization of DAC, thereby reducing net income in the affected reporting period. We review our long-term assumptions about capital market returns and interest rates, along with other assumptions such as contract holder behavior, as part of our annual actuarial review. As additional company specific and/or industry information on contract holder behavior becomes available, related assumptions may change and may potentially have a material impact on liability valuations and net income. Demographics We believe that demographic trends in the U.S. population, the increase in under-insured individuals, the potential risk to governmental social safety net programs and the shifting of responsibility for retirement planning and financial security from employers and other institutions to individuals, highlight the need of individuals to plan for their long-term financial security and will create opportunities to generate significant demand for our products. By focusing our product development and marketing efforts to meeting the needs of certain targeted customer segments identified as part of our strategy, we will be able to focus on offering a smaller number of products that we believe are appropriately priced given current economic conditions, which we believe will benefit our expense ratio thereby increasing our profitability. Competitive Environment The life insurance industry remains highly fragmented and competitive. See “Business - Segments and Corporate & Other” for each of our segments. In particular, we believe that financial strength and financial flexibility are highly relevant differentiators from the perspective of customers and distributors. We believe we are adequately positioned to compete in this environment. Regulatory Developments Our life insurance companies are regulated primarily at the state level, with some products and services also subject to federal regulation. In addition, BHF and its insurance subsidiaries are subject to regulation under the insurance holding company laws of various U.S. jurisdictions. Furthermore, some of our operations, products and services are subject to ERISA, consumer protection laws, securities, broker-dealer and investment advisor regulations, as well as environmental and unclaimed property laws and regulations. See “Business - Regulation” and “Risk Factors - Regulatory and Legal Risks.” In addition, Regulation 187 adopted a “best interest” standard for the sale of life insurance and annuity products in New York, which may have adverse effects on our business by imposing greater compliance, oversight, disclosure and notification requirements on us. The NAIC and the SEC have adopted similar regulations, and other states are also considering standard of conduct regulation. Summary of Critical Accounting Estimates The preparation of financial statements in conformity with GAAP requires management to adopt accounting policies and make estimates and assumptions that affect amounts reported on the Consolidated Financial Statements. The most critical estimates include those used in determining: (i) liabilities for future policy benefits; (ii) amortization of DAC; (iii) investment impairments; (iv) estimated fair values of freestanding derivatives and the recognition and estimated fair value of embedded derivatives requiring bifurcation; and (v) measurement of income taxes and the valuation of deferred tax assets. In applying our accounting policies, we make subjective and complex judgments that frequently require estimates about matters that are inherently uncertain. Many of these policies, estimates and related judgments are common in the insurance and financial services industries; others are specific to our business and operations. Actual results could differ from these estimates. The above critical accounting estimates are described below and in Note 1 of the Notes to the Consolidated Financial Statements. Liability for Future Policy Benefits Future policy benefits for traditional long-duration insurance contracts (term, whole life insurance and income annuities) are payable over an extended period of time and the related liabilities are equal to the present value of future expected benefits to be paid, reduced by the present value of future expected net premiums. Assumptions used to measure the liability are based on the Company’s experience and include a margin for adverse deviation. The principal assumptions used in the establishment of liabilities for future policy benefits are mortality, morbidity, benefit utilization and withdrawals, policy lapse, retirement, disability incidence, disability terminations, investment returns and expenses. These assumptions, intended to estimate the experience for the period the policy benefits are payable, are established at the time the policy is issued and are not updated unless a premium deficiency exists. Utilizing these assumptions, liabilities are established for each line of business. If experience is less favorable than assumed and a premium deficiency exists, DAC may be reduced, and/or additional insurance liabilities established, resulting in a reduction in earnings. Future policy benefit liabilities for GMDBs and certain GMIBs relating to variable annuity contracts are based on estimates of the expected value of benefits in excess of the projected account balance, recognizing the excess ratably over the accumulation period based on total expected assessments. Liabilities for universal and variable life insurance secondary guarantees are determined by estimating the expected value of death benefits payable when the account balance is projected to be zero using a range of scenarios and recognizing those benefits ratably over the contract period based on total expected assessments. The Company also maintains a profit followed by losses reserve on universal life insurance with secondary guarantees. The assumptions of investment performance and volatility for variable products are consistent with historical experience of the underlying separate account funds. We regularly review our assumptions supporting our estimates of actuarial liabilities for future policy benefits. For universal life and annuity product guarantees, assumptions are updated periodically, whereas for traditional long-duration insurance contracts, assumptions are established at inception and not updated unless a premium deficiency exists. We also review our liability projections to determine if profits are projected in earlier years followed by losses projected in later years, which could require us to establish an additional liability. We aggregate insurance contracts by product and segment in assessing whether a premium deficiency or profits followed by losses exists. Differences between actual experience and the assumptions used in pricing our policies and guarantees, as well as adjustments to the related liabilities, result in changes to earnings. See Note 1 of the Notes to the Consolidated Financial Statements for additional information on our accounting policy relating to variable annuity guarantees and liability for future policy benefits. Deferred Policy Acquisition Costs DAC represents deferred costs that relate directly to the successful acquisition or renewal of insurance contracts. The recovery of DAC is dependent upon the future profitability of the related business. DAC related to deferred annuities, universal and variable life insurance contracts is amortized based on expected future gross profits. DAC balances and amortization for variable contracts can be significantly impacted by changes in expected future gross profits related to projected separate account rates of return. Our practice of determining changes in projected separate account returns assumes that long-term appreciation in equity markets is not changed by short-term market fluctuations but is only changed when sustained interim deviations are expected. We monitor these events and only change the assumption when our long-term expectation changes. The effect of an increase (decrease) by 100 basis points in the assumed future rate of return is reasonably likely to result in a decrease (increase) in the DAC amortization with an offset to our unearned revenue liability which nets to approximately $215 million. We use a mean reversion approach to separate account returns where the mean reversion period is five years with a long-term separate account return after the five-year reversion period is over. The current long-term rate of return assumption for variable annuity and variable universal life insurance contracts is in the 6-7% range. We also generally review other long-term assumptions underlying the projections of expected future gross profits on an annual basis. These assumptions primarily relate to general account investment returns, interest crediting rates, mortality, in-force or persistency, benefit elections and withdrawals, and expenses to administer business. Assumptions used in the calculation of expected future gross profits which have significantly changed are updated annually. If the update of assumptions causes expected future gross profits to increase, DAC amortization will generally decrease, resulting in a current period increase to earnings. The opposite result occurs when the assumption update causes expected future gross profits to decrease. Our DAC balances are also impacted by replacing expected future gross profits with actual gross profits in each reporting period, including changes in annuity embedded derivatives and the related nonperformance risk. When the change in expected future gross profits principally relates to the difference between actual and estimates in the current period, an increase in profits will generally result in an increase in amortization and a decrease in profits will generally result in a decrease in amortization. See Notes 1 and 4 of the Notes to the Consolidated Financial Statements for additional information relating to DAC accounting policy and amortization. Investment Impairments One of the significant estimates related to AFS securities is our impairment evaluation. The assessment of whether an other-than-temporary impairment (“OTTI”) occurred is based on our case-by-case evaluation of the underlying reasons for the decline in estimated fair value on a security-by-security basis. Our review of each fixed maturity security for OTTI includes an analysis of gross unrealized losses by three categories of severity and/or age of gross unrealized loss. An extended and severe unrealized loss position may not have any impact on the ability of the issuer to service all scheduled interest and principal payments. Accordingly, such an unrealized loss position may not impact our evaluation of recoverability of all contractual cash flows or the ability to recover an amount at least equal to its amortized cost based on the present value of the expected future cash flows to be collected. Additionally, we consider a wide range of factors about the security issuer and use our best judgment in evaluating the cause of the decline in the estimated fair value of the security and in assessing the prospects for near-term recovery. Inherent in our evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential. Factors we consider in the OTTI evaluation process are described in Note 6 of the Notes to the Consolidated Financial Statements. The determination of the amount of allowances and impairments on the remaining invested asset classes is highly subjective and is based upon our periodic evaluation and assessment of known and inherent risks associated with the respective asset class. Such evaluations and assessments are revised as conditions change and new information becomes available. See Notes 1 and 6 of the Notes to the Consolidated Financial Statements for additional information relating to our determination of the amount of allowances and impairments. Derivatives We use freestanding derivative instruments to hedge various capital market risks in our products, including: (i) certain guarantees, some of which are reported as embedded derivatives; (ii) current or future changes in the fair value of our assets and liabilities; and (iii) current or future changes in cash flows. All derivatives, whether freestanding or embedded, are required to be carried on the balance sheet at fair value with changes reflected in either net income (loss) available to shareholders or in other comprehensive income (“OCI”), depending on the type of hedge. Below is a summary of critical accounting estimates by type of derivative. Freestanding Derivatives The determination of the estimated fair value of freestanding derivatives, when quoted market values are not available, is based on market standard valuation methodologies and inputs that management believes are consistent with what other market participants would use when pricing such instruments. Derivative valuations can be affected by changes in interest rates, foreign currency exchange rates, financial indices, credit spreads, default risk, nonperformance risk, volatility, liquidity and changes in estimates and assumptions used in the pricing models. See Note 7 of the Notes to the Consolidated Financial Statements for additional information on significant inputs into the OTC derivative pricing models and credit risk adjustment. Embedded Derivatives in Variable Annuity Guarantees We issue variable annuity products with guaranteed minimum benefits, some of which are embedded derivatives measured at estimated fair value separately from the host variable annuity product, with changes in estimated fair value reported in net derivative gains (losses). The estimated fair values of these embedded derivatives are determined based on the present value of projected future benefits minus the present value of projected future fees attributable to the guarantee. The projections of future benefits and future fees require capital markets and actuarial assumptions, including expectations concerning policyholder behavior. A risk neutral valuation methodology is used under which the cash flows from the guarantees are projected under multiple capital market scenarios using observable risk-free rates and implied equity volatilities. Market conditions, including, but not limited to, changes in interest rates, equity indices, market volatility and variations in actuarial assumptions, including policyholder behavior, mortality and risk margins related to non-capital market inputs, as well as changes in our nonperformance risk may result in significant fluctuations in the estimated fair value of the guarantees that could have a material impact on net income. Changes to actuarial assumptions, principally related to contract holder behavior such as annuitization utilization and withdrawals associated with GMIB riders, can result in a change of expected future cash outflows of a guarantee between the accrual-based model for insurance liabilities and the fair value based model for embedded derivatives. See Note 1 of the Notes to the Consolidated Financial Statements for additional information relating to the determination of the accounting model. Risk margins are established to capture the non-capital market risks of the instrument which represent the additional compensation a market participant would require to assume the risks related to the uncertainties in certain actuarial assumptions. The establishment of risk margins requires the use of significant management judgment, including assumptions of the amount and cost of capital needed to cover the guarantees. Assumptions for embedded derivatives are reviewed at least annually, and if they change significantly, the estimated fair value is adjusted by a cumulative charge or credit to net income. See Notes 7 and 8 of the Notes to the Consolidated Financial Statements for additional information on our embedded derivatives and the determination of their fair values. Embedded Derivatives in Index-Linked Annuities The Company issues and assumes through reinsurance index-linked annuities that contain equity crediting rates accounted for as an embedded derivative. The crediting rates are measured at estimated fair value which is determined using a combination of an option pricing methodology and an option-budget approach. The estimated fair value includes capital market and actuarial policyholder behavior and biometric assumptions, including expectations for renewals at the end of the term period. Market conditions, including interest rates and implied volatilities, and variations in actuarial assumptions and risk margins as well as changes in our nonperformance risk adjustment may result in significant fluctuations in the estimated fair value that could have a material impact on net income. Nonperformance Risk Adjustment The valuation of our embedded derivatives includes an adjustment for the risk that we fail to satisfy our obligations, which we refer to as our nonperformance risk. The nonperformance risk adjustment is captured as a spread over the risk-free rate in determining the discount rate to discount the cash flows of the liability. The spread over the risk-free rate is based on our creditworthiness taking into consideration publicly available information relating to spreads in the secondary market for BHF’s debt. These observable spreads are then adjusted, as necessary, to reflect the financial strength ratings of the issuing insurance subsidiaries as compared to the credit rating of BHF. The following table illustrates the impact that a range of reasonably likely variances in BHF’s credit spread would have on our consolidated balance sheet, excluding the effect of income tax, related to the embedded derivative valuation on certain variable annuity products measured at estimated fair value. Even when credit spreads do not change, the impact of the nonperformance risk adjustment on fair value will change when the cash flows within the fair value measurement change. The table only reflects the impact of changes in credit spreads on the balance sheet and not these other potential changes. In determining the ranges, we have considered current market conditions, as well as the market level of spreads that can reasonably be anticipated over the near-term. Income Taxes We provide for federal and state income taxes currently payable, as well as those deferred due to temporary differences between the financial reporting and tax bases of assets and liabilities. Our accounting for income taxes represents our best estimate of various events and transactions. Tax laws are often complex and may be subject to differing interpretations by the taxpayer and the relevant governmental taxing authorities. In establishing a provision for income tax expense, we must make judgments and interpretations about the application of tax laws. We must also make estimates about when in the future certain items will affect taxable income in the various taxing jurisdictions. In establishing a liability for unrecognized tax benefits, assumptions may be made in determining whether, and to what extent, a tax position may be sustained. Once established, unrecognized tax benefits are adjusted when there is more information available or when events occur requiring a change. Valuation allowances are established against deferred tax assets, particularly those arising from carryforwards, when management determines, based on available information, that it is more likely than not that deferred income tax assets will not be realized. The realization of deferred tax assets related to carryforwards depends upon the existence of sufficient taxable income within the carryforward periods under the tax law in the applicable tax jurisdiction. Significant judgment is required in projecting future taxable income to determine whether valuation allowances should be established, as well as the amount of such allowances. See Note 1 of the Notes to the Consolidated Financial Statements for additional information relating to our determination of such valuation allowances. We may be required to change our provision for income taxes when estimates used in determining valuation allowances on deferred tax assets significantly change, or when new information indicates the need for adjustment in valuation allowances. Additionally, future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the financial statements in the year these changes occur. See Notes 1 and 13 of the Notes to the Consolidated Financial Statements for additional information on our income taxes. Non-GAAP and Other Financial Disclosures Our definitions of the non-GAAP and other financial measures may differ from those used by other companies. Non-GAAP Financial Disclosures Adjusted Earnings In this report, we present adjusted earnings, which excludes net income (loss) attributable to noncontrolling interests and preferred stock dividends, as a measure of our performance that is not calculated in accordance with GAAP. We believe that this non-GAAP financial measure highlights our results of operations and the underlying profitability drivers of our business, as well as enhances the understanding of our performance by the investor community. However, adjusted earnings should not be viewed as a substitute for net income (loss) available to Brighthouse Financial, Inc.’s common shareholders, which is the most directly comparable financial measure calculated in accordance with GAAP. See “- Results of Operations” for a reconciliation of adjusted earnings to net income (loss) available to Brighthouse Financial, Inc.’s common shareholders. Adjusted earnings, which may be positive or negative, is used by management to evaluate performance, allocate resources and facilitate comparisons to industry results. This financial measure focuses on our primary businesses principally by excluding the impact of market volatility, which could distort trends. The following are significant items excluded from total revenues, net of income tax, in calculating adjusted earnings: • Net investment gains (losses); • Net derivative gains (losses) except earned income on derivatives and amortization of premium on derivatives that are hedges of investments or that are used to replicate certain investments, but do not qualify for hedge accounting treatment (“Investment Hedge Adjustments”); and • Certain variable annuity GMIB fees (“GMIB Fees”) and amortization of unearned revenue related to net investment gains (losses) and net derivative gains (losses). The following are significant items excluded from total expenses, net of income tax, in calculating adjusted earnings: • Amounts associated with benefits related to GMIBs (“GMIB Costs”); • Amounts associated with periodic crediting rate adjustments based on the total return of a contractually referenced pool of assets and market value adjustments associated with surrenders or terminations of contracts (“Market Value Adjustments”); and • Amortization of DAC and VOBA related to (i) net investment gains (losses), (ii) net derivative gains (losses), (iii) GMIB Fees and GMIB Costs and (iv) Market Value Adjustments. The tax impact of the adjustments mentioned is calculated net of the statutory tax rate, which could differ from our effective tax rate. We present adjusted earnings in a manner consistent with management’s view of the primary business activities that drive the profitability of our core businesses. The following table illustrates how each component of adjusted earnings is calculated from the GAAP statement of operations line items: _______________ (1) Italicized items indicate GAAP statement of operations line items. Consistent with GAAP guidance for segment reporting, adjusted earnings is also our GAAP measure of segment performance. Accordingly, we report adjusted earnings by segment in Note 2 of the Notes to the Consolidated Financial Statements. Adjusted Net Investment Income We present adjusted net investment income, which is not calculated in accordance with GAAP. We present adjusted net investment income to measure our performance for management purposes, and we believe it enhances the understanding of our investment portfolio results. Adjusted net investment income represents net investment income including Investment Hedge Adjustments. For a reconciliation of adjusted net investment income to net investment income, the most directly comparable GAAP measure, see footnote 4 to the summary yield table located in “- Investments - Current Environment - Investment Portfolio Results.” Other Financial Disclosures Similar to adjusted net investment income, we present net investment income yields as a performance measure we believe enhances the understanding of our investment portfolio results. Net investment income yields are calculated on adjusted net investment income as a percent of average quarterly asset carrying values. Asset carrying values exclude unrealized gains (losses), collateral received in connection with our securities lending program, freestanding derivative assets and collateral received from derivative counterparties. Results of Operations Index to Results of Operations Page Annual Actuarial Review Consolidated Results for the Years Ended December 31, 2019 and 2018 Reconciliation of Net Income (Loss) Available to Shareholders to Adjusted Earnings Consolidated Results for the Years Ended December 31, 2019 and 2018 - Adjusted Earnings Segments and Corporate & Other - Adjusted Earnings for the Years Ended December 31, 2019 and 2018 GMLB Riders for the Years Ended December 31, 2019 and 2018 Annual Actuarial Review Generally, in the third quarter of each year we conduct an AAR. The most significant impact from the 2019 AAR reflected the change in the long-term general account earned rate for GAAP, which lowered the base 10-year U.S. Treasury rate from 4.25% to 3.75%, which had the largest impact to our ULSG business in the Run-off segment. For our variable annuity business, in addition to the update in the long-term general account earned rate, we updated assumptions regarding separate account fund allocations and volatility, as well as maintenance expenses. In our life business, we updated assumptions related to mortality and expenses. As a result of the 2018 AAR, our variable annuity business reflected the alignment to the statutory variable annuity capital reform framework. These changes included lower lapse and utilization assumptions (consistent with updated Brighthouse policyholder experience and industry participants), as well as updates to the equity market scenario generator, as reflected in the framework. We also updated the tax rate to reflect the statutory tax rate change due to the Tax Act. In our life business, we updated assumptions related to market returns, policyholder behavior and expenses. The following table presents the impact on pre-tax adjusted earnings and net income (loss) before provision for income tax from the AAR for the years ended December 31, 2019 and 2018. The impact related to GMLBs is included in net income (loss) but is not included in pre-tax adjusted earnings. See “- Non-GAAP and Other Financial Disclosures.” Consolidated Results for the Years Ended December 31, 2019 and 2018 Unless otherwise noted, all amounts in the following discussions of our results of operations are stated before income tax except for adjusted earnings, which are presented net of income tax. The following table presents the components of net income (loss) available to shareholders. GMLB Riders. The GMLB Riders reflect (i) changes in the carrying value of GMLB liabilities, including GMIBs, GMWBs and GMABs, and Shield Annuities; (ii) changes in the estimated fair value of the related hedges as well as any ceded reinsurance of the liabilities; (iii) the fees earned from the GMLB liabilities; and (iv) the effects of DAC amortization related to the preceding components. Other Derivative Instruments. We have other derivative instruments, in addition to the hedges and embedded derivatives included in the GMLB Riders, for which changes in estimated fair value are recognized in net derivative gains (losses). Freestanding Derivatives. We have freestanding derivatives that economically hedge certain invested assets and insurance liabilities. The majority of this hedging activity, excluding the GMLB Riders, is focused in the following areas: • as part of the Company’s macro interest rate hedging program, the use of interest rate swaps, swaptions, and interest rate forwards in connection with ULSG; • use of interest rate swaps when we have duration mismatches where suitable assets with maturities similar to those of our long-dated liabilities are not readily available in the market and use of interest rate forwards hedging reinvestment risk from maturing assets with higher yields than currently available in the market that support long-dated liabilities; • use of foreign currency swaps when we hold fixed maturity securities denominated in foreign currencies that are matching insurance liabilities denominated in U.S. dollars; and • use of equity index options to hedge index-linked annuity products against adverse changes in equity markets. The market impacts on the hedges are accounted for in net income (loss) while the offsetting economic impact on the items they are hedging are either not recognized or recognized through OCI in equity. Embedded Derivatives. Certain ceded reinsurance agreements in our Life and Run-off segments are written on a coinsurance with funds withheld basis. The funds withheld component is accounted for as an embedded derivative with changes in the estimated fair value recognized in net income (loss) in the period in which they occur. In addition, the changes in liability values of our fixed index-linked annuity products that result from changes in the underlying equity index are accounted for as embedded derivatives. Pre-tax Adjusted Earnings. As more fully described in “- Non-GAAP and Other Financial Disclosures,” we use adjusted earnings, which does not equate to net income (loss) available to shareholders, as determined in accordance with GAAP. We believe that the presentation of adjusted earnings, as we measure it for management purposes, enhances the understanding of our performance by highlighting the results of operations and the underlying profitability drivers of the business. Adjusted earnings and other financial measures based on adjusted earnings allow analysis of our performance relative to our business plan and facilitate comparisons to industry results. Adjusted earnings should not be viewed as a substitute for net income (loss). Year Ended December 31, 2019 Compared with the Year Ended December 31, 2018 Net loss available to shareholders before provision for income tax was $1.1 billion ($761 million, net of income tax), a decrease of $2.1 billion ($1.6 billion, net of income tax) from net income before provision for income tax of $984 million ($865 million, net of income tax) in the prior period. The decrease in income before provision for income tax was driven by the following key unfavorable items: • losses from GMLB Riders in the current period, compared to gains in the prior period, see “- GMLB Riders for the Years Ended December 31, 2019 and 2018;” • lower pre-tax adjusted earnings, discussed in greater detail below; and • higher policyholder benefits and claims, included in other adjustments, resulting from the adjustment for market performance related to participating products in the Run-off segment, The decrease in income before provision for income tax was partially offset by the following key favorable items: • current period gains on interest rate derivatives used to manage interest rate exposure in our ULSG business due to declining long-term interest rates; and • the change in net investment gains (losses) reflecting: ◦ current period net gains on sales of fixed maturity securities compared to prior period losses; and ◦ current period net mark-to-market gains on equity securities compared to prior period net losses, partially offset by ◦ prior period net gains on limited partnership interests. The provision for income tax in the current period led to an effective tax rate of 29%, compared to 12% in the prior period. Our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. Reconciliation of Net Income (Loss) Available to Shareholders to Adjusted Earnings The following tables reconcile net income (loss) available to shareholders to adjusted earnings: Consolidated Results for the Years Ended December 31, 2019 and 2018 - Adjusted Earnings The following table presents the components of adjusted earnings: Year Ended December 31, 2019 Compared with the Year Ended December 31, 2018 Adjusted earnings were $599 million, a decrease of $293 million. Key net unfavorable impacts were: • higher costs associated with insurance-related activities due to an increase in liability balances resulting from changes in connection with the AAR in our Run-off segment, net of the impact of recapture transactions in both the current and prior period, and • lower fee income due to lower asset-based fees resulting from lower average separate account balances, a portion of which are offset in other expenses. Key favorable impacts were: • higher net investment spread reflecting: ◦ higher average invested assets resulting from positive net flows in the general account; and ◦ higher investment income due to the repositioning of the investment portfolio out of U.S. Treasuries into higher-yielding assets in the prior period, partially offset by ◦ lower net investment income from other limited partnerships for the comparative measurement period; • lower other expenses due to: ◦ lower establishment costs in the current period related to planned technology expenses, and ◦ lower asset-based variable annuity expenses resulting from lower average separate account balances, a portion of which are offset in fee income, and • lower amortization of DAC and VOBA, primarily in our Life segment, due to the impact on gross profits in the current period from higher separate account growth and lower policyholder benefits and claims, partially offset by an unfavorable impact in the current period in connection with the AAR. Certain one-time tax adjustments recognized in the current period, primarily due to a revaluation of certain Separation-related liabilities, resulted in an unusually low effective tax rate of 7%, compared to 13% in the prior period. In addition to such one-time tax adjustments, our effective tax rate differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. Segments and Corporate & Other - Adjusted Earnings for the Years Ended December 31, 2019 and 2018 Annuities The following table presents the components of adjusted earnings for our Annuities segment: A significant portion of our adjusted earnings is driven by separate account balances related to our variable annuity business. Most directly, these balances determine asset-based fee income, but they also impact DAC amortization and asset-based commissions. Below is a rollforward of our variable annuities separate account balances. Variable annuities separate account balances increased for the year ended December 31, 2019. The increase was driven by positive equity market performance, partially offset by negative net flows and policy charges. Year Ended December 31, 2019 Compared with the Year Ended December 31, 2018 Adjusted earnings were $1.0 billion for the current period, an increase of $5 million. Key favorable impacts were: • higher net investment spread driven by: ◦ higher average invested assets resulting from positive net flows in the general account; ◦ higher investment income due to the repositioning of the investment portfolio out of U.S. Treasuries into higher yielding assets in the prior period; and ◦ higher net investment income from other limited partnerships for the comparative measurement period. Key net unfavorable impacts were: • lower fee income due to lower asset-based fees from lower average separate account balances, a portion of which is offset in other expenses; • higher other expenses driven by: ◦ an increase in the allocation of corporate expenses in the current period, partially offset by ◦ lower asset-based variable annuity expenses resulting from lower average separate account balances, a portion of which are offset in fee income; and • higher amortization of DAC and VOBA resulting primarily from changes in the long-term general account earned rate assumptions made in connection with the AAR. The provision for income tax in the current period led to an effective tax rate of 19%, compared to 17% in the prior period. Our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. Life The following table presents the components of adjusted earnings for our Life segment: Year Ended December 31, 2019 Compared with the Year Ended December 31, 2018 Adjusted earnings were $231 million for the current period, an increase of $3 million. Key net favorable impacts were: • lower amortization of DAC and VOBA reflecting: ◦ the impact on gross profits in the current period from lower policyholder benefits and claims and higher separate account growth, and ◦ changes in expense and mortality assumptions made in connection with the AAR; and • a decrease in the allocation of corporate expenses in the current period. Key net unfavorable impacts were: • higher costs associated with insurance-related activities due to higher paid claims, net of reinsurance; • lower fee income due to: ◦ lower unearned revenue amortization from changes in expense and mortality assumptions made in connection with the AAR; and ◦ lower policyholder fees consistent with lower average account balances. The provision for income tax led to an effective tax rate of 20% in both the current and prior period. Our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. Run-off The following table presents the components of adjusted earnings for our Run-off segment: Year Ended December 31, 2019 Compared with the Year Ended December 31, 2018 Adjusted earnings were a loss of $454 million for the current period, a higher loss of $411 million. Key net unfavorable impacts were: • higher costs associated with insurance-related activities, primarily in our ULSG business due to: ◦ an increase in liability balances resulting from changes in the long-term general account earned rate assumptions made in connection with the AAR; and ◦ higher paid claims, net of reinsurance in the current period; partially offset by ◦ a decrease in liability balances from the net impact of recapture transactions in the prior period; • lower fee income in our ULSG business due to: ◦ a decline in net cost of insurance fees driven by the aging in-force business; ◦ lower unearned revenue amortization resulting from recapture transactions in the prior year; ◦ a decrease in policyholder fees consistent with lower average account balances; and • lower net investment spread due to: ◦ lower net investment income from other limited partnerships for the comparative measurement period; and ◦ lower income on interest rate derivatives. The provision for income tax in the current period led to an effective tax rate of 22%, compared to 24% in the prior period. Our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. Corporate & Other The following table presents the components of adjusted earnings for Corporate & Other: Year Ended December 31, 2019 Compared with the Year Ended December 31, 2018 Adjusted earnings were a loss of $206 million, an improvement of $110 million from the prior period. Key net favorable impacts were: • lower other expenses due to: ◦ lower establishment costs in the current period related to planned technology expenses, and ◦ lower branding expenses associated with the Separation, partially offset by ◦ higher interest on debt that was issued in both the first quarter of 2019 and the third quarter of 2018; • higher net investment spread reflecting positive returns on short-term investments. Certain one-time tax adjustments recognized in the current period, primarily due to a revaluation of certain Separation-related liabilities, resulted in an unusually high effective tax rate of 37%, compared to 28% in the prior period, for which both rates represent a tax benefit. In addition to such one-time tax adjustments, our effective tax rate primarily differs from the statutory tax rate due to the impacts of the dividends received deductions and tax credits. We believe the effective tax rate for Corporate & Other is not generally meaningful, neither on a stand-alone basis nor for comparison to prior periods, since taxes for Corporate & Other are derived from the difference between the overall consolidated effective tax rate and total taxes for the combined operating segments. GMLB Riders for the Years Ended December 31, 2019 and 2018 The following table presents the overall impact to income (loss) available to shareholders before provision for income tax from the performance of GMLB Riders, which includes (i) changes in carrying value of the GAAP liabilities, (ii) the mark-to-market of hedges and reinsurance, (iii) fees and (iv) associated DAC offsets. _______________ (1) Includes cumulative changes in estimated fair value of the Shield Annuities embedded derivatives of ($1.6) billion and $358 million for the years ended December 31, 2019 and 2018, respectively. (2) Excludes living benefit fees, included as a component of adjusted earnings, of $64 million and $69 million for the years ended December 31, 2019 and 2018, respectively. GMLB Liabilities. Liabilities reported as part of GMLB Riders (“GMLB Liabilities”) include (i) guarantee rider benefits accounted for as embedded derivatives, (ii) guarantee rider benefits accounted for as insurance and (iii) Shield Annuities embedded derivatives. Liabilities related to guarantee rider benefits represent our obligation to protect policyholders against the possibility that a downturn in the markets will reduce the specified benefits that can be claimed under the base annuity contract. Any periods of significant and/or sustained downturns in equity markets, increased equity volatility, or reduced interest rates could result in an increase in the valuation of these liabilities. An increase in these liabilities would result in a decrease to our net income (loss) available to shareholders, which could be significant. Shield Annuities currently offered provide the ability for the contract holder to participate in the appreciation of certain financial markets up to a stated level, while offering protection from a portion of declines in the applicable indices or benchmark. We believe that Shield Annuities provide us with risk offset to liabilities related to guarantee rider benefits. GMLB Hedges and Reinsurance. We enter into freestanding derivatives to hedge the market risks inherent in the GMLB Liabilities. Generally, the same market factors that impact the estimated fair value of the guarantee rider embedded derivatives impact the value of the hedges, though in the opposite direction. However, the changes in value of the GMLB Liabilities and related hedges may not be symmetrical and the divergence could be significant due to certain factors, such as the guarantee riders accounted for as insurance are not recognized at estimated fair value and there are unhedged risks within the GMLB Liabilities. We may also use reinsurance to manage our exposure related to the GMLB Liabilities. GMLB Fees. We earn fees from the guarantee rider benefits, which are calculated based on the policyholder’s Benefit Base. Fees calculated based on the Benefit Base are more stable in market downturns, compared to fees based on the account value because the Benefit Base excludes the impact of a decline in the market value of the policyholder’s account value. We use the fees directly earned from the guarantee riders to fund the reserves, future claims and costs associated with the hedges of market risks inherent in these liabilities. For guarantee rider embedded derivatives, the future fees are included in the estimated fair value of the embedded derivative liabilities, with changes recorded in net derivative gains (losses). For guarantee rider benefits accounted for as insurance, while the related fees do affect the valuation of these liabilities, they are not included in the resulting liability values, but are recorded separately in universal life and investment-type policy fees. GMLB DAC. Changes in the estimated fair value of GMLB Liabilities that are accounted for as embedded derivatives result in a corresponding recognition of DAC amortization that generally has an inverse effect on net income (loss), which we refer to as the DAC offset. While the DAC offset is generally the most significant driver of GMLB DAC, it can be impacted by other adjustments including amortization related to guarantee benefit riders accounted for as insurance. Year Ended December 31, 2019 Compared with the Year Ended December 31, 2018 Comparative results from GMLB Riders were unfavorable by $2.8 billion, primarily driven by: • a net unfavorable change in the GMLB hedges; and • unfavorable changes in Shield liability reserves, partially offset by: • favorable changes in GMLB DAC. Higher relative equity markets in the current period significantly impacted the following: • unfavorable changes to the estimated fair value of our GMLB hedges; • unfavorable changes to the estimated fair value of the Shield liability reserves, net of favorable changes to the estimated fair value of the related hedges; and • unfavorable changes in GMLB DAC; partially offset by • favorable changes to the estimated fair value of the variable annuity liability reserve. Lower interest rates in the current period significantly impacted the following: • favorable changes to the estimated fair value of our GMLB hedges; and • favorable changes to GMLB DAC; partially offset by • unfavorable changes to the estimated fair value of variable annuity liability reserves. The tightening of our credit default swap spreads combined with the decrease in the underlying base liabilities resulted in an unfavorable change in non-performance risk net of a favorable change in the GMLB DAC offset. The AAR resulted in favorable changes in the current period primarily due to higher reserves recognized in the prior period, net of a corresponding decrease in GMLB DAC relative to the prior period. Effects of Inflation Management believes that inflation has not had a material effect on the Company’s results of operations, except insofar as inflation may affect interest rates. An increase in inflation could affect our business in several ways. During inflationary periods, the value of fixed income investments falls which could increase realized and unrealized losses. Inflation also increases expenses for labor and other materials, potentially putting pressure on profitability if such costs cannot be passed through in our product prices. Prolonged and elevated inflation could adversely affect the financial markets and the economy generally and dispelling it may require governments to pursue a restrictive fiscal and monetary policy, which could constrain overall economic activity, inhibit revenue growth and reduce the number of attractive investment opportunities. Investments Investment Risks Our primary investment objective is to optimize risk-adjusted net investment income and risk-adjusted total return while appropriately matching assets and liabilities. In addition, the investment process is designed to ensure that the portfolio has an appropriate level of liquidity, quality and diversification. We are exposed to the following primary sources of investment risks: • credit risk, relating to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest; • interest rate risk, relating to the market price and cash flow variability associated with changes in market interest rates. Changes in market interest rates will impact the net unrealized gain or loss position of our fixed income investment portfolio and the rates of return we receive on both new funds invested and reinvestment of existing funds; • market valuation risk, relating to the variability in the estimated fair value of investments associated with changes in market factors such as credit spreads and equity market levels. A widening of credit spreads will adversely impact the net unrealized gain (loss) position of the fixed income investment portfolio, will increase losses associated with credit-based non-qualifying derivatives where we assume credit exposure, and, if credit spreads widen significantly or for an extended period of time, will likely result in higher OTTI. Credit spread tightening will reduce net investment income associated with new purchases of fixed maturity securities and will favorably impact the net unrealized gain (loss) position of the fixed income investment portfolio; • liquidity risk, relating to the diminished ability to sell certain investments, in times of strained market conditions; • real estate risk, relating to commercial, agricultural and residential real estate, and stemming from factors, which include, but are not limited to, market conditions, including the demand and supply of leasable commercial space, creditworthiness of borrowers and their tenants and joint venture partners, capital markets volatility and inherent interest rate movements; • currency risk, relating to the variability in currency exchange rates for non-U.S. dollar denominated investments; and • financial and operational risks related to using external investment managers. We manage these risks through asset-type allocation and industry and issuer diversification. Risk limits are also used to promote diversification by asset sector, avoid concentrations in any single issuer and limit overall aggregate credit and equity risk exposure. Real estate risk is managed through geographic and property type and product type diversification. We manage interest rate risk as part of our Asset Liability Management (“ALM”) strategies. Product design, such as the use of market value adjustment features and surrender charges, is also utilized to manage interest rate risk. These strategies include maintaining an investment portfolio that targets a weighted average duration that reflects the duration of our estimated liability cash flow profile. For certain of our liability portfolios, it is not possible to invest assets to the full liability duration, thereby creating some asset/liability mismatch. We also use certain derivatives in the management of currency, credit, interest rate, and equity market risks. Investment Management Agreements Other than our derivatives trading, which we manage in-house, we have engaged a select group of experienced external asset management firms pursuant to several investment management agreements, to manage the investment of the assets comprising our general account portfolio and certain separate account assets of our insurance subsidiaries, as well as assets of BHF and our reinsurance subsidiary, BRCD. Current Environment Our business and results of operations are materially affected by conditions in capital markets and the economy, generally. As a U.S. insurance company, we are affected by the monetary policy of the Federal Reserve Board in the United States. The Federal Reserve may increase or decrease the federal funds rate in the future, which may have an impact on the pricing levels of risk-bearing investments and may adversely impact the level of product sales. We are also affected by the monetary policy of central banks around the world due to the diversification of our investment portfolio. See “- Industry Trends and Uncertainties - Financial and Economic Environment.” Investment Portfolio Results The following summary yield table presents the yield and adjusted net investment income for our investment portfolio for the periods indicated. As described below, this table reflects certain differences from the presentation of net investment income presented in the GAAP statement of operations. This summary yield table presentation is consistent with how we measure our investment performance for management purposes, and we believe it enhances understanding of our investment portfolio results. _______________ (1) Investment income yields are calculated as investment income as a percent of average quarterly asset carrying values. Investment income excludes recognized gains and losses and reflects the adjustments presented in Note 3 below to arrive at adjusted net investment income. Asset carrying values exclude unrealized gains (losses), collateral received in connection with our securities lending program, freestanding derivative assets and collateral received from derivative counterparties. (2) Investment fee and expense yields are calculated as investment fees and expenses as a percent of average quarterly asset estimated fair values. Asset estimated fair values exclude collateral received in connection with our securities lending program, freestanding derivative assets and collateral received from derivative counterparties. (3) Adjusted net investment income included in yield calculations includes Investment Hedge Adjustments. (4) Adjusted net investment income presented in the yield table varies from the most directly comparable GAAP measure due to certain reclassifications, as presented below. See “- Results of Operations - Consolidated Results - Year Ended December 31, 2019 Compared with the Year Ended December 31, 2018” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations - Consolidated Results -Year Ended December 31, 2018 Compared with the Year Ended December 31, 2017” in our 2018 Annual Report for an analysis of the year over year changes in net investment income. Fixed Maturity Securities AFS The following table presents fixed maturity securities AFS by type (public or private) held at: Valuation of Securities. See Note 8 of the Notes to the Consolidated Financial Statements for further information on our valuation controls and procedures including our formal process to challenge any prices received from independent pricing services that are not considered representative of estimated fair value. Fixed Maturity Securities AFS See Notes 1 and 6 of the Notes to the Consolidated Financial Statements for information about fixed maturity securities AFS by sector, contractual maturities and continuous gross unrealized losses. Fixed Maturity Securities Credit Quality - Ratings Rating agency ratings are based on availability of applicable ratings from rating agencies on the NAIC credit rating provider list, including Moody’s, S&P, Fitch, Dominion Bond Rating Service and Kroll Bond Rating Agency. If no rating is available from a rating agency, then an internally developed rating is used. The NAIC has methodologies to assess credit quality for certain Structured Securities comprised of non-agency RMBS, CMBS and ABS. The NAIC’s objective with these methodologies is to increase the accuracy in assessing expected losses, and to use the improved assessment to determine a more appropriate capital requirement for such Structured Securities. The methodologies reduce regulatory reliance on rating agencies and allow for greater regulatory input into the assumptions used to estimate expected losses from Structured Securities. We apply the NAIC methodologies to Structured Securities held by our insurance subsidiaries. The NAIC’s present methodology is to evaluate Structured Securities held by insurers on an annual basis. If our insurance subsidiaries acquire Structured Securities that have not been previously evaluated by the NAIC but are expected to be evaluated by the NAIC in the upcoming annual review, an internally developed designation is used until a final designation becomes available. The following table presents total fixed maturity securities by NRSRO rating and the applicable NAIC designation from the NAIC published comparison of NRSRO ratings to NAIC designations, except for certain Structured Securities, which are presented using the revised NAIC methodologies, as well as the percentage, based on estimated fair value that each NAIC designation is comprised of at: The following tables present total fixed maturity securities, based on estimated fair value, by sector classification and by NRSRO rating and the applicable NAIC designations from the NAIC published comparison of NRSRO ratings to NAIC designations, except for certain Structured Securities, which are presented using the NAIC methodologies as described above: U.S. and Foreign Corporate Fixed Maturity Securities We maintain a diversified portfolio of corporate fixed maturity securities across industries and issuers. This portfolio does not have any exposure to any single issuer in excess of 1% of total investments and the top ten holdings in aggregate comprise 2% of total investments at both December 31, 2019 and 2018. The tables below present our U.S. and foreign corporate securities holdings by industry at: Structured Securities We held $16.8 billion and $15.9 billion of Structured Securities, at estimated fair value, at December 31, 2019 and 2018, respectively, as presented in the RMBS, CMBS and ABS sections below. RMBS The following table presents our RMBS holdings at: Historically, our exposure to sub-prime RMBS holdings has been managed by focusing primarily on senior tranche securities, stress-testing the portfolio with severe loss assumptions and closely monitoring the performance of the portfolio. Our sub-prime RMBS portfolio consists predominantly of securities that were purchased after 2012 at significant discounts to par value and discounts to the expected principal recovery value of these securities. The vast majority of these securities are investment grade under the NAIC designations (e.g., NAIC 1 and NAIC 2). The estimated fair value of our sub-prime RMBS holdings purchased since 2012 was $851 million and $883 million at December 31, 2019 and 2018, respectively, with unrealized gains (losses) of $61 million and $50 million at December 31, 2019 and 2018, respectively. CMBS Our CMBS holdings are diversified by vintage year. The following tables present our CMBS holdings by vintage year at: The estimated fair value of CMBS rated Aaa using rating agency ratings was $4.3 billion, or 74.9% of total CMBS, and designated NAIC 1 was $5.6 billion, or 97.5% of total CMBS, at December 31, 2019. The estimated fair value of CMBS Aaa rating agency ratings was $3.5 billion, or 66.9% of total CMBS, and designated NAIC 1 was $5.2 billion, or 98.8% of total CMBS, at December 31, 2018. ABS Our ABS are diversified both by collateral type and by issuer. The following table presents our ABS holdings at: Evaluation of AFS Securities for OTTI and Temporary Impairment See Note 6 of the Notes to the Consolidated Financial Statements for information about the evaluation of fixed maturity securities AFS for OTTI and temporary impairment. Securities Lending We participate in a securities lending program whereby securities are loaned to third parties, primarily brokerage firms and commercial banks. We obtain collateral, usually cash, in an amount generally equal to 102% of the estimated fair value of the securities loaned, which is obtained at the inception of a loan and maintained at a level greater than or equal to 100% for the duration of the loan. We monitor the estimated fair value of the securities loaned on a daily basis with additional collateral obtained as necessary throughout the duration of the loan. Securities loaned under such transactions may be sold or re-pledged by the transferee. We are liable to return to our counterparties the cash collateral under our control. Security collateral received from counterparties may not be sold or re-pledged, unless the counterparty is in default, and is not reflected in the financial statements. These transactions are treated as financing arrangements and the associated cash collateral liability is recorded at the amount of the cash received. See “- Liquidity and Capital Resources - The Company - Liquidity and Capital Uses - Securities Lending” and Note 6 of the Notes to the Consolidated Financial Statements for information regarding our securities lending program. Mortgage Loans Our mortgage loans are principally collateralized by commercial, agricultural and residential properties. Mortgage loans and the related valuation allowances are summarized as follows at: We diversify our mortgage loan portfolio by both geographic region and property type to reduce the risk of concentration. For our commercial and agricultural mortgage loan portfolios, the percentage collateralized by properties located in the U.S. were 97% at both December 31, 2019 and 2018. The remainder was collateralized by properties located outside of the U.S. The carrying value as a percentage of total commercial and agricultural mortgage loans for the top three states in the U.S. is as follows at: Additionally, we manage risk when originating commercial and agricultural mortgage loans by generally lending up to 75% of the estimated fair value of the underlying real estate collateral. We manage our residential mortgage loan portfolio in a similar manner to reduce risk of concentration. All residential mortgage loans were collateralized by properties located in the U.S. at both December 31, 2019 and 2018. The carrying value as a percentage of total residential mortgage loans for the top three states in the U.S. is as follows at: Commercial Mortgage Loans by Geographic Region and Property Type. Commercial mortgage loans are the largest component of the mortgage loan invested asset class. The tables below present the diversification across geographic regions and property types of commercial mortgage loans at: Mortgage Loan Credit Quality - Monitoring Process. Our investment managers monitor our mortgage loan investments on an ongoing basis, including a review of loans that are current, past due, restructured and under foreclosure. Quarterly, we conduct a formal review of the portfolio with our investment managers. See Note 6 of the Notes to the Consolidated Financial Statements for information on mortgage loans by credit quality indicator, past due and nonaccrual mortgage loans, as well as impaired mortgage loans. Our investment managers review our commercial mortgage loans on an ongoing basis. These reviews may include an analysis of the property financial statements and rent roll, lease rollover analysis, property inspections, market analysis, estimated valuations of the underlying collateral, loan-to-value ratios, debt-service coverage ratios and tenant creditworthiness. The monitoring process focuses on higher risk loans, which include those that are classified as restructured, delinquent or in foreclosure, as well as loans with higher loan-to-value ratios and lower debt-service coverage ratios. The monitoring process for agricultural mortgage loans is generally similar, with a focus on higher risk loans, such as loans with higher loan-to-value ratios, including reviews on a geographic and sector basis. We review our residential mortgage loans on an ongoing basis. See Note 6 of the Notes to the Consolidated Financial Statements for information on our evaluation of residential mortgage loans and related valuation allowance methodology. Loan-to-value ratios and debt-service coverage ratios are common measures in the assessment of the quality of commercial mortgage loans. Loan-to-value ratios are a common measure in the assessment of the quality of agricultural mortgage loans. Loan-to-value ratios compare the amount of the loan to the estimated fair value of the underlying collateral. A loan-to-value ratio greater than 100% indicates that the loan amount is greater than the collateral value. A loan-to-value ratio of less than 100% indicates an excess of collateral value over the loan amount. Generally, the higher the loan-to-value ratio, the higher the risk of experiencing a credit loss. The debt-service coverage ratio compares a property’s net operating income to amounts needed to service the principal and interest due under the loan. Generally, the lower the debt-service coverage ratio, the higher the risk of experiencing a credit loss. For our commercial mortgage loans, our average loan-to-value ratio was 53% and 52% at December 31, 2019 and 2018, respectively, and our average debt-service coverage ratio was 2.2x at both December 31, 2019 and 2018. The debt-service coverage ratio, as well as the values utilized in calculating the ratio, is updated annually on a rolling basis, with a portion of the portfolio updated each quarter. In addition, the loan-to-value ratio is routinely updated for all but the lowest risk loans as part of our ongoing review of our commercial mortgage loan portfolio. For our agricultural mortgage loans, our average loan-to-value ratio was 47% and 46% at December 31, 2019 and 2018, respectively. The values utilized in calculating the agricultural mortgage loan loan-to-value ratio are developed in connection with the ongoing review of the agricultural loan portfolio and are routinely updated. Mortgage Loan Valuation Allowances. See Notes 6 and 8 of the Notes to the Consolidated Financial Statements for information about how valuation allowances are established and monitored, activity in and balances of the valuation allowance, and the estimated fair value of impaired mortgage loans and related impairments included within net investment gains (losses) at and for the years ended December 31, 2019 and 2018. Limited Partnerships and Limited Liability Companies The following table presents the carrying value of our limited partnerships and limited liability companies (“LLCs”) at: _______________ (1) The estimated fair value of real estate limited partnerships and LLCs was $529 million and $572 million at December 31, 2019 and 2018, respectively. Cash distributions on these investments are generated from investment gains, operating income from the underlying investments of the funds and liquidation of the underlying investments of the funds. We estimate that the underlying investment of the private equity funds will typically be liquidated over the next 10 to 20 years. Other Invested Assets The following table presents the carrying value of our other invested assets by type at: Derivatives Derivative Risks We are exposed to various risks relating to our ongoing business operations, including interest rate, foreign currency exchange rate, credit and equity market. We use a variety of strategies to manage these risks, including the use of derivatives. See Note 7 of the Notes to the Consolidated Financial Statements: • A comprehensive description of the nature of our derivatives, including the strategies for which derivatives are used in managing various risks. • Information about the gross notional amount, estimated fair value, and primary underlying risk exposure of our derivatives by type of hedge designation, excluding embedded derivatives held at December 31, 2019 and 2018. • The statement of operations effects of derivatives in cash flow, fair value, or non-qualifying hedge relationships for the years ended December 31, 2019, 2018 and 2017. See “- Risk Management Strategies” and “Business - Segments and Corporate & Other - Annuities” for more information about our use of derivatives by major hedging programs, as well as “- Results of Operations - Annual Actuarial Review.” Fair Value Hierarchy See Note 8 of the Notes to the Consolidated Financial Statements for derivatives measured at estimated fair value on a recurring basis and their corresponding fair value hierarchy. The valuation of Level 3 derivatives involves the use of significant unobservable inputs and generally requires a higher degree of management judgment or estimation than the valuations of Level 1 and Level 2 derivatives. Although Level 3 inputs are unobservable, management believes they are consistent with what other market participants would use when pricing such instruments and are considered appropriate given the circumstances. The use of different inputs or methodologies could have a material effect on the estimated fair value of Level 3 derivatives and could materially affect net income. Derivatives categorized as Level 3 at December 31, 2019 include: credit default swaps priced using unobservable credit spreads, or that are priced through independent broker quotations; equity variance swaps with unobservable volatility inputs; foreign currency swaps with certain unobservable inputs and equity index options with unobservable correlation inputs. See Note 8 of the Notes to Consolidated Financial Statements for a rollforward of the fair value measurements for derivatives measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs. Credit Risk See Note 7 of the Notes to the Consolidated Financial Statements for information about how we manage credit risk related to derivatives and for the estimated fair value of our net derivative assets and net derivative liabilities after the application of master netting agreements and collateral. Our policy is not to offset the fair value amounts recognized for derivatives executed with the same counterparty under the same master netting agreement. This policy applies to the recognition of derivatives in the balance sheets and does not affect our legal right of offset. Credit Derivatives The following table presents the gross notional amount and estimated fair value of credit default swaps at: The maximum amount at risk related to our written credit default swaps is equal to the corresponding gross notional amount. In a replication transaction, we pair an asset on our balance sheet with a written credit default swap to synthetically replicate a corporate bond, a core asset holding of life insurance companies. Replications are entered into in accordance with the guidelines approved by state insurance regulators and the NAIC and are an important tool in managing the overall corporate credit risk within the Company. In order to match our long-dated insurance liabilities, we seek to buy long-dated corporate bonds. In some instances, these may not be readily available in the market, or they may be issued by corporations to which we already have significant corporate credit exposure. For example, by purchasing Treasury bonds (or other high-quality assets) and associating them with written credit default swaps on the desired corporate credit name, we, can replicate the desired bond exposures and meet our ALM needs. This can expose the Company to changes in credit spreads as the written credit default swap tenor is shorter than the maturity of Treasury bonds. Embedded Derivatives See Note 8 of the Notes to the Consolidated Financial Statements for information about embedded derivatives measured at estimated fair value on a recurring basis and their corresponding fair value hierarchy. See Note 8 of the Notes to the Consolidated Financial Statements for a rollforward of the fair value measurements for net embedded derivatives measured at estimated fair value on a recurring basis using significant unobservable (Level 3) inputs. See Note 7 of the Notes to the Consolidated Financial Statements for information about the nonperformance risk adjustment included in the valuation of guaranteed minimum benefits accounted for as embedded derivatives. See “- Summary of Critical Accounting Estimates - Derivatives” for further information on the estimates and assumptions that affect embedded derivatives. Off-Balance Sheet Arrangements Collateral for Securities Lending and Derivatives We have a securities lending program for the purpose of enhancing the total return on our investment portfolio. Periodically we receive non-cash collateral for securities lending from counterparties, which cannot be sold or re-pledged, and which is not recorded on our consolidated balance sheets. The Company did not hold non-cash collateral at December 31, 2019. The amount of this collateral was $55 million at estimated fair value at December 31, 2018. See Note 6 of the Notes to the Consolidated Financial Statements, as well as “- Investments - Securities Lending” for discussion of our securities lending program, the classification of revenues and expenses, and the nature of the secured financing arrangement and associated liability. We enter into derivatives to manage various risks relating to our ongoing business operations. We have non-cash collateral from counterparties for derivatives, which can be sold or re-pledged subject to certain constraints, and which has not been recorded on our consolidated balance sheets. The amount of this non-cash collateral was $593 million and $145 million at December 31, 2019 and 2018, respectively. See Note 7 of the Notes to the Consolidated Financial Statements for information regarding the earned income on and the gross notional amount, estimated fair value of assets and liabilities and primary underlying risk exposure of our derivatives. Guarantees See “Guarantees” in Note 15 of the Notes to the Consolidated Financial Statements. Other Additionally, we enter into commitments for the purpose of enhancing the total return on our investment portfolio: mortgage loan commitments and commitments to fund partnership investments, bank credit facilities and private corporate bond investments. See Note 6 of the Notes to the Consolidated Financial Statements for information on the investment income, investment expense, gains and losses from such investments. See also “- Investments - Fixed Maturity and Equity Securities AFS” and “- Investments - Mortgage Loans” for information on our investments in fixed maturity securities and mortgage loans. See “- Investments - Real Estate Limited Partnerships and Limited Liability Companies” and “- Investments - Other Limited Partnership Interests” for information on our partnership investments. Other than the commitments disclosed in Note 15 of the Notes to the Consolidated Financial Statements, there are no other material obligations or liabilities arising from the commitments to fund mortgage loans, partnership investments, bank credit facilities and private corporate bond investments. For further information on commitments to fund partnership investments, mortgage loans, bank credit facilities and private corporate bond investments. See “- Liquidity and Capital Resources - The Company - Contractual Obligations.” Policyholder Liabilities We establish, and carry as liabilities, actuarially determined amounts that are calculated to meet policy obligations or to provide for future annuity payments. Amounts for actuarial liabilities are computed and reported in the financial statements in conformity with GAAP. For more details on policyholder liabilities, see “- Summary of Critical Accounting Estimates.” Due to the nature of the underlying risks and the uncertainty associated with the determination of actuarial liabilities, we cannot precisely determine the amounts that will ultimately be paid with respect to these actuarial liabilities, and the ultimate amounts may vary from the estimated amounts, particularly when payments may not occur until well into the future. We periodically review the assumptions supporting our estimates of actuarial liabilities for future policy benefits. We revise estimates, to the extent permitted or required under GAAP, if we determine that future expected experience differs from assumptions used in the development of actuarial liabilities. We charge or credit changes in our liabilities to expenses in the period the liabilities are established or re-estimated. If the liabilities originally established for future benefit payments prove inadequate, we must increase them. Such an increase could adversely affect our earnings and have a material adverse effect on our business, results of operations and financial condition. We have experienced, and will likely in the future experience, catastrophe losses and possibly acts of terrorism, as well as turbulent financial markets that may have an adverse impact on our business, results of operations, and financial condition. Due to their nature, we cannot predict the incidence, timing, severity or amount of losses from catastrophes and acts of terrorism, but we make broad use of catastrophic and non-catastrophic reinsurance to manage risk from these perils. Future Policy Benefits We establish liabilities for amounts payable under insurance policies. See “- Summary of Critical Accounting Estimates - Liability for Future Policy Benefits” and Notes 1 and 3 of the Notes to the Consolidated Financial Statements. A discussion of future policy benefits by segment, as well as Corporate & Other follows. Annuities Future policy benefits for the annuities business are comprised mainly of liabilities for life contingent income annuities, and liabilities for the variable annuity guaranteed minimum benefits accounted for as insurance. Life Future policy benefits for the life business are comprised mainly of liabilities for traditional life and for universal and variable life insurance contracts. In order to manage risk, we have often reinsured a portion of the mortality risk on life insurance policies. The reinsurance programs are routinely evaluated, and this may result in increases or decreases to existing coverage. We have entered into various derivative positions, primarily interest rate swaps, to mitigate the risk that investment of premiums received and reinvestment of maturing assets over the life of the policy will be at rates below those assumed in the original pricing of these contracts. Run-off Future policy benefits primarily include liabilities for structured settlement annuities and pension risk transfers. There is no interest rate crediting flexibility on the liabilities for payout annuities. As a result, a sustained low interest rate environment could negatively impact earnings; however, we mitigate our risks by applying various ALM strategies, including the use of derivative positions, primarily interest rate swaps, to mitigate the risks associated with such a scenario. Corporate & Other Future policy benefits primarily include liabilities for long-term care and workers’ compensation business reinsured through 100% quota share reinsurance agreements. Policyholder Account Balances Policyholder account balances are generally equal to the account value, which includes accrued interest credited, but excludes the impact of any applicable charge that may be incurred upon surrender. See “- Variable Annuity Guarantees” and “Quantitative and Qualitative Disclosures About Market Risk - Market Risk - Fair Value Exposures - Interest Rates.” See Notes 1 and 3 of the Notes to the Consolidated Financial Statements for additional information. A discussion of policyholder account balances by segment, as well as Corporate & Other, follows. Annuities Policyholder account balances for annuities are held for fixed deferred annuities, the fixed account portion of variable annuities, and non-life contingent income annuities. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. A sustained low interest rate environment could negatively impact earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We have various interest rate derivative positions, as part of the Company’s macro interest rate hedging program, to partially mitigate the risks associated with such a scenario. Additionally, policyholder account balances are held for variable annuity guaranteed minimum living benefits that are accounted for as embedded derivatives. The following table presents the breakdown of account value subject to minimum guaranteed crediting rates for Annuities at: _______________ (1) These amounts are not adjusted for policy loans. As a result of acquisitions, we establish additional liabilities known as excess interest reserves for policies with credited rates in excess of market rates as of the applicable acquisition dates. Excess interest reserves for Annuities were $262 million and $285 million at December 31, 2019 and 2018, respectively. Life Life policyholder account balances are held for retained asset accounts, universal life policies and the fixed account of universal variable life insurance policies. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. A sustained low interest rate environment could negatively impact earnings as a result of the minimum credited rate guarantees present in most of these policyholder account balances. We have various derivative positions to partially mitigate the risks associated with such a scenario. The following table presents the breakdown of account value subject to minimum guaranteed crediting rates for Life at: _______________ (1) These amounts are not adjusted for policy loans. As a result of acquisitions, we establish additional liabilities known as excess interest reserves for policies with credited rates in excess of market rates as of the applicable acquisition dates. Excess interest reserves for Life were $33 million and $22 million at December 31, 2019 and 2018, respectively. Run-off Policyholder account balances in Run-off are comprised of ULSG funding agreements and COLI. Interest crediting rates vary by type of contract and can be fixed or variable. Variable interest crediting rates are generally tied to an external index, most commonly (one-month or three-month) LIBOR. We are exposed to interest rate risks, when guaranteeing payment of interest and return on principal at the contractual maturity date. We mitigate our risks by applying various ALM strategies. The following table presents the breakdown of account value subject to minimum guaranteed crediting rates for Run-off as of: _______________ (1) These amounts are not adjusted for policy loans. As a result of acquisitions, we establish additional liabilities known as excess interest reserves for policies with credited rates in excess of market rates as of the applicable acquisition dates. Excess interest reserves for Run-off were $95 million and $62 million at December 31, 2019 and 2018, respectively. Variable Annuity Guarantees We issue certain variable annuity products with guaranteed minimum benefits that provide the policyholder a minimum return based on their initial deposit (i.e., the Benefit Base) less withdrawals. In some cases, the Benefit Base may be increased by additional deposits, bonus amounts, accruals or optional market value step-ups. Certain of our variable annuity guarantee features are accounted for as insurance liabilities and recorded in future policy benefits while others are accounted for at fair value as embedded derivatives and recorded in policyholder account balances. Generally speaking, a guarantee is accounted for as an insurance liability if the guarantee is paid only upon either (i) the occurrence of a specific insurable event, or (ii) annuitization. Alternatively, a guarantee is accounted for as an embedded derivative if a guarantee is paid without requiring (i) the occurrence of specific insurable event, or (ii) the policyholder to annuitize, that is, the policyholder can receive the guarantee on a net basis. In certain cases, a guarantee may have elements of both an insurance liability and an embedded derivative and in such cases the guarantee is split and accounted for under both models. Further, changes in assumptions, principally involving behavior, can result in a change of expected future cash outflows of a guarantee between portions accounted for as insurance liabilities and portions accounted for as embedded derivatives. Guarantees accounted for as insurance liabilities in future policy benefits include GMDBs, the life contingent portion of the GMWBs and the portion of the GMIBs that require annuitization, as well as the life contingent portion of the expected annuitization when the policyholder is forced into an annuitization upon depletion of their account value. These insurance liabilities are accrued over the accumulation phase of the contract in proportion to actual and future expected policy assessments based on the level of guaranteed minimum benefits generated using multiple scenarios of separate account returns. The scenarios are based on best estimate assumptions consistent with those used to amortize DAC. When current estimates of future benefits exceed those previously projected or when current estimates of future assessments are lower than those previously projected, liabilities will increase, resulting in a current period charge to net income. The opposite result occurs when the current estimates of future benefits are lower than those previously projected or when current estimates of future assessments exceed those previously projected. At each reporting period, we update the actual amount of business remaining in-force, which impacts expected future assessments and the projection of estimated future benefits resulting in a current period charge or increase to earnings. See Note 3 of the Notes to the Consolidated Financial Statements for additional details of guarantees accounted for as insurance liabilities. Guarantees accounted for as embedded derivatives in policyholder account balances include the non-life contingent portion of GMWBs, GMABs, and for GMIBs the non-life contingent portion of the expected annuitization when the policyholder is forced into an annuitization upon depletion of their account value, as well as the Guaranteed Principal Option. The estimated fair values of guarantees accounted for as embedded derivatives are determined based on the present value of projected future benefits minus the present value of projected future fees. At policy inception, we attribute to the embedded derivative a portion of the projected future guarantee fees to be collected from the policyholder equal to the present value of projected future guaranteed benefits. Any additional fees represent “excess” fees and are reported in universal life and investment-type product policy fees. In valuing the embedded derivative, the percentage of fees included in the fair value measurement is locked-in at inception. The projections of future benefits and future fees require capital market and actuarial assumptions including expectations concerning policyholder behavior. A risk neutral valuation methodology is used to project the cash flows from the guarantees under multiple capital market scenarios to determine an economic liability. The reported estimated fair value is then determined by taking the present value of these risk-free generated cash flows using a discount rate that incorporates a spread over the risk-free rate to reflect our nonperformance risk and adding a risk margin. For more information on the determination of estimated fair value. See Note 8 of the Notes to the Consolidated Financial Statements. Liquidity and Capital Resources Our business and results of operations are materially affected by conditions in the global capital markets and the economy generally. Stressed conditions, volatility or disruptions in global capital markets, particular markets or financial asset classes can impact us adversely, in part because we have a large investment portfolio and our insurance liabilities and derivatives are sensitive to changing market factors. Changing conditions in the global capital markets and the economy may affect our financing costs and market interest rates for our debt or equity securities. For further information regarding market factors that could affect our ability to meet liquidity and capital needs, see “- Industry Trends and Uncertainties” and “- Investments - Current Environment.” Liquidity and Capital Management Based upon our capitalization, expectations regarding maintaining our business mix, ratings and funding sources available to us, we believe we have sufficient liquidity to meet business requirements under current market conditions and certain stress scenarios. Our Board of Directors and senior management are directly involved in the governance of the capital management process, including proposed changes to the annual capital plan and capital targets. We are targeting a debt-to-capital ratio commensurate with our parent company credit ratings and our insurance subsidiaries’ financial strength ratings. We continuously monitor and adjust our liquidity and capital plans in light of market conditions, as well as changing needs and opportunities. We maintain a substantial short-term liquidity position, which was $2.8 billion and $2.2 billion at December 31, 2019 and 2018, respectively. Short-term liquidity is comprised of cash and cash equivalents and short-term investments, excluding assets that are pledged or otherwise committed. Assets pledged or otherwise committed include amounts received in connection with securities lending, derivatives and assets held on deposit or in trust. An integral part of our liquidity management includes managing our level of liquid assets, which was $42.6 billion and $36.5 billion at December 31, 2019 and 2018, respectively. Liquid assets are comprised of cash and cash equivalents, short-term investments and publicly-traded securities, excluding assets that are pledged or otherwise committed. Assets pledged or otherwise committed include amounts received in connection with securities lending, derivatives and assets held on deposit or in trust. The Company Liquidity Liquidity refers to our ability to generate adequate cash flows from our normal operations to meet the cash requirements of our operating, investing and financing activities. We determine our liquidity needs based on a rolling 12-month forecast by portfolio of invested assets which we monitor daily. We adjust the general account asset and derivatives mix and general account asset maturities based on this rolling 12-month forecast. To support this forecast, we conduct cash flow and stress-testing, which reflect the impact of various scenarios, including (i) the potential increase in our requirement to pledge additional collateral or return collateral to our counterparties, (ii) a reduction in new business sales, and (iii) the risk of early contract holder and policyholder withdrawals, as well as lapses and surrenders of existing policies and contracts. We include provisions limiting withdrawal rights in many of our products, which deter the customer from making withdrawals prior to the maturity date of the product. If significant cash is required beyond our anticipated liquidity needs, we have various alternatives available depending on market conditions and the amount and timing of the liquidity need. These available alternative sources of liquidity include cash flows from operations, sales of liquid assets and funding sources including secured funding agreements, unsecured credit facilities and secured committed facilities. Under certain adverse market and economic conditions, our access to liquidity may deteriorate, or the cost to access liquidity may increase. See “Risk Factors - Economic Environment and Capital Markets-Related Risks - Adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs and our access to capital.” Capital We manage our capital position to maintain our financial strength and credit ratings. Our capital position is supported by our ability to generate cash flows within our insurance companies, our ability to effectively manage the risks of our businesses and our expected ability to borrow funds and raise additional capital to meet operating and growth needs in the event of adverse market and economic conditions. We target to maintain a debt-to-capital ratio of approximately 25%, which we monitor using an average of our key leverage ratios as calculated by A.M. Best, Fitch, Moody’s and S&P. As such, we may opportunistically look to pursue additional financing over time, which may include the incurrence of additional term loans, borrowings under credit facilities, the issuance of debt, equity or hybrid securities or the refinancing of existing indebtedness. There can be no assurance that we will be able to complete any such financing transactions on terms and conditions favorable to us or at all. Additionally, with our early adoption of VA Reform, our management of and hedging strategy associated with our variable annuity business aligns with the new regulatory framework. Given this alignment and the fact that we have a large non-variable annuity business, we have shifted our focus on capital metrics from a CTE target to a combined RBC ratio target. In support of our target combined RBC ratio between 400% and 450%, we expect to continue to maintain a capital and exposure risk management program that targets total assets supporting our variable annuity contracts at or above the CTE98 level in normal market conditions. We refer to our target level of assets as our “Variable Annuity Target Funding Level.” While total assets supporting our variable annuity capital may exceed the CTE98 level, under stressed conditions we intend to allow such assets supporting our variable annuities to range between a target floor level of CTE95 and CTE98. At December 31, 2019, we held approximately $11.1 billion of total assets supporting our variable annuity contracts, which equals approximately $1.7 billion above CTE98 and $3.3 billion above CTE95. In August 2018, we authorized the repurchase of up to $200 million of our common stock, on May 3, 2019, we authorized the repurchase of up to an additional $400 million of our common stock, and on February 6, 2020, we authorized the repurchase of up to an additional $500 million of our common stock. No common stock repurchases have been made under the February 6, 2020 authorization as of February 26, 2020. Future repurchases may be made through open market purchases, including pursuant to 10b5-1 plans or pursuant to accelerated stock repurchase plans, or through privately negotiated transactions, from time to time at management’s discretion in accordance with applicable legal requirements. Common stock repurchases are dependent upon several factors, including our capital position, liquidity, financial strength and credit ratings, general market conditions, the market price of our common stock compared to management’s assessment of the stock’s underlying value and applicable regulatory approvals, as well as other legal and accounting factors. We currently have no plans to declare and pay dividends on our common stock. Any future declaration and payment of dividends or other distributions or returns of capital will be at the discretion of our Board of Directors and will depend on and be subject to our financial condition, results of operations, cash needs, regulatory and other constraints, capital requirements (including capital requirements of our subsidiaries), contractual restrictions and any other factors that our Board of Directors deems relevant in making such a determination. Therefore, there can be no assurance that we will pay any dividends or make other distributions or returns of capital on our common stock, or as to the amount of any such dividends, distributions or returns of capital. Rating Agencies The following financial strength ratings represent each rating agency’s current opinion of our principal insurance subsidiaries’ ability to pay obligations under insurance policies and contracts in accordance with their terms and are not evaluations directed toward the protection of investors in our securities. Financial strength ratings are not statements of fact nor are they recommendations to purchase, hold or sell any security, contract or policy. Each rating should be evaluated independently of any other rating. Our financial strength ratings as of the date of this filing are indicated in the following table. All financial strength ratings have a stable outlook. _______________ NR = Not rated Our long-term issuer credit ratings as of the date of this filing are indicated in the following table. All long-term issuer credit ratings have a stable outlook. _______________ (1) Long-term Issuer Credit Rating refers to issuer credit rating, issuer default rating, long-term issuer rating and long-term counterparty credit rating for A.M. Best, Fitch, Moody’s and S&P, respectively. Additional information about financial strength ratings and credit ratings can be found on the respective websites of the rating agencies. Rating agencies may continue to review and adjust our ratings. See “Risk Factors - Risks Related to Our Business - A downgrade or a potential downgrade in our financial strength or credit ratings could result in a loss of business and materially adversely affect our financial condition and results of operations” for an in-depth description of the impact of a ratings downgrade. Sources and Uses of Liquidity and Capital Our primary sources and uses of liquidity and capital are summarized as follows: Cash Flows from Operating Activities The principal cash inflows from our insurance activities come from insurance premiums, annuity considerations and net investment income. The principal cash outflows are the result of various annuity and life insurance products, operating expenses and income tax, as well as interest expense. The primary liquidity concern with respect to these cash flows is the risk of early contract holder and policyholder withdrawal. Cash Flows from Investing Activities The principal cash inflows from our investment activities come from repayments of principal, proceeds from maturities and sales of investments, as well as settlements of freestanding derivatives. The principal cash outflows relate to purchases of investments and settlements of freestanding derivatives. We typically can have a net cash outflow from investing activities because cash inflows from insurance operations are reinvested in accordance with our ALM discipline to fund insurance liabilities. We closely monitor and manage these risks through our comprehensive investment risk management process. The primary liquidity concerns with respect to these cash flows are the risk of default by debtors and market disruption. Cash Flows from Financing Activities The principal cash inflows from our financing activities come from issuances of debt and equity securities, deposits of funds associated with policyholder account balances and lending of securities. The principal cash outflows come from repayments of debt, common stock repurchases, preferred stock dividends, withdrawals associated with policyholder account balances and the return of securities on loan. The primary liquidity concerns with respect to these cash flows are market disruption and the risk of early policyholder withdrawal. Primary Sources of Liquidity and Capital In addition to the summary description of liquidity and capital sources discussed in “- Sources and Uses of Liquidity and Capital,” the following additional information is provided regarding our primary sources of liquidity and capital: Funding Sources Liquidity is provided by a variety of funding sources, including secured funding agreements, unsecured credit facilities and secured committed facilities. Capital is provided by a variety of funding sources, including issuances of debt and equity securities, as well as borrowings under our credit facilities. We maintain a shelf registration statement with the SEC that permits the issuance of public debt, equity and hybrid securities. As a “Well-Known Seasoned Issuer” under SEC rules, our shelf registration statement provides for automatic effectiveness upon filing and has no stated issuance capacity. The diversity of our funding sources enhances our funding flexibility, limits dependence on any one market or source of funds and generally lowers the cost of funds. Our primary funding sources include: Preferred Stock On March 25, 2019, BHF issued depositary shares, each representing a 1/1,000th ownership interest in a share of BHF’s perpetual 6.600% Series A non-cumulative preferred stock (the “Series A Preferred Stock”) and in the aggregate representing 17,000 shares of Series A Preferred Stock, with a stated amount of $25,000 per share, for aggregate net cash proceeds of $412 million. See Note 10 of the Notes to the Consolidated Financial Statements. Federal Home Loan Bank Funding Agreements, Reported in Policyholder Account Balances Brighthouse Life Insurance Company is a member of the Federal Home Loan Bank (“FHLB”) of Atlanta and maintains a funding agreement program with certain FHLBs. At both December 31, 2019 and 2018, Brighthouse Life Insurance Company had obligations outstanding under funding agreements with certain FHLBs of $595 million. During the years ended December 31, 2019, 2018 and 2017, Brighthouse Life Insurance Company issued $0, $0 and $25 million, respectively, and repaid $0, $0 and $75 million, respectively, under such funding agreements. Activity related to these funding agreements is reported in the Run-off segment. Farmer Mac Funding Agreements, Reported in Policyholder Account Balances On February 1, 2019, Brighthouse Life Insurance Company entered into a funding agreement program with the Federal Agricultural Mortgage Corporation and its affiliate Farmer Mac Mortgage Securities Corporation (“Farmer Mac”), pursuant to which the parties may enter into funding agreements in an aggregate amount of up to $500 million. At December 31, 2019, there were no borrowings under this funding agreement program. Activity related to these funding agreements is reported in the Run-off segment. Long-term Debt Issued In September 2018, BHF issued $375 million of 6.25% unsecured junior subordinated debentures due 2058. In June 2017, BHF issued $3.0 billion of unsecured senior notes consisting of (i) $1.5 billion of 3.70% senior notes due 2027 and (ii) $1.5 billion of 4.70% senior notes due 2047. Credit Facilities On February 1, 2019, BHF entered into a term loan agreement with respect to a $1.0 billion unsecured term loan facility (as amended, the “2019 Term Loan Facility”) scheduled to mature in February 2024. On February 1, 2019, BHF borrowed $1.0 billion under the 2019 Term Loan Facility, terminated its former term loan facility due December 2, 2019 (the “2017 Term Loan Facility”) without penalty and repaid $600 million of borrowings outstanding under the 2017 Term Loan Facility, with the remainder of the proceeds used for general corporate purposes. On May 7, 2019, BHF entered into an amended and restated revolving credit agreement with respect to a $1.0 billion senior unsecured revolving credit facility (the “2019 Revolving Credit Facility”) scheduled to mature in May 2024, all of which may be used for revolving loans and/or letters of credit. The 2019 Revolving Credit Facility replaced BHF’s former $2.0 billion senior unsecured revolving credit facility, which was scheduled to mature in December 2021. At December 31, 2019, there were no borrowings under the 2019 Revolving Credit Facility. Committed Facilities Repurchase Facility In April 2018, Brighthouse Life Insurance Company entered into a secured committed repurchase facility (the “Repurchase Facility”) with a financial institution, pursuant to which Brighthouse Life Insurance Company may enter into repurchase transactions in an aggregate amount of up to $2.0 billion. The Repurchase Facility has a term ending on July 31, 2021. Under the Repurchase Facility, Brighthouse Life Insurance Company may sell certain eligible securities at a purchase price based on the market value of the securities less an applicable margin based on the types of securities sold, with a concurrent agreement to repurchase such securities at a predetermined future date (ranging from two weeks to three months) and at a price which represents the original purchase price plus interest. At December 31, 2019, there were no borrowings under the Repurchase Facility. Reinsurance Financing Arrangement Our reinsurance subsidiary, BRCD, was formed to manage our capital and risk exposures and to support our term and ULSG businesses through the use of affiliated reinsurance arrangements and related reserve financing. At December 31, 2019, BRCD had a $10.0 billion financing arrangement with a pool of highly rated third-party reinsurers. This financing arrangement consists of credit-linked notes that each mature in 2037. At December 31, 2019, there were no borrowings under this facility, and there was $10.0 billion of funding available under this financing arrangement. BRCD is capitalized with cash and invested assets, including funds withheld (“Minimum Initial Target Assets”) at a level we believe to be sufficient to satisfy its future cash obligations assuming a permanent level yield curve, consistent with NAIC cash flow testing scenarios. BRCD utilizes the above referenced financing arrangement to cover the difference between full required statutory assets (i.e., XXX/AXXX reserves plus target risk margin appropriate to meet capital needs) and Minimum Initial Target Assets. An admitted deferred tax asset, could also serve to reduce the amount of funding required under the above referenced financing arrangement. Outstanding Long-term Debt The following table summarizes our outstanding long-term debt at: _______________ (1) Includes unamortized debt issuance costs and debt discount totaling $42 million and $46 million at December 31, 2019 and 2018, respectively, for senior notes and junior subordinated debentures on a combined basis. (2) Represents non-recourse debt for which creditors have no access, subject to customary exceptions, to the general assets of the Company other than recourse to certain investment companies. Debt and Facility Covenants The Company’s debt instruments and credit and committed facilities contain certain administrative, reporting and legal covenants. Additionally, the Company’s credit facilities contain financial covenants, including requirements to maintain a specified minimum adjusted consolidated net worth, to maintain a ratio of total indebtedness to total capitalization not in excess of a specified percentage and that place limitations on the dollar amount of indebtedness that may be incurred by the Company, which could restrict our operations and use of funds. At December 31, 2019, the Company was in compliance with these financial covenants. Primary Uses of Liquidity and Capital In addition to the summarized description of liquidity and capital uses discussed in “- Sources and Uses of Liquidity and Capital,” and “- Contractual Obligations,” the following additional information is provided regarding our primary uses of liquidity and capital: Common Stock Repurchases During the years ended December 31, 2019 and 2018, we repurchased 11,658,208 shares and 2,628,167 shares, respectively, of our common stock through open market purchases, pursuant to 10b5-1 plans, for $442 million and $105 million, respectively. In 2020, through February 21, 2020, BHF repurchased an additional 947,605 shares of its common stock through open market purchases, pursuant to 10b5-1 plans, for $39 million. Preferred Stock Dividends During the year ended December 31, 2019, we paid dividends totaling $21 million on our preferred stock. See Note 10 of the Notes to the Consolidated Financial Statements for information regarding the calculation and timing of these dividend payments. Debt Repurchases We may from time to time seek to retire or purchase our outstanding indebtedness through cash purchases and/or exchanges for other securities, purchases in the open market, privately negotiated transactions or otherwise. Any such repurchases or exchanges will be dependent upon several factors, including our liquidity requirements, contractual restrictions, general market conditions, and applicable regulatory, legal and accounting factors. Whether or not we repurchase any debt and the size and timing of any such repurchases will be determined at our discretion. Collateral Financing Arrangement Repaid In April 2017, MetLife, Inc. and MetLife Reinsurance Company of South Carolina (which was subsequently merged into BRCD) terminated a collateral financing arrangement and, as a result, the $2.8 billion obligation outstanding under this arrangement was extinguished. Insurance Liabilities Liabilities arising from our insurance activities primarily relate to benefit payments under various annuity and life insurance products, as well as payments for policy surrenders, withdrawals and loans. Surrender or lapse behavior differs somewhat by product but tends to occur in the ordinary course of business. During the years ended December 31, 2019 and 2018, general account surrenders and withdrawals totaled $2.3 billion and $3.0 billion, respectively, of which $2.1 billion and $2.4 billion, respectively, was attributable to products within the Annuities segment. Pledged Collateral We pledge collateral to, and have collateral pledged to us by, counterparties in connection with our derivatives. At December 31, 2019 and 2018, counterparties were obligated to return cash collateral pledged by us of $0 and $64 million, respectively. At December 31, 2019 and 2018, we were obligated to return cash collateral pledged to us by counterparties of $1.3 billion and $1.4 billion, respectively. See Note 7 of the Notes to the Consolidated Financial Statements for additional information about pledged collateral. We also pledge collateral from time to time in connection with funding agreements. Securities Lending We have a securities lending program whereby securities are loaned to third parties, primarily brokerage firms and commercial banks. We obtain collateral, usually cash, from the borrower, which must be returned to the borrower when the loaned securities are returned to us. Under our securities lending program, we were liable for cash collateral under our control of $3.1 billion and $3.6 billion at December 31, 2019 and 2018, respectively. Of these amounts, $1.3 billion and $1.5 billion at December 31, 2019 and 2018, respectively, were on open, meaning that the related loaned security could be returned to us on the next business day requiring the immediate return of cash collateral we hold. The estimated fair value of the securities on loan related to the cash collateral on open at December 31, 2019 was $1.2 billion, all of which were U.S. government and agency securities which, if put back to us, could be immediately sold to satisfy the cash requirement. See Note 6 of the Notes to the Consolidated Financial Statements. Litigation Putative or certified class action litigation and other litigation, and claims and assessments against us, in addition to those discussed elsewhere herein and those otherwise provided for in the financial statements, have arisen in the course of our business, including, but not limited to, in connection with our activities as an insurer, employer, investor, investment advisor, and taxpayer. Further, state insurance regulatory authorities and other federal and state authorities regularly make inquiries and conduct investigations concerning our compliance with applicable insurance and other laws and regulations. See Note 15 of the Notes to the Consolidated Financial Statements. Contractual Obligations The following table summarizes our major contractual obligations at December 31, 2019: Insurance Liabilities and Policyholder Account Balances Insurance liabilities reflect future estimated cash flows and (i) are based on mortality, morbidity, lapse and other assumptions comparable with our experience and expectations of future payment patterns; and (ii) consider future premium receipts on current policies in-force. Additionally, the more than five years category includes estimated payments due for periods extending for more than 100 years. The total amount presented for insurance liabilities of $54.5 billion exceeds the liability amounts of $42.8 billion presented on the consolidated balance sheet principally due to (i) the time value of money, which accounts for a substantial portion of the difference; and (ii) differences in assumptions, most significantly mortality, between the date the liabilities were initially established and the current date; and are partially offset by liabilities related to accounting conventions (such as interest reserves and unearned revenue), or which are not contractually due, which are excluded. Policyholder account balances generally represent the estimated cash payments on customer deposits and are based on assumptions related to withdrawals, including unscheduled or partial withdrawals; policy lapses; surrender charges; annuitization; mortality; future interest credited; policy loans and other contingent events as appropriate for the respective product type. The total amount presented for policyholder account balances of $50.7 billion exceeds the liability amount of $45.8 billion presented on the consolidated balance sheet principally due to (i) the time value of money, which accounts for a substantial portion of the difference; (ii) differences in assumptions between the date the liabilities were initially established and the current date; and (iii) liabilities related to accounting conventions (such as interest reserves and embedded derivatives), or which are not contractually due, which are excluded. Actual cash payments on insurance liabilities and policyholder account balances may differ significantly from the liabilities as presented on the consolidated balance sheet and the estimated cash payments as presented due to differences between actual experience and the assumptions used in the establishment of these liabilities and the estimation of these cash payments. All estimated cash payments are presented gross of any reinsurance recoverable. Payables for Collateral Under Securities Loaned and Other Transactions We have accepted cash collateral in connection with securities lending and derivatives. As the securities lending transactions expire within the next year and the timing of the return of the derivatives collateral is uncertain, the return of the collateral has been included in the one year or less category in the table. We also held non-cash collateral, which is not reflected as a liability on the consolidated balance sheet of $488 million at December 31, 2019. Long-term Debt The total amount presented for long-term debt differs from the total amount presented on the consolidated balance sheet as the amounts presented herein do not include unamortized premiums or discounts and debt issuance costs incurred upon issuance and include future interest on such obligations for the period from January 1, 2020 through maturity. Future interest on variable rate debt was computed using prevailing rates at December 31, 2019 and, as such, does not consider the impact of future rate movements. Future interest on fixed rate debt was computed using the stated rate on the obligations. Investment Commitments Investment commitments primarily include commitments to lend funds under partnership investments, which we anticipate could be invested any time over the next five years; however, as the timing of the fulfillment of the obligation cannot be predicted, such obligations are presented in the one year or less category. See Note 15 of the Notes to the Consolidated Financial Statements and “- Off-Balance Sheet Arrangements.” Other Other obligations are principally comprised of (i) the estimated fair value of derivative obligations, (ii) amounts due under reinsurance agreements, (iii) obligations under deferred compensation arrangements, (iv) payables related to securities purchased but not yet settled and (v) other accruals and accounts payable for which the Company is contractually liable, which are reported in other liabilities on the consolidated balance sheet. If the timing of any of these other obligations is sufficiently uncertain, the amounts are included within the one year or less category. Separate account liabilities are excluded as they are fully funded by cash flows from the corresponding separate account assets and are set equal to the estimated fair value of separate account assets. The Parent Company Liquidity and Capital In evaluating liquidity, it is important to distinguish the cash flow needs of the parent company from the cash flow needs of the combined group of companies. BHF is largely dependent on cash flows from its insurance subsidiaries to meet its obligations. Constraints on BHF’s liquidity may occur as a result of operational demands and/or as a result of compliance with regulatory requirements. See “Risk Factors - Economic Environment and Capital Markets-Related Risks - Adverse capital and credit market conditions may significantly affect our ability to meet liquidity needs and our access to capital,” “Risk Factors - Regulatory and Legal Risks - Our insurance business is highly regulated, and changes in regulation and in supervisory and enforcement policies may materially impact our capitalization or cash flows, reduce our profitability and limit our growth” and “Risk Factors - Capital-Related Risks - As a holding company, BHF depends on the ability of its subsidiaries to pay dividends.” Short-term Liquidity and Liquid Assets At December 31, 2019 and 2018, BHF and certain of its non-insurance subsidiaries had short-term liquidity of $723 million and $520 million, respectively. Short-term liquidity is comprised of cash and cash equivalents and short-term investments. At December 31, 2019 and 2018, BHF and certain of its non-insurance subsidiaries had liquid assets of $767 million and $752 million, respectively, of which $715 million and $693 million, respectively, was held by BHF. Liquid assets are comprised of cash and cash equivalents, short-term investments and publicly-traded securities. Statutory Capital and Dividends The NAIC and state insurance departments have established regulations that provide minimum capitalization requirements based on RBC formulas for insurance companies. RBC is based on a formula calculated by applying factors to various asset, premium, claim, expense and statutory reserve items. The formula takes into account the risk characteristics of the insurer, including asset risk, insurance risk, interest rate risk, market risk and business risk and is calculated on an annual basis. The formula is used as an early warning regulatory tool to identify possible inadequately capitalized insurers for purposes of initiating regulatory action, and not as a means to rank insurers generally. State insurance laws provide insurance regulators the authority to require various actions by, or take various actions against, insurers whose TAC does not meet or exceed certain RBC levels. As of the date of the most recent annual statutory financial statements filed with insurance regulators, the TAC of each of our insurance subsidiaries subject to these requirements was in excess of each of those RBC levels. The amount of dividends that our insurance subsidiaries can ultimately pay to BHF through their various parent entities provides an additional margin for risk protection and investment in our businesses. Such dividends are constrained by the amount of surplus our insurance subsidiaries hold to maintain their ratings, which is generally higher than minimum RBC requirements. We proactively take actions to maintain capital consistent with these ratings objectives, which may include adjusting dividend amounts and deploying financial resources from internal or external sources of capital. Certain of these activities may require regulatory approval. Furthermore, the payment of dividends and other distributions by our insurance subsidiaries is governed by insurance laws and regulations. See Notes 10 and 18 of the Notes to the Consolidated Financial Statements. Normalized Statutory Earnings Normalized statutory earnings is used by management to measure our insurance companies’ ability to pay future distributions and is reflective of whether our hedging program functions as intended. Normalized statutory earnings is calculated as statutory pre-tax net gain from operations adjusted for the favorable or unfavorable impacts of (i) net realized capital gains (losses), (ii) the change in both the reserve-based and capital methodology-based CTE95 calculation, net of the change in our variable annuity reserves, and (iii) unrealized gains (losses) associated with our variable annuities risk management strategy. Normalized statutory earnings may be further adjusted for certain unanticipated items that impacted our results in order to help management and investors better understand, evaluate and forecast those results. Our variable annuity block is managed by funding the balance sheet with assets equal to or greater than a CTE95 level. We also manage market-related risks of increases in these asset requirements by hedging the market sensitivity of the CTE95 level to changes in the capital markets. By including hedge gains and losses related to our variable annuity risk management strategy in our calculation of normalized statutory earnings, we are able to fully reflect the change in value of the hedges, as well as the change in the value of the underlying CTE95 total asset requirement level. We believe this allows us to determine whether our hedging program is providing the desired level of protection. The following table presents the components of normalized statutory earnings: Primary Sources and Uses of Liquidity and Capital The principal sources of funds available to BHF include distributions from BH Holdings, dividends and returns of capital from its insurance subsidiaries, capital markets issuances, as well as its own cash and cash equivalents and short-term investments. These sources of funds may also be supplemented by alternate sources of liquidity either directly or indirectly through our insurance subsidiaries. For example, we have established internal liquidity facilities to provide liquidity within and across our regulated and non-regulated entities to support our businesses. The primary uses of liquidity of BHF include debt service obligations (including interest expense and debt repayments), preferred stock dividends, capital contributions to subsidiaries, common stock repurchases and payment of general operating expenses. Based on our analysis and comparison of our current and future cash inflows from the dividends we receive from subsidiaries that are permitted to be paid without prior insurance regulatory approval, our investment portfolio and other cash flows and anticipated access to the capital markets, we believe there will be sufficient liquidity and capital to enable BHF to make payments on debt, pay preferred stock dividends, contribute capital to its subsidiaries, repurchase its common stock, pay all general operating expenses and meet its cash needs. In addition to the liquidity and capital sources discussed in “- The Company - Primary Sources of Liquidity and Capital” and “- The Company - Primary Uses of Liquidity and Capital,” the following additional information is provided regarding BHF’s primary sources and uses of liquidity and capital: Distributions from and Capital Contributions to BH Holdings During the years ended December 31, 2019, 2018 and 2017, BHF received cash distributions of $195 million, $52 million and $50 million, respectively, from BH Holdings and made cash capital contributions of $412 million, $208 million and $1.3 billion, respectively, to BH Holdings. Short-term Intercompany Loans As of December 31, 2019, BHF, as borrower, had a short-term intercompany loan agreement with certain of its non-insurance subsidiaries, as lenders, for the purposes of facilitating the management of the available cash of the borrower and the lenders on a short-term and consolidated basis. Such intercompany loan agreement allows management to optimize the efficient use of and maximize the yield on cash between BHF and its subsidiary lenders. Each loan entered into under this intercompany loan agreement has a term not more than 364 days and bears interest on the unpaid principal amount at a variable rate, payable monthly. During the years ended December 31, 2019, 2018 and 2017, BHF borrowed $1.2 billion, $478 million and $136 million, respectively, from certain of its non-insurance subsidiaries under short-term intercompany loan agreements and repaid $1.1 billion, $311 million and $0, respectively, to certain of its non-insurance company subsidiaries under short-term intercompany loan agreements. At December 31, 2019 and 2018, BHF had total obligations outstanding of $343 million and $303 million, respectively, under such agreements. See Note 3 of the Schedule II - Condensed Financial Information (Parent Company Only). Intercompany Liquidity Facilities As of December 31, 2019, we maintained intercompany liquidity facilities with certain of our insurance and non-insurance company subsidiaries to provide short-term liquidity within and across the combined group of companies. Under these facilities, which are comprised of a series of revolving loan agreements among BHF and its participating subsidiaries, each company may lend to or borrow from each other, subject to certain maximum limits for a term not more than 364 days. In the second quarter of 2018, BHF borrowed $40 million from NELICO under this liquidity facility and repaid such borrowing in the third quarter of 2018. At December 31, 2019 and 2018, BHF had no obligations outstanding under such facilities. See Note 3 of the Schedule II - Condensed Financial Information (Parent Company Only). GLOSSARY Glossary of Selected Financial Terms Account value The amount of money in a policyholder’s account. The value increases with additional premiums and investment gains, and it decreases with withdrawals, investment losses and fees. Actuarial Guideline 43 (“AG 43”) See “Business - Regulation - Insurance Regulation - Surplus and Capital; Risk-Based Capital.” Adjusted earnings See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP and Other Financial Disclosures.” Alternative investments General account invested assets in other limited partnership interests. Assets under management (“AUM”) General account investments and separate account assets. Conditional tail expectation (“CTE”) A statistical tail risk measure used to assess the adequacy of assets supporting variable annuity contract liabilities, which is calculated as the average amount of total assets required to satisfy obligations over the life of the contract or policy in the worst “x%” of scenarios. Represented as CTE (100 less x). Example: CTE95 represents the five worst percent of scenarios. Credit loss The difference between the amortized cost of the security and the present value of projected future cash flows expected to be collected is recognized as an OTTI in earnings. Deferred acquisition cost (“DAC”) Represents the incremental costs related directly to the successful acquisition of new and renewal insurance and annuity contracts and which have been deferred on the balance sheet as an asset. Deferred sales inducements (“DSI”) Represent amounts that are credited to a policyholder’s account balance that are higher than the expected crediting rates on similar contracts without such an inducement and that are an incentive to purchase a contract and also meet the accounting criteria to be deferred as an asset that is amortized over the life of the contract. Deferred tax asset or deferred tax liability Assets or liabilities that are recorded for the difference between book basis and tax basis of an asset or a liability. General account assets All insurance company assets not allocated to separate accounts. Invested assets General account investments. Includes fixed maturity securities, equity securities, mortgage loans, policy loans, alternative investments, real estate limited partnerships and limited liability companies, other invested assets and short-term investments. Investment Hedge Adjustments Earned income on derivatives and amortization of premium on derivatives that are hedges of investments or that are used to replicate certain investments, but do not qualify for hedge accounting treatment. Life Insurance Sales Life insurance sales consist of 100 percent of annualized new premium for term life, first-year paid premium for whole life, universal life, and variable universal life, and total paid premium for indexed universal life. We exclude company-sponsored internal exchanges, corporate-owned life insurance, bank-owned life insurance, and private placement variable universal life. Market Value Adjustments Amounts associated with periodic crediting rate adjustments based on the total return of a contractually referenced pool of assets and market value adjustments associated with surrenders or terminations of contracts. Minimum Initial Target Assets Cash and invested assets, including funds withheld. Net amount at risk (“NAR”) Represents the difference between a claim amount payable if a specific event occurs and the amount set aside to support the claim. The calculation of NAR can differ by policy type and/or guarantee. Net investment spread See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP and Other Financial Disclosures.” Normalized statutory earnings Normalized statutory earnings is used by management to measure our insurance companies' ability to pay future distributions and is reflective of whether our hedging program functions as intended. Normalized statutory earnings is calculated as statutory pre-tax net gain from operations adjusted for the favorable or unfavorable impacts of (i) net unrealized capital gains (losses), (ii) the change in both the reserve-based and capital methodology-based CTE95 calculation, net of the change in our variable annuity reserves and (iii) unrealized gains (losses) associated with our variable annuities risk management strategy. Normalized statutory earnings may be further adjusted for certain unanticipated items that impacted our results in order to help management and investors better understand, evaluate and forecast those results. Reinsurance Insurance that an insurance company buys for its own protection. Reinsurance enables an insurance company to expand its capacity, stabilize its underwriting results, or finance its expanding volume. Risk-based capital (“RBC”) ratio The risk-based capital ratio is a method of measuring an insurance company’s capital, taking into consideration its relative size and risk profile, in order to ensure compliance with minimum regulatory capital requirements set by the National Association of Insurance Commissioners. When referred to as “combined,” represents that of our insurance subsidiaries as a whole. Total adjusted capital (“TAC”) Total adjusted capital primarily consists of statutory capital and surplus, as well as the statutory asset valuation reserve. When referred to as “combined,” represents that of our insurance subsidiaries as a whole. Tax-deferral An investment with earnings such as interest, dividends or capital gains that accumulate tax-free until the investor withdraws and takes possession of them. The most common types of tax-deferred investments include those in individual retirement accounts and individual retirement annuities (collectively, “IRAs”) and deferred annuities. Value of business acquired (“VOBA”) Present value of projected future gross profits from in-force policies of acquired businesses. Glossary of Product Terms Accumulation phase The phase of a variable annuity contract during which assets accumulate based on the policyholder’s lump sum or periodic deposits and reinvested interest, capital gains and dividends that are generally tax-deferred. Annuitant The person who receives annuity payments or the person whose life expectancy determines the amount of variable annuity payments upon annuitization of a life contingent annuity. Annuities Long-term, tax-deferred investments designed to help investors save for retirement. Annuitization The process of converting an annuity investment into a series of periodic income payments, generally for life. Benefit Base A notional amount (not actual cash value) used to calculate the owner’s guaranteed benefits within an annuity contract. The death benefit and living benefit within the same contract may not have the same Benefit Base. Cash surrender value The amount an insurance company pays (minus any surrender charge) to the variable annuity owner when the contract is voluntarily terminated prematurely. Deferred annuity An annuity purchased with premiums paid either over a period of years or as a lump sum, for which savings accumulate prior to annuitization or surrender, and upon annuitization, such savings are exchanged for either a future lump sum or periodic payments for a specific length of time or for a lifetime. Dollar-for-dollar withdrawal A method of calculating the reduction of a variable annuity Benefit Base after a withdrawal in which the benefit is reduced by one dollar for every dollar withdrawn. Enhanced death benefit An optional benefit that locks in investment gains annually, or every few years, or pays a minimum stated interest rate on purchase payments to the beneficiary. Fixed annuity An annuity that guarantees a set annual rate of return with interest at rates we determine, subject to specified minimums. Credited interest rates are guaranteed not to change for certain limited periods of time. Future policy benefits Future policy benefits for the annuities business are comprised mainly of liabilities for life contingent income annuities, and liabilities for the variable annuity guaranteed minimum benefits accounted for as insurance. Guaranteed minimum accumulation benefits (“GMAB”) An optional benefit (available for an additional cost) which entitles an annuitant to a minimum payment, typically in lump sum, after a set period of time, typically referred to as the accumulation period. The minimum payment is based on the Benefit Base, which could be greater than the underlying account value. Guaranteed minimum death benefits (“GMDB”) An optional benefit (available for an additional cost) that guarantees an annuitant’s beneficiaries are entitled to a minimum payment based on the Benefit Base, which could be greater than the underlying account value, upon the death of the annuitant. Guaranteed minimum income benefits (“GMIB”) An optional benefit (available for an additional cost) where an annuitant is entitled to annuitize the policy and receive a minimum payment stream based on the Benefit Base, which could be greater than the underlying account value. Guaranteed minimum living benefits (“GMLB”) A reference to all forms of guaranteed minimum living benefits, including GMIBs, GMWBs and GMABs (does not include GMDBs). Guaranteed minimum withdrawal benefit for life (“GMWBL”) An optional benefit (available for an additional cost) where an annuitant is entitled to withdraw a maximum amount of their Benefit Base each year, for the duration of the contract holder’s life, regardless of account performance. Guaranteed minimum withdrawal benefit riders (“GMLB Riders”) Changes in the carrying value of GMLB liabilities, related hedges and reinsurance; the fees earned directly from the GMLB liabilities; and related DAC offsets. Guaranteed minimum withdrawal benefits (“GMWB”) An optional benefit (available for an additional cost) where an annuitant is entitled to withdraw a maximum amount of their Benefit Base each year, for which cumulative payments to the annuitant could be greater than the underlying account value. Guaranteed minimum benefits (“GMxB”) A general reference to all forms of guaranteed minimum benefits, inclusive of living benefits and death benefits. Immediate income annuity A type of annuity for which the owner pays a lump sum and receives periodic payments immediately or soon after purchase. Single premium immediate annuities (“SPIAs”) are single premium annuity products that provide a guaranteed level of income to the owner generally for a specified number of years and/or for the life of the annuitant. Deferred income annuities (“DIAs”) provide a pension-like stream of income payments after a specified deferral period. Index-linked annuities An annuity that provides for asset accumulation and asset distribution needs with an ability to share in the upside from certain financial markets such as equity indices, or an interest rate benchmark. With an index-linked annuity, the customer’s account value can grow or decline due to various external financial market indices performance. Living benefits Optional benefits (available at an additional cost) that guarantee that the owner will get back at least his original investment when the money is withdrawn. Mortality and expense risk fee (“M&E fee”) A fee charged by insurance companies to compensate for the risk they take by issuing variable annuity contracts. Net flows Net change in customer account balances in a period including, but not limited to, new sales, full or partial exits and the net impact of clients utilizing or withdrawing their funds. It excludes the impact of markets on account balances. Period certain annuity Type of annuity that guarantees payment to the annuitant for a specified time period and to the beneficiary if the annuitant dies before the period ends. Policyholder account balances Annuities: Policyholder account balances are held for fixed deferred annuities, the fixed account portion of variable annuities, and non-life contingent income annuities. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. Life Insurance Policies: Policyholder account balances are held for retained asset accounts, universal life policies and the fixed account of universal variable life insurance policies. Interest is credited to the policyholder’s account at interest rates we determine which are influenced by current market rates, subject to specified minimums. Rider An optional feature or benefit that a variable annuity contract holder can purchase at an additional cost. Roll-up rate The guaranteed percentage that the Benefit Base increases by each year. Separate account An insurance company account, legally segregated from the general account, that holds the contract assets or subaccount investments that can be actively or passively managed and invest in stock, bonds or money market portfolios. Step-up An optional variable annuity feature (available at an additional cost) that can increase the Benefit Base amount if the variable annuity account value is higher than the Benefit Base on specified dates. Surrender charge A fee paid by a contract owner for the early withdrawal of an amount that exceeds a specific percentage or for cancellation of the contract within a specified amount of time after purchase. Term life products Term life products provide a fixed death benefit in exchange for a guaranteed level premium over a specified period of time, usually ten to thirty years. Generally, term life does not include any cash value, savings or investment components. Universal life products Life insurance products that provide a death benefit in return for payment of specified annual policy charges that are generally related to specific costs, which may change over time. To the extent that the policyholder chooses to pay more than the charges required in any given year to keep the policy in-force, the excess premium will be placed into the account value of the policy and credited with a stated interest rate on a monthly basis. Variable annuity A type of annuity that offers guaranteed periodic payments for a defined period of time or for life and gives purchasers the ability to invest in various markets though the underlying investment options, which may result in potentially higher, but variable, returns. Variable universal life Universal life products where the excess amount paid over policy charges can be directed by the policyholder into a variety of separate account investment options. In the separate account investment options, the policyholder bears the entire risk and returns of the investment results. Whole life products Life insurance products that provide a guaranteed death benefit in exchange for a guaranteed level premium for a specified period of time in order to maintain coverage for the life of the insured. Whole life products also have guaranteed minimum cash surrender values. Although the primary purpose is protection, the policyholder can withdraw or borrow against the policy (sometimes on a tax favored basis).

<s>[INST] Page Introduction Executive Summary Risk Management Strategies Industry Trends and Uncertainties Summary of Critical Accounting Estimates NonGAAP and Other Financial Disclosures Results of Operations Effects of Inflation Investments Derivatives OffBalance Sheet Arrangements Policyholder Liabilities Liquidity and Capital Resources Glossary Introduction For purposes of this discussion, unless otherwise mentioned or unless the context indicates otherwise, “Brighthouse,” “Brighthouse Financial,” the “Company,” “we,” “our” and “us” refer to Brighthouse Financial, Inc. a corporation incorporated in Delaware in 2016, and its subsidiaries. We use the term “BHF” to refer solely to Brighthouse Financial, Inc., and not to any of its subsidiaries. Until August 4, 2017, BHF was a whollyowned subsidiary of MetLife, Inc. (together with its subsidiaries and affiliates, “MetLife”). Following this summary is a discussion addressing the consolidated results of operations and financial condition of the Company for the periods indicated. This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with “Note Regarding ForwardLooking Statements,” “Risk Factors,” “Selected Financial Data,” “Quantitative and Qualitative Disclosures About Market Risk” and the Company’s consolidated financial statements included elsewhere herein. The term “Separation” refers to the separation of MetLife’s former Brighthouse Financial segment from MetLife’s other businesses and the creation of a separate, publiclytraded company, BHF, as well as the distribution on August 4, 2017 of 96,776,670, or 80.8%, of the 119,773,106 shares of BHF common stock outstanding immediately prior to the distribution date by MetLife, Inc. to holders of MetLife, Inc. common stock as of the record date for the distribution. The term “MetLife Divestiture” refers to the disposition by MetLife, Inc. on June 14, 2018 of all its remaining shares of BHF common stock. Effective with the MetLife Divestiture, MetLife, Inc. and its subsidiaries and affiliates are no longer considered related parties to BHF and its subsidiaries and affiliates. See Note 1 of the Notes to the Consolidated Financial Statements. The following discussion may contain forwardlooking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in these forwardlooking statements. Factors that could cause or contribute to these differences include those factors discussed below and elsewhere in this report, particularly in “Note Regarding ForwardLooking Statements” and “Risk Factors.” Presentation Prior to discussing our Results of Operations, we present background information and definitions that we believe are useful to understanding the discussion of our financial results. This information precedes the Results of Operations and is most beneficial when read in the sequence presented. A summary of key informational sections is as follows: “Executive Summary” contains the following subsections: “Overview” provides information regarding our business, segments and results as discussed in the Results of Operations. “Background” presents details of the Company’s legal entity structure. “Risk Management Strategies” describes the Company’s risk management strategy to protect against capital market risks specific to our variable annuity and ULSG businesses. “Industry Trends and Uncertainties” discusses updates and changes to a number of trends and uncertainties that we believe may materially affect our future financial condition, results of operations or cash flows. “Summary of Critical Accounting Estimates” explains the most critical estimates and judgments applied in determining our GAAP results. “NonGAAP and Other Financial Disclosures” defines key financial measures presented in the Results of Operations that are not calculated in accordance with GAAP but are used by management in evaluating company and segment performance. As described in this section, adjusted earnings is presented by key business activities which are derived from, but different than, the line items presented in the GAAP statement of operations. This section also refers to certain other terms used to describe our insurance [/INST] Negative. </s>

Safety, Income & Growth, Inc.

2018-02-20

2017-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This discussion summarizes the significant factors affecting our consolidated operating results, financial condition and liquidity during the three-year period ended December 31, 2017. This discussion should be read in conjunction with our consolidated financial statements and related notes for the three-year period ended December 31, 2017 included elsewhere in this Annual Report on Form 10-K. These historical financial statements may not be indicative of our future performance. Certain prior year amounts have been reclassified in the Company's consolidated financial statements and the related notes to conform to the current period presentation. Introduction We believe that we are the first and only publicly-traded company focused primarily on ground leases. Ground leases generally represent the ownership of land underlying commercial real estate properties, which are leased on a long term basis (often 30 to 99 years) by the land owner (landlord) to a tenant that owns and operates the building on top of the land ("Ground Lease"). The property is generally leased on a triple net basis with the tenant responsible for taxes, maintenance and insurance as well as all operating costs and capital expenditures. Ground Leases typically provide that at the end of the lease term or upon tenant default, the land, building and all improvements revert back to the landlord. We seek to become the industry leader in Ground Leases by demonstrating their value-added characteristics to real estate investors and expanding their use throughout major metropolitan areas. We have a diverse portfolio that is comprised of 15 properties located in major metropolitan areas, 12 of which were acquired or originated by iStar over the past 20 years. All of the properties in our portfolio are subject to long-term leases consisting of 10 Ground Leases and one master lease (covering five properties) that provide for periodic contractual rent escalations or percentage rent participations in gross revenues generated at the relevant properties. We have chosen to focus on Ground Leases in part because they offer a unique combination of safety, income growth and the potential for capital appreciation. We believe that Ground Leases offer the opportunity to realize superior risk-adjusted total returns when compared to certain other alternative commercial real estate property investments. Safety: We believe that a Ground Lease represents a safe position in a property's capital structure. This safety is derived from the typical structure of a Ground Lease, which we believe creates a low likelihood of a tenant default and a low likelihood of a loss by the Ground Lease landlord in the event of a tenant default. A Ground Lease landlord typically has the right to regain possession of its land and take ownership of the buildings and improvements thereon upon a tenant default, which provides a strong incentive for a Ground Lease tenant to make the required Ground Lease rent payments. Additionally, the value of a property subject to a Ground Lease typically exceeds the amount of the Ground Lease landlord's investment at the time it was made; therefore, even if the Ground Lease landlord takes over the property following a tenant default or upon expiration of the Ground Lease, the landlord is reasonably likely to recover substantially all of its Ground Lease investment, and possibly amounts in excess of its investment, depending upon prevailing market conditions. Income Growth: Ground Leases typically provide growing income streams through contractual base rent escalators that may compound over the duration of the lease. These rent escalators may be based on fixed increases, a Consumer Price Index ("CPI") or a combination thereof, and may also include a participation in the gross revenues of the underlying property. We believe that this rental growth over time can mitigate the effects of inflation and compensate for anticipated increases in land values over time, as well as serving as a basis for growing our dividend. Opportunity for Capital Appreciation: The opportunity for capital appreciation with Ground Leases comes in two forms. First, as the ground rent grows over time, the value of the Ground Lease should grow under market conditions in which capitalization rates remain flat. Second, at the expiration or earlier termination of our Ground Leases, we typically have the right to regain possession of the land underlying the Ground Lease and take title to the buildings and other improvements thereon for no additional consideration. This reversion right creates additional potential value to our stockholders that may be realized by us at the end of the Ground Lease, either by entering into a new Ground Lease on the then current market terms, selling the land and improvements thereon or operating the property directly. We generally target Ground Lease investments in which the initial value of the Ground Lease represents 30% to 45% of the Combined Property Value. If the initial value of a Ground Lease is equal to 35% of the Combined Property Value, the balance of 65% of the Combined Property Value represents potential value accretion to us upon the reversion of the property, assuming no intervening decline in the Combined Property Value. We refer to this potential value accretion as the "Value Bank," defined as the difference between the initial cost of the Ground Lease and the Combined Property Value. In our view, there is a strong correlation between inflation and commercial real estate values over time, which supports our belief that the value of our Value Bank should increase over time as inflation increases. Our ability to recognize value through reversion rights may be limited by the rights of our tenants under some of our Ground Leases, including tenant rights to purchase our land in certain circumstances and the right of one tenant to level improvements prior to the expiration of the lease. See "Risk Factors" for a discussion of these tenant rights. We believe that the reversion right is a unique feature distinguishing Ground Leases from other property types. Accordingly, we periodically estimate the value of our Value Bank based in part on valuations of our Ground Leases. We retain an independent valuation firm to prepare (a) initial reports of the Combined Property Value associated with each Ground Lease in our portfolio and (b) periodic updates of such reports. As reported in our Current Report on Form 8-K filed on February 15, 2018, as of December 31, 2017, our estimated Value Bank is $989.2 million in aggregate and our estimated Value Bank per share is $54.38. Please review that 8-K for a discussion of the valuation methodology used and important limitations and qualifications of the calculation of Value Bank. See also "Risk Factors - There can be no assurance that we will realize any incremental value from the Value Bank or that the market price of our common stock will reflect any value attributable thereto." Market Opportunity: We believe that there is a significant market opportunity for a dedicated provider of Ground Lease capital like us. We believe that the market for existing Ground Leases is fragmented with ownership comprised primarily of high net worth individuals, pension funds, life insurance companies, estates and endowments. However, while we intend to pursue acquisitions of existing Ground Leases, our investment thesis is predicated, in part, on what we believe is an untapped market opportunity to expand the use of Ground Leases to a broader component of the approximately $7.0 trillion institutional commercial property market in the United States. We intend to capture this market opportunity by utilizing multiple sourcing and origination channels, including manufacturing new Ground Leases with third-party owners and developers of commercial real estate and originating Ground Leases to provide capital for development and redevelopment. We further believe that Ground Leases generally represent an attractive source of capital for our tenants and may allow them to generate superior returns on their invested equity as compared to utilizing alternative sources of capital. We intend to draw on the extensive investment origination and sourcing platform of iStar, the parent company of our Manager, to actively promote the benefits of the Ground Lease structure to prospective Ground Lease tenants. Organization Safety, Income & Growth Inc. ("Original Safety") is a Maryland corporation that was formed as a wholly-owned subsidiary of iStar on October 24, 2016. iStar contributed a pre-existing portfolio of Ground Leases to Original Safety and sought third party capital to grow its Ground Lease business. A second entity, SIGI Acquisition, Inc. ("SIGI") was capitalized on April 14, 2017 by iStar and two institutional investors. On April 14, 2017, Original Safety merged with and into SIGI with SIGI surviving the merger and being renamed Safety, Income & Growth Inc. References herein to us or we refer to Original Safety before such merger and to the surviving company of such merger thereafter. Through these and other formation transactions, we (i) acquired iStar's entire Ground Lease portfolio consisting of 12 properties (the "Initial Portfolio"), all of which were wholly-owned as of December 31, 2016, (ii) completed the $227 million 2017 Secured Financing (refer to Note 6) on March 30, 2017, (iii) issued 2,875,000 shares of our common stock to two institutional investors for $20.00 per share, or $57.5 million (representing a 51% ownership interest in us at such time), and 2,775,000 shares of our common stock to iStar for $20.00 per share, or $55.5 million (representing a 49% ownership interest in us at such time), and (iv) paid $340.0 million in total consideration to iStar for the Initial Portfolio. On June 27, 2017, we completed our initial public offering raising $205.0 million in gross proceeds and concurrently completed a $45.0 million private placement with iStar. The initial public offering price was $20.00 per share. iStar paid organization and offering costs in connection with these transactions, including commissions payable to the underwriters and other offering expenses. iStar received no reimbursement for its payment of the organization and offering costs. We intend to elect to qualify as a real estate investment trust ("REIT") for U.S. federal income tax purposes, commencing with the tax year ending December 31, 2017. We were structured as an Umbrella Partnership REIT ("UPREIT"). As such, all of our properties are owned by a subsidiary partnership, Safety Income and Growth Operating Partnership LP (the "Operating Partnership"), which is currently wholly-owned by us. The UPREIT structure may afford us with certain benefits as we seek to acquire properties from third parties who may want to defer taxes on the contribution of their Ground Leases to us. Executive Overview We acquire, manage and capitalize Ground Leases and report our business as a single segment. We believe owning a portfolio of Ground Leases affords our investors the opportunity for safe, growing income. Safety is derived from a Ground Lease's super senior position in the commercial real estate capital structure. Growth is realized through long-term leases with contractual periodic increases in rent. Capital appreciation is realized though growth in the value of the land over time and when, at the end of the life of the lease, the commercial real estate property reverts back to us, as landlord, and we are able to realize the value of the leasehold, which may be substantial. Our leases share similarities with triple net leases in that typically we are not responsible for any operating or capital expenses over the life of the lease, making the management of our portfolio relatively simple, with limited working capital needs. Our Initial Portfolio was comprised of 12 properties located in major metropolitan areas that were acquired or originated by iStar over the past 20 years. All of the properties in our Initial Portfolio are subject to long-term leases consisting of seven Ground Leases and one master lease (covering five properties) that provide for contractual periodic rental escalations or percentage rent participations in gross revenues generated at the relevant properties. In June 2017, we acquired two additional Ground Leases. The Ground Leases were purchased from third-party sellers for an aggregate purchase price of approximately $142.0 million. Both transactions are well located urban developments, and based upon our estimate of net operating income at the properties upon stabilization, have significant coverage to the initial Ground Lease payment due under the leases, greater than 5.4x. We intend to grow our portfolio through future acquisitions and originations of Ground Leases and believe these transactions are indicative of some of the types of Ground Leases we are pursuing for acquisition and origination. We acquired the Ground Lease at 6201 Hollywood Boulevard, a 183,802 square foot land parcel subject to a long term Ground Lease located in Los Angeles, CA in the Hollywood neighborhood adjacent to the Hollywood/Vine metro station. The land is improved with approximately 535 apartments, 71,200 square feet of retail space, 1,300 underground parking spaces, and signage facing Hollywood Boulevard. The Ground Lease had 87 years remaining on its term. We also acquired the Ground Lease at 6200 Hollywood Boulevard, a 143,151 square foot land parcel subject to a long term Ground Lease located in Los Angeles, CA in the Hollywood neighborhood adjacent to the Hollywood/Vine metro station. The site is currently under construction; once completed, it will be improved with approximately 507 apartments, 56,100 square feet of retail space, 1,237 underground parking spaces, and signage facing Hollywood Boulevard. The Ground Lease had 87 years remaining on its term. Total development cost of these leasehold improvements is estimated to be $450 million, giving the projects a Combined Property Value of approximately $600 million. The $450 million of leasehold improvements reverts back to us as lessor at the end of the lease, which we refer to as the value bank ("Value Bank"). In August 2017, we originated a Ground Lease at 3333 LifeHope in Atlanta, GA for a purchase price of $16.0 million. The property is being converted into a class-A medical office building. The Ground Lease has a term of 99 years and initial rent of $0.9 million, subject to annual increases of 2%, and based upon the anticipated net operating income at the property upon stabilization, has coverage of more than 3.5x to the initial Ground Lease payment due under the lease. In addition, the ground lessee will construct a 185-space parking deck adjacent to the building scheduled to be completed in 2018, which will be engineered to accommodate future development of the site. We have a right of first refusal to provide funding for up to 30% of the construction cost of an additional 160,000 square feet of development on terms consistent with the Ground Lease. iStar, our largest shareholder and Manager, committed to provide a $24.0 million construction loan to the ground lessee with an initial term of one year for the renovation of the property. In October 2017, we entered into a purchase agreement to acquire land subject to a Ground Lease on which a 301 unit, luxury multi-family project known as “Great Oaks” is currently being constructed in San Jose, California. Pursuant to the purchase agreement, we will purchase the Ground Lease on November 1, 2020 from iStar for $34.0 million. iStar committed to provide a $80.5 construction loan to the ground lessee. The Ground Lease expires in 2116. We currently estimate that the Ground Rent Coverage at the time of stabilization will be in excess of 5.0x, assuming that construction is completed on or before November 1, 2020. Our Portfolio Our portfolio is comprised of 15 properties located in 10 states with 11 tenants. Our portfolio is comprised of 10 Ground Leases and a master lease (relating to five hotel assets that we refer to as our “Park Hotels Portfolio”) that has many of the characteristics of a Ground Lease, including length of lease term, percentage rent participations, triple net terms and strong Ground Rent Coverage. We acquired 12 of our properties prior to the completion of our initial public offering, and we acquired the remainder of our portfolio after the completion of our initial public offering. The tables below present an overview of our portfolio as of December 31, 2017, unless otherwise indicated ($ in millions): _______________________________________________________________________________ (1) Ground Rent Coverage is defined as the ratio of the Underlying Property's NOI to the annualized base rental payment due us. Underlying Property NOI is defined as the trailing twelve month net operating income of the commercial real estate being operated at the property without giving effect to any rent paid or payable under our Ground Lease. Net operating income is calculated as property-level revenues less property-level operating expenses as reported to us by the tenant, or as otherwise publicly available. We rely on net operating income as reported to us by our tenants, or as otherwise publicly available, without any independent investigation by us. (2) Property is part of the Park Hotels Portfolio and is subject to a single master lease. (3) A majority of the land underlying this property is owned by a third party and is ground leased to us through 2044 subject to changes in the CPI; however, our tenant pays this cost directly to the third party. (4) For One Ally Center, calculated using Underlying Property NOI of approximately $15.4 million, calculated as the underwritten net operating income for One Ally Center as reported in the prospectus dated December 14, 2017 of the Wells Fargo Commercial Mortgage Trust 2017-C42, and adding back the ground rent payable to us. (5) Calculated using estimated Underlying Property NOI which, for properties under development or renovation, reflects our estimated annual rent coverage at the expected stabilization or completion of renovation at the applicable property. (6) Underlying Property NOI is based on trailing twelve month September 30, 2017 figures. Great Oaks Purchase Commitment In October 2017, we entered into a purchase agreement to acquire land subject to a Ground Lease on which a 301 unit, luxury multi-family project known as “Great Oaks” is currently being constructed in San Jose, California. Pursuant to the purchase agreement, we will purchase the Ground Lease on November 1, 2020 from iStar for $34.0 million. iStar committed to provide a $80.5 million construction loan to the ground lessee. The Ground Lease expires in 2116. We currently estimate that the Ground Rent Coverage at the time of stabilization will be in excess of 5.0x, assuming that construction is completed on or before November 1, 2020. New Origination On January 25, 2018, we acquired land for $38.5 million and simultaneously entered into a Ground Lease as part of the Ground Lease tenant's acquisition of Onyx on First (the “Property”). The Property is a 2008-vintage, 14-story, 266-unit multifamily building well-located in the Navy Yards neighborhood of Washington, D.C., just one block away from the Navy Yards metro station and a short walk to Nationals Park. The building features amenities including underground parking, a gym, a courtyard, lounge, concierge, and a landscaped roof deck with a pool and views of the Capitol Building. The Ground Lease has a term of 99 years. Tenant Concentration During the year ended December 31, 2017, the tenant under our Park Hotels Portfolio accounted for approximately $10.4 million, or 45%, of our total revenues, and the tenant who leases the land on which the One Ally Center in Detroit, Michigan is located accounted for approximately $5.3 million, or 23%, of our total revenues. In addition, some of our tenants operate hotels at the leased properties. For the year ended December 31, 2017, 49.3% of our total revenues came from rent payments by these hotel tenants. For additional information on tenant concentrations, see "Item 1A. Risk Factors-Risks Related to Our Portfolio and Our Business-Tenant concentration may expose us to financial credit risk and hotel industry concentration exposes us to the financial risks of a downturn in the hotel industry generally, and the hotel operations at our specific properties." Results of Operations for the Year Ended December 31, 2017 compared to the Year Ended December 31, 2016(1) _______________________________________________________________________________ (1) Operations prior to April 14, 2017 represent the activity of Safety, Income & Growth Inc. Predecessor. In addition, as a result of our acquisition of the Initial Portfolio from iStar, the periods subsequent to April 14, 2017 are presented on a new basis of accounting pursuant to Accounting Standards Codification ("ASC") 805. (2) Real estate expense includes reimbursable property taxes at one of our properties. Ground and other lease income increased to $22.9 million during the year ended December 31, 2017 from $21.7 million for the same period in 2016. The increase in 2017 was primarily due to additional rental income earned on three Ground Leases originated in 2017, partially offset by a one-time $2.5 million decrease in 2017 percentage rent on the Park Hotels Portfolio resulting from an amendment to the master lease. Other income for the year ended December 31, 2017 consists primarily of interest income earned on our cash balances. Other income for the year ended December 31, 2016 consists primarily of interest income earned on fundings provided to a certain investment in a Ground Lease. During the year ended December 31, 2017, we incurred interest expense from our secured financings including the 2017 Secured Financing, the 2017 Revolver and the 2017 Hollywood Mortgage of $7.8 million and we incurred an allocation of interest expense from iStar of $2.1 million for the period prior to the 2017 Secured Financing. During the year ended December 31, 2016, interest expense of $8.2 million represents the amount of interest expense allocated to us by iStar. Interest expense was allocated to us by calculating our average net assets as a percentage of the average net assets in iStar’s net lease business segment and multiplying that percentage by the interest expense allocated to iStar’s net lease business segment. Real estate expense was $1.5 million and $0.9 million during the years ended December 31, 2017 and 2016, respectively. During the year ended December 31, 2017, real estate expenses consisted primarily of non-cash rent expense related to the amortization of a below market lease asset at one of our hotel properties, recoverable property taxes at one of our properties and insurance, consulting and legal fees. During the year ended December 31, 2016, real estate expenses consisted primarily of recoverable property taxes at one of our properties. The increase in 2017 was primarily due to the non-cash rent expense related to the amortization of a below market lease asset at one of our hotel properties. Depreciation and amortization was $7.3 million and $3.1 million during the years ended December 31, 2017 and 2016, respectively, and primarily relates to our ownership of the hotels under our master lease and our ownership of the structure at the Buckler Apartments property. Beginning on April 14, 2017 we accounted for the acquisition of the Initial Portfolio from iStar in accordance with ASC 805 and began recording depreciation based on the acquisition date fair values of the real estate and recognizing amortization expense resulting from in-place intangible lease assets. During the year ended December 31, 2017, general and administrative expenses include management fees (which our Manager is waiving payment of during the first year of the management agreement), stock-based compensation for equity awards granted to our directors who are not employees of our Manager or iStar, costs of operating as a public company and an allocation of expenses to us from our Manager and iStar (which our Manager is waiving during the first year of the management agreement). Although we pay no management fee or expense reimbursements to our Manager through June 30, 2018, GAAP requires us to record expenses and a non-cash capital contribution from iStar despite iStar not receiving any compensation for its services. During the year ended December 31, 2016, general and administrative expenses primarily includes an allocation of expenses to us from iStar. General and administrative expenses were allocated to us for certain iStar corporate functions, including executive oversight, treasury, finance, human resources, tax compliance and planning, internal audit, financial reporting, information technology and investor relations. General and administrative expenses, including stock based compensation, were allocated to us based on a pro rata allocation of costs from iStar’s net lease and corporate business segments based on our average net assets. The following table presents our general and administrative expenses for the years ended December 31, 2017 and 2016 ($ in thousands): ______________________________________________________ (1) For the period from January 1, 2017 to April 13, 2017 and the year ended December 31, 2016, stock-based compensation represents an allocation from iStar. (2) Waived through June 30, 2018. During the year ended December 31, 2017, other expense consists primarily of non-recurring acquisition costs, unsuccessful investment pursuit costs and costs associated with entering into hedges. During the year ended December 31, 2017, we recognized income from sales of real estate of $0.5 million resulting from the sale of a parking facility from our Park Hotels Portfolio. Results of Operations for the Year Ended December 31, 2016 compared to the Year Ended December 31, 2015 Ground and other lease income increased to $21.7 million during the year ended December 31, 2016 from $18.6 million for the same period in 2015. The increase in 2016 was primarily the result of us acquiring a property subject to a 99-year Ground Lease in March 2015 and an increase in lease income at one of our hotel properties due to a lease amendment executed on September 30, 2015. In 2016, other income represents interest income earned on fundings provided to a certain investment in a Ground Lease and other ancillary income at a multi-family property. Interest expense represents the amount of interest expense allocated to us by iStar. Interest expense was allocated to us by calculating our average net assets as a percentage of the average net assets in iStar's net lease business segment and multiplying that percentage by the interest expense allocated to iStar's net lease business segment. The increase during the year ended December 31, 2016 was primarily due to an increase in our allocable base of assets in 2016 from 2015. Real estate expenses increased to $0.9 million during the year ended December 31, 2016 from $0.2 million during the same period in 2015. The increase was primarily related to an increase in recoverable property taxes at one of our properties. Depreciation and amortization was $3.1 million during the year ended December 31, 2016 and 2015 and primarily relates to our ownership of the hotels under our master lease and our ownership of the structure at the Buckler Apartments property. General and administrative expenses represent an allocation of expenses to us from iStar. General and administrative expenses include certain iStar corporate functions, including executive oversight, treasury, finance, human resources, tax compliance and planning, internal audit, financial reporting, information technology and investor relations. General and administrative expenses, including stock based compensation, represent a pro rata allocation of costs from iStar's net lease and corporate business segments based on our average net assets. General and administrative expenses increased to $2.9 million for the year ended December 31, 2016 from $2.3 million for the same period in 2015, primarily due to an increase in our allocable base of assets in 2016 from 2015. Non-GAAP Financial Measures In addition to net income (loss) prepared in conformity with GAAP, we use certain non-GAAP financial measures to measure our operating performance. We present below a discussion of funds from operations ("FFO"), and adjusted funds from operations ("AFFO"). We present FFO and AFFO because we consider them to be important supplemental measures of our operating performance and believe that they are frequently used by management, securities analysts, investors and other interested parties in the evaluation of REITs. FFO is a widely recognized non-GAAP financial measure for REITs that we believe, when considered with financial statements determined in accordance with GAAP, is useful to investors in understanding financial performance and providing a relevant basis for comparison among REITs. We compute FFO in accordance with the National Association of Real Estate Investment Trusts ("NAREIT"), which defines FFO as net income (loss) (determined in accordance with GAAP), excluding gains or losses from sales of depreciable operating property, plus real estate-related depreciation and amortization. We compute AFFO by adding (or subtracting) to FFO the following items: straight-line rental income, the amortization of real estate-related intangibles, non-cash management fees and expense reimbursements, stock-based compensation, acquisition costs and the amortization of deferred financing costs and other expenses related to debt obligations. We consider AFFO to be a useful metric when evaluating the key drivers of our long term operating performance, which are relatively straightforward. Our Ground Lease investments generate rental income and our tenants are typically responsible for all property level expenses. As a result, we incur minimal property level cash expenses that are not reimbursed. Furthermore, we subtract straight-line rent because it represents non-cash GAAP income, which creates a material difference between our GAAP rental income recorded and the cash rent we receive, particularly due to the very long duration of our leases. AFFO is presented prior to the impact of the amortization of lease intangibles, non-cash management fees and expense reimbursements, stock-based compensation, and other expenses which represent non-cash expenses. We also add back acquisition expenses incurred for the acquisition of Ground Leases due to the long-term nature of our Ground Lease business. Our Ground Lease assets typically have long-term leases (typically 30-99 years) and acquisition expenses will only affect our operations in periods in which Ground Leases are acquired. In addition, we believe FFO and AFFO are useful to investors as they capture features particular to real estate performance by recognizing that real estate has generally appreciated over time or maintains residual value to a much greater extent than do other depreciable assets. Investors should review FFO and AFFO, along with GAAP net income (loss), when trying to understand the operating performance of an equity REIT like us. However, because FFO and AFFO exclude depreciation and amortization and do not capture the changes in the value of our properties that result from use or market conditions, which have real economic effect and could materially impact our results from operations, the utility of FFO and AFFO as measures of our performance is limited. There can be no assurance that FFO and AFFO as presented by us is comparable to similarly titled measures of other REITs. FFO and AFFO do not represent cash generated from operating activities and should not be considered as alternatives to net income (loss) (determined in accordance with GAAP) or to cash flow from operating activities (determined in accordance with GAAP). FFO and AFFO are not indicative of cash available to fund ongoing cash needs, including the ability to make cash distributions to our stockholders. Although FFO and AFFO are measures used for comparability in assessing the performance of REITs, as the NAREIT White Paper only provides guidelines for computing FFO, the computation of FFO and AFFO may vary from one company to another. The following table presents a reconciliation of our historical consolidated and combined net income (loss), the most directly comparable GAAP measure, to FFO and AFFO, for the periods presented (1): _______________________________________________________________________________ (1) Operations prior to April 14, 2017 represent the activity of Safety, Income & Growth Inc. Predecessor. (2) For the period from April 14, 2017 to December 31, 2017, AFFO does not include any percentage rent from the Park Hotels Portfolio, which is recorded annually in the first quarter of each year. For the year ended December 31, 2016, we recorded $3.0 million in percentage rent from the Park Hotels Portfolio. We present below a discussion of earnings before interest, depreciation and amortization, or EBITDA. We compute EBITDA as the sum of net income (loss) before interest expense and depreciation and amortization. We present EBITDA because we believe that EBITDA, along with cash flow from operating activities, investing activities and financing activities, provides investors with an additional indicator of our ability to incur and service debt. EBITDA should not be considered as an alternative to net income (loss) (determined in accordance with GAAP), as an indication of our financial performance, as an alternative to net cash flows from operating activities (determined in accordance with GAAP), or as a measure of our liquidity. The following table presents a reconciliation of our historical consolidated and combined net income (loss), the most directly comparable GAAP measure, to EBITDA, for the periods presented (1): _______________________________________________________________________________ (1) Operations prior to April 14, 2017 represent the activity of Safety, Income & Growth Inc. Predecessor. Liquidity and Capital Resources Liquidity is a measure of our ability to meet potential cash requirements, including to pay interest and repay borrowings, fund and maintain our assets and operations, complete acquisitions and originations of investments, make distributions to our stockholders and meet other general business needs. In order to qualify as a REIT, we are required under the Internal Revenue Code of 1986 to distribute to our stockholders, on an annual basis, at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gains. We expect to make quarterly cash distributions to our stockholders sufficient to meet REIT qualification requirements. As of December 31, 2017, we had unrestricted cash and unused borrowing capacity under our 2017 Revolver of $458 million. Our primary sources of cash to date have been proceeds of $205 million from our initial public offering, proceeds of $45 million from our private placement to iStar, proceeds of $113 million from our initial capitalization by iStar and two institutional investors and borrowings from our other facilities. Our primary uses of cash to date have been the $113 million acquisition of the Initial Portfolio from iStar (which was subject to the 2017 Secured Financing, as defined below), the acquisition/origination of three Ground Leases for an aggregate purchase price of approximately $158 million and repayments on our debt facilities. Our primary sources of liquidity going forward will generally consist of cash on hand and cash generated from our operating activities, financings and unused borrowing capacity under our 2017 Revolver. We expect our short-term liquidity requirements to include: •debt service; •distributions to our stockholders; and •working capital. We expect to meet our short-term liquidity requirements through our cash on hand, our cash flows from operations and our 2017 Revolver. The availability of our 2017 Revolver is subject to the conditions set forth in the applicable loan agreement. We expect our long-term liquidity requirements to include: •acquisitions and originations of Ground Lease investments; and •debt maturities. We expect to meet our long-term liquidity requirements through our cash on hand, cash flows from operations, mortgage financings, debt issuances, common and/or preferred equity issuances and asset sales. Contractual Obligations-The following table outlines the contractual obligations related to our long-term debt obligations and purchase commitments as of December 31, 2017 (refer to Note 6 and Note 7 to the consolidated and combined financial statements). _______________________________________________________________________________ (1) Assumes the extended maturity date for all debt obligations. (2) Interest payable does not include interest that may be payable under our derivatives. (3) Refer to Note 4 of the consolidated and combined financial statements. (4) We are also obligated to pay the third-party owner of a property that is ground leased to us $0.4 million, subject to adjustment for changes in the CPI, per year through 2044; however, our tenant pays this expense directly under the terms of a master lease through 2035. 2017 Secured Financing-In March 2017, we entered into a $227.0 million non-recourse secured financing transaction (the "2017 Secured Financing") that bears interest at a fixed rate of 3.795% and matures in April 2027. The 2017 Secured Financing was collateralized by the Initial Portfolio including seven Ground Leases and one master lease (covering the accounts of five properties). In connection with and prior to the closing of the 2017 Secured Financing, we entered into a $200 million notional rate lock swap, reducing the effective rate of the 2017 Secured Financing from 3.795% to 3.773% (refer to Note 3). 2017 Revolver-In June 2017, we entered into a recourse senior secured revolving credit facility with a group of lenders in the maximum aggregate initial original principal amount of up to $300.0 million (the "2017 Revolver"). The 2017 Revolver has a term of three years with two 12-month extension options exercisable by us, subject to certain conditions, and bears interest at an annual rate of applicable LIBOR plus 1.35%. An undrawn credit facility commitment fee ranges from 0.15% to 0.25%, based on utilization each quarter. This fee was waived for the first six months after the closing date of June 27, 2017. The 2017 Revolver will allow us to leverage Ground Leases up to 67%. The 2017 Revolver provides an accordion feature to increase, subject to certain conditions, the maximum availability up to $500.0 million. We incurred $3.0 million of lender and third-party fees, all of which were capitalized in "Deferred expenses and other assets, net" on our consolidated balance sheet. 2017 Hollywood Mortgage-In December 2017, we entered into a $71.0 million mortgage on 6200 Hollywood Boulevard and 6201 Hollywood Boulevard (the "2017 Hollywood Mortgage"). The 2017 Hollywood Mortgage bears interest at a rate of one-month LIBOR plus 1.33%, matures in January 2023 and is callable without pre-payment penalty beginning in January 2021. Debt Covenants-We are subject to financial covenants under the 2017 Revolver, including maintaining: a limitation on total consolidated leverage of not more than 70%, or 75% for no more than 180 days, of our total consolidated assets; a consolidated fixed charge coverage ratio of at least 1.45x; a consolidated tangible net worth of at least 75% of our tangible net worth at the date of the 2017 Revolver plus 75% of future issuances of net equity; a consolidated secured leverage ratio of not more than 70%, or 75% for no more than 180 days, of our total consolidated assets; and a secured recourse debt ratio of not more than 5.0% of our total consolidated assets. Additionally, the 2017 Revolver restricts our ability to pay distributions to our stockholders. For 2017, we were permitted to make distributions based on an annualized distribution rate of 3.0% of the initial public offering price per share of our common stock. Beginning in 2018, we will be permitted to make annual distributions up to an amount equal to 110% of our adjusted funds from operations, as calculated in accordance with the 2017 Revolver. In addition, we may make distributions to the extent necessary to maintain our qualification as a REIT. As of December 31, 2017, we were in compliance with all of our financial covenants. Off-Balance Sheet Arrangements-We are not dependent on the use of any off-balance sheet financing arrangements for liquidity. Critical Accounting Estimates Basis of Presentation-For periods prior to April 14, 2017, the accompanying combined financial statements do not represent the financial position and results of operations of one legal entity, but rather a combination of entities under common control that have been ‘‘carved out’’ from iStar’s consolidated financial statements. For periods prior to April 14, 2017, these combined financial statements reflect the revenues and expenses of the Predecessor and include certain material assets and liabilities of iStar that are specifically identifiable and generated through, or associated with, an in-place lease, which have been reflected at iStar’s historical basis. For periods subsequent to April 14, 2017, the accompanying consolidated financial statements represent the consolidated financial statements of the Company. In addition, as a result of the Company’s acquisition of the Initial Portfolio from iStar, the consolidated financial statements subsequent to April 14, 2017 are presented on a new basis of accounting pursuant to Accounting Standards Codification (“ASC”) 805 (refer to Note 4). The preparation of these consolidated and combined financial statements in conformity with generally accepted accounting principles in the United States of America (‘‘GAAP’’) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. These combined financial statements for the periods prior to April 14, 2017 include an allocation of general and administrative expenses and interest expense to the Predecessor from iStar. General and administrative expenses include certain iStar corporate functions, including executive oversight, treasury, finance, human resources, tax compliance and planning, internal audit, financial reporting, information technology and investor relations. General and administrative expenses, including stock based compensation, represent a pro rata allocation of costs from iStar’s net lease and corporate business segments based on our average net assets as a percentage of iStar’s average net assets. Interest expense was allocated to the Predecessor by calculating its average net assets as a percentage of the average net assets in iStar’s net lease business segment and multiplying that percentage by the interest expense allocated to iStar’s net lease business segment (only for the number of days in the period in which the Predecessor did not have debt obligations outstanding-refer to Note 6). The Company believes the allocation methodology for the general and administrative expenses and interest expense is reasonable. Accordingly, the general and administrative expense allocation presented in our combined statements of operations for Predecessor periods does not necessarily reflect what our general and administrative expenses will be as a standalone public company for future reporting periods. For the periods prior to April 14, 2017, most of the entities included in the Predecessor financial statements did not have bank accounts for the periods presented, and most cash transactions for the Predecessor were transacted through bank accounts owned by iStar. For the periods prior to April 14, 2017, the combined statements of cash flows for the periods presented were prepared as if operating, investing and financing transactions for the Predecessor had been transacted through its own bank accounts. Certain prior period amounts have been reclassified in the Company’s consolidated financial statements and the related notes to conform to the current period presentation. Real estate-Real estate assets are recorded at cost less accumulated depreciation and amortization, as follows: Capitalization and depreciation-Certain improvements and replacements are capitalized when they extend the useful life of the asset. Repair and maintenance costs are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful life, which is generally 40 years for facilities, the shorter of the remaining lease term or expected life for tenant improvements and the remaining useful life of the facility for facility improvements. Purchase price allocation-Upon acquisition of real estate, we determine whether the transaction is a business combination, which is accounted for under the acquisition method, or an acquisition of assets. For both types of transactions, we recognize and measure identifiable assets acquired, liabilities assumed and any noncontrolling interest in the acquiree based on their relative fair values. For business combinations, we recognize and measure goodwill or gain from a bargain purchase, if applicable, and expense acquisition-related costs in the periods in which the costs are incurred. For acquisitions of assets, acquisition-related costs are capitalized and recorded in "Real estate, net" on our combined balance sheets. If we acquire real estate and simultaneously enter into a lease of the real estate, the acquisition will be accounted for as an asset acquisition. We account for our acquisition of properties by recording the purchase price of tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. The value of the tangible assets, consisting of land, buildings, building improvements and tenant improvements is determined as if these assets are vacant. Intangible assets may include the value of lease incentive assets, above-market leases, below-market Ground Lease assets and in-place leases, which are each recorded at their estimated fair values and included in "Deferred expenses and other assets, net" on our consolidated and combined balance sheets. Intangible liabilities may include the value of below-market leases, which are recorded at their estimated fair values and included in "Accounts payable, accrued expenses and other liabilities" on our combined balance sheets. In-place leases are amortized over the remaining non-cancelable term and the amortization expense is included in "Depreciation and amortization" in our combined statements of operations. Lease incentive assets and above-market (or below-market) lease value are amortized as a reduction of (or, increase to) ground and other lease income over the remaining non-cancelable term of each lease plus any renewal periods with fixed rental terms that are considered to be below-market. We may also engage in sale/leaseback transactions whereby we execute a net lease with the occupant simultaneously with the purchase of the asset. Impairments-We review real estate assets for impairment in value whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. The value of a long-lived asset held for use is impaired if management's estimate of the aggregate future cash flows (undiscounted and without interest charges) to be generated by the asset (taking into account the anticipated holding period of the asset) are less than its carrying value. Such estimate of cash flows considers factors such as expected future operating income trends, as well as the effects of demand, competition and other economic factors. To the extent impairment has occurred, the loss will be measured as the excess of the carrying amount of the asset over the estimated fair value of the asset and reflected as an adjustment to the basis of the asset. Impairments of real estate assets are recorded in "Impairment of assets" in our combined statements of operations. Cash and cash equivalents-Cash and cash equivalents include cash held in banks or, if applicable, invested in money market funds with original maturity terms of less than 90 days. Restricted Cash-Restricted cash includes $1.7 million required to be maintained under certain of our derivative transactions. Ground and other lease income-Ground and other lease income includes rent earned from leasing land and buildings owned by us to our tenants. Ground and other lease income is recognized on the straight-line method of accounting, generally from the later of the date the lessee takes possession of the space and it is ready for its intended use or the date of acquisition of the asset subject to existing leases. Accordingly, contractual lease payment increases are recognized evenly over the term of the lease. The periodic difference between ground and other lease income recognized under this method and contractual lease payment terms is recorded as deferred ground and other lease income receivable and is included in ‘‘Deferred ground and other lease income receivable, net’’ on our consolidated and combined balance sheets. We are also entitled to percentage rent pursuant to some of our leases and record percentage rent as ground and other lease income when earned. Ground and other lease income also includes the amortization of finite lived intangible assets and liabilities, which are amortized over the period during which the assets or liabilities are expected to contribute directly or indirectly to the future cash flows of the business acquired. We estimate losses within ground and other lease income receivable and deferred ground and other lease income receivable balances as of the balance sheet date and incorporate an asset-specific reserve based on management's evaluation of the credit risks associated with these receivables. As of December 31, 2017 and 2016, we did not have an allowance for doubtful accounts related to real estate tenant receivables or deferred ground and other lease income. Other income-Other income primarily includes interest income, non-recurring lease termination fees and other ancillary income. Interest income on other assets is recognized on an accrual basis using the effective interest method. We consider receivables to be non-performing and place receivables on non-accrual status at such time as: (1) the receivable becomes 90 days delinquent; (2) the receivable has a maturity default; or (3) management determines it is probable that we will be unable to collect all amounts due according to the contractual terms of the receivable. Earnings per share-We have one class of common stock. Earnings per share is calculated by dividing net income (loss) attributable to common stockholders by the weighted average number of common stock outstanding (refer to Note 9 for a summary of shares outstanding). Deferred expenses and other assets-Deferred expenses include deferred financing fees associated with our 2017 Revolver (refer to Note 6), derivative assets, purchase deposits, leasing costs such as brokerage, legal and other costs which are amortized over the life of the respective leases and presented as an operating activity in our consolidated and combined statements of cash flows. Amortization of leasing costs is included in "Depreciation and amortization" in our consolidated and combined statements of operations. As of December 31, 2016, other assets primarily includes a receivable related to the funding provided to a certain investment in a Ground Lease. This receivable is classified as held-for-investment and is reported at its outstanding unpaid principal balance and includes accrued and paid-in-kind interest. Deferred financing fees-Deferred financing fees associated with the 2017 Revolver (refer to Note 6) are recorded in ‘‘Deferred expenses and other assets, net’’ on our consolidated and combined balance sheets. Deferred financing fees associated with our other facilities are recorded in ‘‘Debt obligations, net’’ on our consolidated and combined balance sheets. The amortization of deferred financing fees is included in ‘‘Interest expense’’ our consolidated and combined statements of operations. Dispositions-Gains on the sale of real estate assets are recognized in "Income from sales of real estate" in accordance with Accounting Standards Codification 360-20, Real Estate Sales. Gains on sales of real estate are recognized for full profit recognition upon closing of the sale transactions, when the profit is determinable, the earnings process is virtually complete, the parties are bound by the terms of the contract, all consideration has been exchanged, any permanent financing for which the seller is responsible has been arranged and all conditions for closing have been performed. We primarily use specific identification and the relative sales value method to allocate costs. Stock-based compensation-We account for stock-based compensation awards using the fair value method, which requires an estimate of fair value of the award at the time of grant. On June 27, 2017, our directors who are not officers or employees of our Manager or iStar were granted 40,000 restricted shares in our common stock with an aggregate grant date fair value of $0.8 million. The shares granted to our board of directors vested immediately and we recognized $0.8 million in stock-based compensation which is classified within "General and administrative" in our consolidated statements of operations. Income taxes-We intend to elect and qualify to be taxed as a REIT under sections 856 through 859 of the Code beginning with our taxable year ending December 31, 2017. We will be subject to U.S. federal and state income taxation at corporate rates on our net taxable income; we, however, may claim a deduction for the amount of dividends paid to our stockholders. Amounts distributed as dividends by us will be subject to taxation at the stockholder level only. While we must distribute at least 90% of our REIT taxable income (excluding net capital gains) to qualify as a REIT, we intend to distribute substantially all of our net taxable income, if any, and eliminate U.S. federal and state taxes on undistributed net taxable income. Certain states may impose minimum franchise taxes. In addition, we are allowed certain other non-cash deductions or adjustments, such as depreciation expense attributable to certain of our assets (not including land), when computing our net taxable income and distribution requirement. These deductions permit us to reduce our dividend payout requirement under federal tax laws. We intend to operate in a manner consistent with our intention to qualify as a REIT. For the periods presented, we did not have any TRS that would be subject to taxation. Derivative instruments and hedging activity-Our use of derivative financial instruments is primarily limited to the utilization of interest rate swaps, interest rate caps or other instruments to manage interest rate risk exposure. We do not enter into derivatives for trading purposes. We recognize derivatives as either assets or liabilities on our consolidated and combined balance sheets at fair value. Derivative assets are recorded in "Deferred expenses and other assets, net" and derivative liabilities are recorded in "Accounts payable, accrued expenses and other liabilities" on our consolidated and combined balance sheets. If certain conditions are met, a derivative may be specifically designated as a hedge of the exposure to changes in the fair value of a recognized asset or liability, a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability. Fair Values-We are required to disclose fair value information with regard to our financial instruments, whether or not recognized in the consolidated and combined balance sheets, for which it is practical to estimate fair value. The Financial Accounting Standards Board guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. We determine the estimated fair values of financial assets and liabilities based on a hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of us and our own assumptions about market participant assumptions. We determined the carrying values of our financial instruments including cash and cash equivalents; restricted cash; ground and other lease income receivable; deferred ground and other lease income receivable, net; deferred expenses and other assets, net; and accounts payable, accrued expenses, and other liabilities approximated their the fair values of the instruments. For our debt obligations not traded in secondary markets, we determine fair value primarily by using market rates currently available for debt obligations with similar terms and remaining maturities. We determined that the significant inputs used to value our debt obligations, net fall within Level 3 of the fair value hierarchy. We determined the fair value of our debt obligations, net as of December 31, 2017 was approximately $308.7 million. New Accounting Pronouncements-For a discussion of the impact of new accounting pronouncements on our financial condition or results of operations, refer to Note 3 to the consolidated and combined financial statements.

<s>[INST] Introduction We believe that we are the first and only publiclytraded company focused primarily on ground leases. Ground leases generally represent the ownership of land underlying commercial real estate properties, which are leased on a long term basis (often 30 to 99 years) by the land owner (landlord) to a tenant that owns and operates the building on top of the land ("Ground Lease"). The property is generally leased on a triple net basis with the tenant responsible for taxes, maintenance and insurance as well as all operating costs and capital expenditures. Ground Leases typically provide that at the end of the lease term or upon tenant default, the land, building and all improvements revert back to the landlord. We seek to become the industry leader in Ground Leases by demonstrating their valueadded characteristics to real estate investors and expanding their use throughout major metropolitan areas. We have a diverse portfolio that is comprised of 15 properties located in major metropolitan areas, 12 of which were acquired or originated by iStar over the past 20 years. All of the properties in our portfolio are subject to longterm leases consisting of 10 Ground Leases and one master lease (covering five properties) that provide for periodic contractual rent escalations or percentage rent participations in gross revenues generated at the relevant properties. We have chosen to focus on Ground Leases in part because they offer a unique combination of safety, income growth and the potential for capital appreciation. We believe that Ground Leases offer the opportunity to realize superior riskadjusted total returns when compared to certain other alternative commercial real estate property investments. Safety: We believe that a Ground Lease represents a safe position in a property's capital structure. This safety is derived from the typical structure of a Ground Lease, which we believe creates a low likelihood of a tenant default and a low likelihood of a loss by the Ground Lease landlord in the event of a tenant default. A Ground Lease landlord typically has the right to regain possession of its land and take ownership of the buildings and improvements thereon upon a tenant default, which provides a strong incentive for a Ground Lease tenant to make the required Ground Lease rent payments. Additionally, the value of a property subject to a Ground Lease typically exceeds the amount of the Ground Lease landlord's investment at the time it was made; therefore, even if the Ground Lease landlord takes over the property following a tenant default or upon expiration of the Ground Lease, the landlord is reasonably likely to recover substantially all of its Ground Lease investment, and possibly amounts in excess of its investment, depending upon prevailing market conditions. Income Growth: Ground Leases typically provide growing income streams through contractual base rent escalators that may compound over the duration of the lease. These rent escalators may be based on fixed increases, a Consumer Price Index ("CPI") or a combination thereof, and may also include a participation in the gross revenues of the underlying property. We believe that this rental growth over time can mitigate the effects of inflation and compensate for anticipated increases in land values over time, as well as serving as a basis for growing our dividend. Opportunity for Capital Appreciation: The opportunity for capital appreciation with Ground Leases comes in two forms. First, as the ground rent grows over time, the value of the Ground Lease should grow under market conditions in which capitalization rates remain flat. Second, at the expiration or earlier termination of our Ground Leases, we typically have the right to regain possession of the land underlying the Ground Lease and take title to the buildings and other improvements thereon for no additional consideration. This reversion right creates additional potential value to our stockholders that may be realized by us at the end of the Ground Lease, either by entering into a new Ground Lease on the then current market terms, selling the land and improvements thereon or operating the property directly. We generally target Ground Lease investments in which the initial value of the Ground Lease represents 30% to 45% of the Combined Property Value. If the initial value of a Ground Lease is equal to 35% of the Combined Property Value, the balance of 65% of the Combined Property Value represents potential value accretion to us upon the reversion of the property, assuming no intervening [/INST] Positive. </s>

Safety, Income & Growth, Inc.

2019-02-14

2018-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This discussion summarizes the significant factors affecting our consolidated operating results, financial condition and liquidity during the two-year period ended December 31, 2018. This discussion should be read in conjunction with our consolidated financial statements and related notes for the two-year period ended December 31, 2018 included elsewhere in this Annual Report on Form 10-K. These historical financial statements may not be indicative of our future performance. Introduction We are a publicly-traded company that originates and acquires Ground Leases in order to generate attractive long-term risk-adjusted returns from our investments. We believe that our business has characteristics comparable to a high-grade fixed income investment business, but with certain unique advantages. Relative to alternative fixed income investments generally, our Ground Leases typically benefit from built-in growth derived from contractual rent increases, and the opportunity to realize value from future rights to acquire the buildings and other improvements on our land at no additional cost to us. We believe that these features offer us the opportunity to realize superior risk-adjusted total returns when compared to certain alternative highly-rated investments. We have a diverse portfolio of 28 properties located in major metropolitan areas. All of the properties in our portfolio are subject to long-term leases consisting of 23 Ground Leases and one master lease (covering five properties) that provide for periodic contractual rent escalations or percentage rent participations in gross revenues generated at the relevant properties. We have chosen to focus on Ground Leases because we believe they meet an important need in the commercial real estate capital markets and offer a unique combination of safety, income growth and the potential for capital appreciation (refer to Item 1. Business). We generally target Ground Lease investments in which the initial cost of the Ground Lease represents 30% to 45% of the Combined Property Value. If the initial cost of a Ground Lease is equal to 35% of the Combined Property Value, the remaining 65% of the Combined Property Value represents potential value accretion to us upon the reversion of the property, assuming no intervening change in the Combined Property Value. We refer to this potential value accretion as the "Value Bank," defined as the difference between the initial cost of the Ground Lease and the Combined Property Value. In our view, there is a strong correlation between inflation and commercial real estate values over time, which supports our belief that the value of our Value Bank should increase over time as inflation increases. Our ability to recognize value through reversion rights may be limited by the rights of our tenants under some of our Ground Leases, including tenant rights to purchase our land in certain circumstances and the right of one tenant to demolish improvements prior to the expiration of the lease. See "Risk Factors" for a discussion of these tenant rights. We believe that the reversion right is a unique feature distinguishing Ground Leases from other fixed income investments and property types; however, no amounts relating to Value Bank are recorded on our balance sheet or reflected in our earnings. Accordingly, we periodically estimate and report the value of our Value Bank based in part on valuations of the Combined Property Value under our Ground Leases. We retain an independent valuation firm to prepare: (a) initial reports of the Combined Property Value associated with each Ground Lease in our portfolio; and (b) periodic updates of such reports. As reported in our Current Report on Form 8-K filed on February 14, 2019, as of December 31, 2018, our estimated Value Bank is $1,809 million. Please review that 8-K for a discussion of the valuation methodology used and important limitations and qualifications of the calculation of Value Bank. See also "Risk Factors - There can be no assurance that we will realize any incremental value from the Value Bank or that the market price of our common stock will reflect any value attributable thereto." We believe that there is a significant market opportunity for a dedicated provider of Ground Lease capital like us. We believe that the market for existing Ground Leases is fragmented with ownership comprised primarily of high net worth individuals, pension funds, life insurance companies, estates and endowments. However, while we intend to pursue acquisitions of existing Ground Leases, our investment thesis is predicated, in part, on what we believe is an untapped market opportunity to expand the use of Ground Leases to a broader component of the approximately $7.0 trillion institutional commercial property market in the U.S. We intend to capture this market opportunity by utilizing multiple sourcing and origination channels, including manufacturing new Ground Leases with third-party owners and developers of commercial real estate and originating Ground Leases to provide capital for development and redevelopment. We further believe that Ground Leases generally represent an attractive source of capital for our tenants and may allow them to generate superior returns on their invested equity as compared to utilizing alternative sources of capital. We draw on the extensive investment origination and sourcing platform of iStar, the parent company of our Manager, to actively promote the benefits of the Ground Lease structure to prospective Ground Lease tenants. Our common stock is listed on the New York Stock Exchange under the symbol "SAFE." We were incorporated in Maryland on April 14, 2017. We elected to be taxed as a REIT for U.S. federal income tax purposes, commencing with the tax year ended December 31, 2017. We conduct all of our business and own all of our properties through our Operating Partnership. Executive Overview We acquire, manage and capitalize Ground Leases and report our business as a single reportable segment. We believe owning a portfolio of Ground Leases affords our investors the opportunity for safe, growing income. Safety is derived from a Ground Lease's super senior position in the commercial real estate capital structure. Growth is realized through long-term leases with contractual periodic increases in rent. Capital appreciation is realized though growth in the value of the land over time and when, at the end of the lease, the commercial real estate property reverts to us, as landlord, and we are able to realize the value of the leasehold, which may be substantial. Our leases share similarities with triple net leases because typically we are not responsible for any operating or capital expenses over the life of the lease, making the management of our portfolio relatively simple, with limited working capital needs. We have a diverse portfolio of 28 properties located in major metropolitan areas. All of the properties in our portfolio are subject to long-term leases consisting of 23 Ground Leases and one master lease (covering five properties) that provide for contractual periodic rental escalations or percentage rent participations in gross revenues generated at the relevant properties. Our Portfolio We have a portfolio of 28 properties that are diversified by property type and location. Our portfolio is comprised of 23 Ground Leases and a master lease (relating to five hotel assets that we refer to as our “Park Hotels Portfolio”) that has many of the characteristics of a Ground Lease, including length of lease term, percentage rent participations, triple net terms and strong Ground Rent Coverage. Below is an overview of our portfolio as of December 31, 2018: _______________________________________________________________________________ (1) Property is part of the Park Hotels Portfolio and is subject to a single master lease. (2) A majority of the land underlying this property is owned by a third party and is ground leased to us through 2044 subject to changes in the CPI; however, our tenant at the property pays this cost directly to the third party. Great Oaks Purchase Commitment In October 2017, we entered into a commitment to acquire land subject to a Ground Lease on which a 301-unit, luxury multi-family project known as “Great Oaks” is currently being constructed in San Jose, California. Pursuant to the purchase agreement, we will acquire the Ground Lease on November 1, 2020 from iStar for $34.0 million. iStar committed to provide a $80.5 million construction loan to the ground lessee. The Ground Lease has a term of 99 years. Washington, DC Multi-Family Purchase Commitment In August 2018, we entered into a commitment to acquire land and provide a Ground Lease for the Ground Lease tenant's construction of a 315-unit multi-family property in Washington, DC. The Ground Lease will have a term of 99 years. We have a call option to purchase the land at any time and expect to acquire the land in September 2019. We expect to fund the leasehold improvement allowance in early 2020. Tenant Concentration During the year ended December 31, 2018, the tenant under our Park Hotels Portfolio accounted for approximately $13.2 million, or 27%, of our total revenues, and the tenant who leases the land on which the One Ally Center in Detroit, Michigan is located accounted for approximately $5.3 million, or 11%, of our total revenues. In addition, some of our tenants operate offices and hotels at the leased properties. For the year ended December 31, 2018, 35% and 28% of our total revenues came from office and hotel properties, respectively. For additional information on tenant concentrations, see "Item 1A. Risk Factors-Risks Related to Our Portfolio and Our Business-Tenant concentration may expose us to financial credit risk and hotel industry concentration exposes us to the financial risks of a downturn in the hotel industry generally, and the hotel operations at our specific properties." Results of Operations for the Year Ended December 31, 2018 compared to the Year Ended December 31, 2017(1) _______________________________________________________________________________ (1) Operations prior to April 14, 2017 represent the activity of Safety, Income & Growth Inc. Predecessor. In addition, as a result of our acquisition of the Initial Portfolio (refer to Note 1) from iStar, the periods subsequent to April 14, 2017 are presented on a new basis of accounting pursuant to Accounting Standards Codification ("ASC") 805. Ground and other lease income increased to $47.4 million during the year ended December 31, 2018 from $22.9 million for the same period in 2017. The increase in 2018 was primarily due to $17.7 million of ground and other lease income earned on 13 Ground Leases originated or acquired in 2018, $4.4 million of additional ground and other lease income earned on 3 Ground Leases originated or acquired in 2017 and an increase of $2.8 million related to percentage rent recognized on our Park Hotels Portfolio. Other income for the year ended December 31, 2018 was $2.3 million and consists of $1.5 million received by us in connection with the termination of a contract for the purchase of the leased fee interest in a property due to the exercise by another entity of a pre-existing pre-emptive right to acquire such property and $0.8 million of interest income earned on our cash balances. Other income for the year ended December 31, 2017 was $0.4 million and consists primarily of interest income earned on our cash balances. During the year ended December 31, 2018, we incurred interest expense from our secured financings of $15.4 million compared to $7.8 million in 2017, and we incurred an allocation of interest expense from iStar of $2.1 million for the Predecessor period prior to the 2017 Secured Financing. The increase in 2018 was primarily the result of additional borrowings to fund our growing investment portfolio. Real estate expense was $1.6 million and $1.5 million during the years ended December 31, 2018 and 2017, respectively. During the year ended December 31, 2018, real estate expenses consisted primarily of $1.0 million related to the amortization of a below market lease asset at one of our hotel properties, property appraisal fees and insurance expense. During the year ended December 31, 2017, real estate expenses consisted primarily of the amortization of a below market lease asset at one of our hotel properties, recoverable property taxes at one of our properties and insurance, consulting and legal fees. Depreciation and amortization was $9.1 million and $7.3 million during the years ended December 31, 2018 and 2017, respectively, and primarily relates to our ownership of the Park Hotels Portfolio and our ownership of the Buckler multi-family property. Beginning on April 14, 2017 we accounted for the acquisition of the Initial Portfolio from iStar in accordance with ASC 805 and began recording depreciation based on the acquisition date fair values of the real estate and recognizing amortization expense resulting from in-place intangible lease assets. The amortization expense from in-place intangible lease assets during the years ended December 31, 2018 and 2017 was $3.1 million and $2.2 million, respectively. General and administrative expenses include management fees (which our Manager waived during the first year of the management agreement), stock-based compensation, costs of operating as a public company, research and developments costs targeted towards scaling our business and an allocation of expenses to us from our Manager and iStar (which our Manager waived during the first year of the management agreement). Although we paid no management fee or expense reimbursements to our Manager through June 30, 2018, GAAP required us to record expenses and a non-cash capital contribution from iStar despite iStar not receiving any compensation or reimbursement for its services. Prior to April 14, 2017, general and administrative expenses were allocated to us for certain iStar corporate functions, including executive oversight, treasury, finance, human resources, tax compliance and planning, internal audit, financial reporting, information technology and investor relations. General and administrative expenses, including stock based compensation, were allocated to us based on a pro rata allocation of costs from iStar’s net lease and corporate business segments based on our average net assets. The following table presents our general and administrative expenses for the years ended December 31, 2018 and 2017 ($ in thousands): ______________________________________________________ (1) For the period from January 1, 2017 to April 13, 2017, stock-based compensation represents an allocation from iStar. (2) Waived through June 30, 2018. (3) In July 2018, our board of directors engaged our current auditor to re-audit our financial statements included in the 2017 Annual Report that were audited by our predecessor auditor so that in connection with future securities offerings, we would not have to obtain consents and comfort letters from more than one accounting firm. During the year ended December 31, 2018, we incurred $0.3 million in connection with the re-audit. During the year ended December 31, 2018, other expense consists primarily of costs related to an unsuccessful acquisition (but for which we received a $1.5 million termination fee), investment pursuit costs and fees related to our derivative transactions. During the year ended December 31, 2017, other expense consists primarily of non-recurring acquisition costs, unsuccessful investment pursuit costs and costs associated with entering into hedges. During the year ended December 31, 2017, we recognized income from sales of real estate of $0.5 million resulting from the sale of a parking facility from our Park Hotels Portfolio. Non-GAAP Financial Measures In addition to net income (loss) prepared in conformity with GAAP, we have historically reported the supplemental non-GAAP performance measures funds from operations ("FFO") and adjusted funds from operations ("AFFO"), which are frequently used by securities analysts, investors and other interested parties in the evaluation of REITs. Such measures reflect adjustments to net income that we considered to be useful when evaluating our core business, which is generating increasing cash flows from long-term leases with minimal unreimbursed property-level expenses, and owning land which, as an asset class, has historically appreciated in value over time. For periods beginning January 1, 2019, we intend no longer to report AFFO and FFO. We expect that after the adoption of ASU 2016-02, "Leases" and ASU 2018-11, "Leases" (refer to Note 3), a significant majority of our newly originated Ground Leases will be classified as sales-type leases, and lease payments received by us will be recorded as interest income and amortization of the net investment in the lease. Furthermore, most of our new investments in land structured as Ground Leases will be classified as net investment in lease on our consolidated balance sheet. We believe that the GAAP treatment of these leases under the new accounting standards captures many of the fixed-income like aspects of our business such that AFFO and FFO will be of less utility as supplemental measures going forward. Under the new standards, the cash flows from our Ground Leases will be recognized as interest income on an effective interest method similar to other fixed income investments. We believe that after the adoption of these ASUs, GAAP net income will be more indicative of our operating performance as a high grade, fixed income investment business. The table below presents a reconciliation of our consolidated and combined net income (loss) allocable to Safety, Income & Growth Inc. common shareholders, the most directly comparable GAAP measure, to FFO and AFFO allocable to Safety, Income & Growth Inc. common shareholders, for the periods presented. We compute FFO in accordance with the National Association of Real Estate Investment Trusts ("NAREIT"), which defines FFO as net income (loss) (determined in accordance with GAAP), excluding gains or losses from sales of depreciable operating property, plus real estate-related depreciation and amortization. We compute AFFO by adding (or subtracting) to FFO the following items: straight-line rental income, the amortization of real estate-related intangibles, non-cash management fees and expense reimbursements, stock-based compensation, acquisition costs, the amortization of deferred financing costs and premiums/discounts related to debt obligations and the allocable share of noncontrolling interests' amortization of real estate-related intangibles and straight-line rental income. _______________________________________________________________________________ (1) Operations prior to April 14, 2017 represent the activity of Safety, Income & Growth Inc. Predecessor. Investors should view FFO and AFFO as supplemental to, and not replacements of, GAAP net income (loss). The utility of FFO and AFFO as measures of our performance is limited because, among other things, they exclude depreciation and amortization and do not capture changes in the value of our properties that result from use or market conditions, which could materially impact our results from operations. FFO and AFFO are not indicative of cash available to fund ongoing cash needs, including the ability to make cash distributions to our stockholders. Although FFO and AFFO are measures used for comparability in assessing the performance of REITs, the NAREIT White Paper only provides guidelines for computing FFO; therefore, the computation of FFO and AFFO may vary from one company to another. Liquidity and Capital Resources Liquidity is a measure of our ability to meet potential cash requirements, including to pay interest and repay borrowings, fund and maintain our assets and operations, complete acquisitions and originations of investments, make distributions to our stockholders and meet other general business needs. In order to qualify as a REIT, we are required under the Internal Revenue Code of 1986 to distribute to our stockholders, on an annual basis, at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gains. We expect to make quarterly cash distributions to our stockholders sufficient to meet REIT qualification requirements. As of December 31, 2018, we had $16.4 million of unrestricted cash and the ability to borrow an additional $2.9 million on our 2017 Revolver, subject to the conditions set forth in the applicable loan agreement (refer to Note 6 for more information on our 2017 Revolver), without pledging any additional assets to the facility. We refer to this $19.3 million of unrestricted cash and additional borrowing capacity as our "equity" liquidity which can be used for general corporate purposes or leveraged (a maximum of 2:1 in the case of our 2017 Revolver) to acquire new Ground Lease assets. Our primary sources of cash to date have been proceeds of $205.0 million from our initial public offering, proceeds of $45.0 million from our private placement to iStar, proceeds of $113.0 million from our initial capitalization by iStar and two institutional investors, borrowings from our debt facilities and, cash on January 2, 2019 of $250.0 million from iStar's purchase of Investor Units in our Operating Partnership (which was used to repay in full the $169.5 million outstanding on our 2017 Revolver). Our primary uses of cash to date have been the $113.0 million acquisition of the Initial Portfolio from iStar (which was subject to the 2017 Secured Financing, as defined below), the acquisition/origination of 16 Ground Leases for an aggregate purchase price of approximately $544 million, repayments on our debt facilities and distributions to our stockholders. Our primary sources of liquidity going forward will generally consist of cash on hand and cash generated from our operating activities, financings, and unused borrowing capacity under our 2017 Revolver (which we can leverage a maximum of 2:1). We expect our short-term liquidity requirements to include: •debt service and debt repayments; •distributions to our stockholders and noncontrolling interests; and •working capital. We expect to meet our short-term liquidity requirements through our cash on hand, our cash flows from operations and borrowing capacity under our 2017 Revolver. The availability of our 2017 Revolver is subject to the conditions set forth in the applicable loan agreement. We expect our long-term liquidity requirements to include: •acquisitions and originations of Ground Lease investments; and •debt maturities. We expect to meet our long-term liquidity requirements through our cash on hand, cash flows from operations, mortgage financings, debt issuances and common and/or preferred equity issuances. Contractual Obligations-The following table outlines the contractual obligations related to our long-term debt obligations and purchase commitments as of December 31, 2018 (refer to Note 6 and Note 7 to the consolidated and combined financial statements). _______________________________________________________________________________ (1) Assumes the extended maturity date for all debt obligations. (2) The 2017 Revolver was repaid in full on January 2, 2019 from the proceeds of the sale to iStar of Investor Units in our Operating Partnership (refer to Note 13). (3) Variable-rate debt assumes 1-month LIBOR of 2.50%. Interest payable does not include interest that may be payable under our derivatives. (4) Refer to Note 7 of the consolidated and combined financial statements. 2018 Portfolio Financing-In November 2018, we entered into a non-recourse portfolio financing (the "2018 Portfolio Financing") for seven Ground Leases originated in 2018 that were previously financed by the 2017 Revolver (see below). The 2018 Portfolio Financing is interest only, bears interest at an initial rate of 3.94%, increasing by 2.0% every 12 months (3.94% in Year 1, 4.02% in Year 2, 4.10% in Year 3, etc.) and matures in December 2028. 2017 Secured Financing-In March 2017, we entered into a $227.0 million non-recourse secured financing transaction (the "2017 Secured Financing") that bears interest at a fixed rate of 3.795% and matures in April 2027. The 2017 Secured Financing was collateralized by the Initial Portfolio including seven Ground Leases and one master lease (covering the accounts of five properties). In connection with and prior to the closing of the 2017 Secured Financing, we entered into a $200 million notional rate lock swap, reducing the effective rate of the 2017 Secured Financing from 3.795% to 3.773%. 2017 Revolver-In June 2017, we entered into a recourse senior secured revolving credit facility with a group of lenders in the maximum aggregate initial original principal amount of up to $300.0 million (the "2017 Revolver"). The 2017 Revolver provides an accordion feature to increase, subject to certain conditions, the maximum availability up to $500.0 million. In July 2018, we added an additional lender to the 2017 Revolver bringing total capacity for the 2017 Revolver to $350.0 million. The 2017 Revolver has an initial maturity of June 2020 with two 12-month extension options exercisable by us, subject to certain conditions, and bears interest at an annual rate of applicable LIBOR plus 1.35%. An undrawn credit facility commitment fee ranges from 0.15% to 0.25%, based on utilization each quarter. This fee was waived for the first six months after the closing date of June 27, 2017. The 2017 Revolver allows us to leverage Ground Leases up to a maximum 67%. The 2017 Revolver was repaid in full on January 2, 2019 from the proceeds of the sale to iStar of Investor Units in our Operating Partnership (refer to Note 13). 2017 Hollywood Mortgage-In December 2017, we entered into a $71.0 million mortgage on 6200 Hollywood Boulevard and 6201 Hollywood Boulevard (the "2017 Hollywood Mortgage"). The 2017 Hollywood Mortgage bears interest at a rate of one-month LIBOR plus 1.33%, matures in January 2023 and is callable without prepayment penalty beginning in January 2021. Debt Covenants-We are subject to financial covenants under the 2017 Revolver, including maintaining: a limitation on total consolidated leverage of not more than 70%, or 75% for no more than 180 days, of our total consolidated assets; a consolidated fixed charge coverage ratio of at least 1.45x; a consolidated tangible net worth of at least 75% of our tangible net worth at the date of the 2017 Revolver plus 75% of future issuances of net equity; a consolidated secured leverage ratio of not more than 70%, or 75% for no more than 180 days, of our total consolidated assets; and a secured recourse debt ratio of not more than 5.0% of our total consolidated assets. Additionally, the 2017 Revolver restricts our ability to pay distributions to our stockholders. In 2017, we were permitted to make distributions based on an annualized distribution rate of 3.0% of the initial public offering price per share of our common stock. In 2018, we were permitted to make distributions up to an amount equal to 110% of our adjusted funds from operations, as calculated in accordance with the 2017 Revolver. In addition, we may make distributions to the extent necessary to maintain our qualification as a REIT. The 2018 Portfolio Financing contains no significant maintenance or ongoing financial covenants. As of December 31, 2018, we were in compliance with all of our financial covenants. Off-Balance Sheet Arrangements-We are not dependent on the use of any off-balance sheet financing arrangements for liquidity. Critical Accounting Estimates Basis of Presentation-For periods prior to April 14, 2017, the accompanying combined financial statements do not represent the financial position and results of operations of one legal entity, but rather a combination of entities under common control that have been ‘‘carved out’’ from iStar’s consolidated financial statements. For periods prior to April 14, 2017, these combined financial statements reflect the revenues and expenses of the Predecessor and include certain material assets and liabilities of iStar that are specifically identifiable and generated through, or associated with, an in-place lease, which have been reflected at iStar’s historical basis. For periods subsequent to April 14, 2017, the accompanying consolidated financial statements represent the consolidated financial statements of the Company. In addition, as a result of the Company’s acquisition of the Initial Portfolio from iStar, the consolidated financial statements subsequent to April 14, 2017 are presented on a new basis of accounting pursuant to Accounting Standards Codification (“ASC”) 805 (refer to Note 4). The preparation of these consolidated and combined financial statements in conformity with generally accepted accounting principles in the United States of America (‘‘GAAP’’) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. These combined financial statements for the periods prior to April 14, 2017 include an allocation of general and administrative expenses and interest expense to the Predecessor from iStar. General and administrative expenses include certain iStar corporate functions, including executive oversight, treasury, finance, human resources, tax compliance and planning, internal audit, financial reporting, information technology and investor relations. General and administrative expenses, including stock based compensation, represent a pro rata allocation of costs from iStar’s net lease and corporate business segments based on our average net assets as a percentage of iStar’s average net assets. Interest expense was allocated to the Predecessor by calculating its average net assets as a percentage of the average net assets in iStar’s net lease business segment and multiplying that percentage by the interest expense allocated to iStar’s net lease business segment (only for the number of days in the period in which the Predecessor did not have debt obligations outstanding-refer to Note 6). The Company believes the allocation methodology for the general and administrative expenses and interest expense is reasonable. Accordingly, the general and administrative expense allocation presented in our combined statements of operations for Predecessor periods does not necessarily reflect what our general and administrative expenses will be as a standalone public company for future reporting periods. For the periods prior to April 14, 2017, most of the entities included in the Predecessor financial statements did not have bank accounts for the periods presented, and most cash transactions for the Predecessor were transacted through bank accounts owned by iStar. For the periods prior to April 14, 2017, the combined statements of cash flows for the periods presented were prepared as if operating, investing and financing transactions for the Predecessor had been transacted through its own bank accounts. Certain prior period amounts have been reclassified in the Company’s consolidated financial statements and the related notes to conform to the current period presentation. Real estate-Real estate assets are recorded at cost less accumulated depreciation and amortization, as follows: Capitalization and depreciation-Certain improvements and replacements are capitalized when they extend the useful life of the asset. Repair and maintenance costs are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful life, which is generally 40 years for facilities, the shorter of the remaining lease term or expected life for tenant improvements and the remaining useful life of the facility for facility improvements. Purchase price allocation-Upon acquisition of real estate, we determine whether the transaction is a business combination, which is accounted for under the acquisition method, or an acquisition of assets. For both types of transactions, we recognize and measure identifiable assets acquired, liabilities assumed and any noncontrolling interest in the acquiree based on their relative fair values. For business combinations, we recognize and measure goodwill or gain from a bargain purchase, if applicable, and expense acquisition-related costs in the periods in which the costs are incurred. For acquisitions of assets, acquisition-related costs are capitalized and recorded in "Real estate, net," "Real estate-related intangible assets, net" and "Real estate-related intangible liabilities, net" on our consolidated balance sheets. If we acquire real estate and simultaneously enter into a lease of the real estate, the acquisition will be accounted for as an asset acquisition. We account for our acquisition of properties by recording the purchase price of tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. The value of the tangible assets, consisting of land, buildings, building improvements and tenant improvements is determined as if these assets are vacant. Intangible assets may include the value of lease incentive assets, above-market leases, below-market Ground Lease assets and in-place leases, which are each recorded at their estimated fair values and included in "Real estate-related intangible assets, net" on our consolidated balance sheets. Intangible liabilities may include the value of below-market leases, which are recorded at their estimated fair values and included in "Real estate-related intangible liabilities, net" on our consolidated balance sheets. In-place leases are amortized over the remaining non-cancelable term of the lease and the amortization expense is included in "Depreciation and amortization" in our consolidated and combined statements of operations. Lease incentive assets and above-market (or below-market) lease value are amortized as a reduction of (or, increase to) ground and other lease income over the remaining non-cancelable term of each lease plus any renewal periods with fixed rental terms that are considered to be below-market. We may also engage in sale/leaseback transactions whereby we execute a net lease with the occupant simultaneously with the purchase of the asset. Impairments-We review real estate assets for impairment in value whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. The value of a long-lived asset held for use is impaired if management's estimate of the aggregate future cash flows (undiscounted and without interest charges) to be generated by the asset (taking into account the anticipated holding period of the asset) are less than its carrying value. Such estimate of cash flows considers factors such as expected future operating income trends, as well as the effects of demand, competition and other economic factors. To the extent impairment has occurred, the loss will be measured as the excess of the carrying amount of the asset over the estimated fair value of the asset and reflected as an adjustment to the basis of the asset. Impairments of real estate assets, if any, are recorded in "Impairment of assets" in our consolidated and combined statements of operations. Ground and other lease income-Ground and other lease income includes rent earned from leasing land and buildings owned by us to our tenants. Ground and other lease income is recognized on the straight-line method of accounting, generally from the later of the date the lessee takes possession of the space and it is ready for its intended use or the date of acquisition of the asset subject to existing leases. Accordingly, contractual lease payment increases are recognized evenly over the term of the lease. The periodic difference between ground and other lease income recognized under this method and contractual lease payment terms is recorded as deferred ground and other lease income receivable and is included in ‘‘Deferred ground and other lease income receivable, net’’ on our consolidated balance sheets. We are also entitled to percentage rent, representing a portion of our lessee's gross revenues from the properties, pursuant to some of our leases and record percentage rent as ground and other lease income when earned. Ground and other lease income also includes the amortization of finite lived intangible assets and liabilities, which are amortized over the period during which the assets or liabilities are expected to contribute directly or indirectly to the future cash flows of the business acquired. We estimate losses within ground and other lease income receivable and deferred ground and other lease income receivable balances as of the balance sheet date and incorporate an asset-specific reserve based on management's evaluation of the credit risks associated with these receivables. As of December 31, 2018 and 2017, we did not have an allowance for doubtful accounts related to real estate tenant receivables or deferred ground and other lease income. Fair Values-We are required to disclose fair value information with regard to our financial instruments, whether or not recognized in the consolidated balance sheets, for which it is practical to estimate fair value. The Financial Accounting Standards Board guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. We determine the estimated fair values of financial assets and liabilities based on a hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of us and our own assumptions about market participant assumptions. We determined the carrying values of our financial instruments including cash and cash equivalents; restricted cash; ground and other lease income receivable; deferred ground and other lease income receivable, net; deferred expenses and other assets, net; and accounts payable, accrued expenses, and other liabilities approximated their the fair values of the instruments. We determined the fair value of our debt obligations, net as of December 31, 2018 and 2017 was approximately $537.8 million and $308.7 million, respectively. New Accounting Pronouncements-For a discussion of the impact of new accounting pronouncements on our financial condition or results of operations, refer to Note 3 to the consolidated and combined financial statements.

<s>[INST] Introduction We are a publiclytraded company that originates and acquires Ground Leases in order to generate attractive longterm riskadjusted returns from our investments. We believe that our business has characteristics comparable to a highgrade fixed income investment business, but with certain unique advantages. Relative to alternative fixed income investments generally, our Ground Leases typically benefit from builtin growth derived from contractual rent increases, and the opportunity to realize value from future rights to acquire the buildings and other improvements on our land at no additional cost to us. We believe that these features offer us the opportunity to realize superior riskadjusted total returns when compared to certain alternative highlyrated investments. We have a diverse portfolio of 28 properties located in major metropolitan areas. All of the properties in our portfolio are subject to longterm leases consisting of 23 Ground Leases and one master lease (covering five properties) that provide for periodic contractual rent escalations or percentage rent participations in gross revenues generated at the relevant properties. We have chosen to focus on Ground Leases because we believe they meet an important need in the commercial real estate capital markets and offer a unique combination of safety, income growth and the potential for capital appreciation (refer to Item 1. Business). We generally target Ground Lease investments in which the initial cost of the Ground Lease represents 30% to 45% of the Combined Property Value. If the initial cost of a Ground Lease is equal to 35% of the Combined Property Value, the remaining 65% of the Combined Property Value represents potential value accretion to us upon the reversion of the property, assuming no intervening change in the Combined Property Value. We refer to this potential value accretion as the "Value Bank," defined as the difference between the initial cost of the Ground Lease and the Combined Property Value. In our view, there is a strong correlation between inflation and commercial real estate values over time, which supports our belief that the value of our Value Bank should increase over time as inflation increases. Our ability to recognize value through reversion rights may be limited by the rights of our tenants under some of our Ground Leases, including tenant rights to purchase our land in certain circumstances and the right of one tenant to demolish improvements prior to the expiration of the lease. See "Risk Factors" for a discussion of these tenant rights. We believe that the reversion right is a unique feature distinguishing Ground Leases from other fixed income investments and property types; however, no amounts relating to Value Bank are recorded on our balance sheet or reflected in our earnings. Accordingly, we periodically estimate and report the value of our Value Bank based in part on valuations of the Combined Property Value under our Ground Leases. We retain an independent valuation firm to prepare: (a) initial reports of the Combined Property Value associated with each Ground Lease in our portfolio; and (b) periodic updates of such reports. As reported in our Current Report on Form 8K filed on February 14, 2019, as of December 31, 2018, our estimated Value Bank is $1,809 million. Please review that 8K for a discussion of the valuation methodology used and important limitations and qualifications of the calculation of Value Bank. See also "Risk Factors There can be no assurance that we will realize any incremental value from the Value Bank or that the market price of our common stock will reflect any value attributable thereto." We believe that there is a significant market opportunity for a dedicated provider of Ground Lease capital like us. We believe that the market for existing Ground Leases is fragmented with ownership comprised primarily of high net worth individuals, pension funds, life insurance companies, estates and endowments. However, while we intend to pursue acquisitions of existing Ground Leases, our investment thesis is predicated, in part, on what we believe is an untapped market opportunity to expand the use of Ground Leases to a broader component of the approximately $7.0 trillion institutional commercial property market in the U.S. We intend to capture this market opportunity by utilizing multiple sourcing and origination channels, including manufacturing new Ground Leases with thirdparty owners and developers of commercial real estate and originating Ground Leases to provide capital for development and redevelopment. We further believe that Ground Leases generally represent an attractive source of capital for our tenants and may allow [/INST] Positive. </s>

Safehold Inc.

2020-02-13

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This discussion summarizes the significant factors affecting our consolidated operating results, financial condition and liquidity during the two-year period ended December 31, 2019. This discussion should be read in conjunction with our consolidated financial statements and related notes for the two-year period ended December 31, 2019 included elsewhere in this Annual Report on Form 10-K. These historical financial statements may not be indicative of our future performance. Executive Overview We acquire, manage and capitalize Ground Leases and report our business as a single reportable segment. We believe owning a portfolio of Ground Leases affords our investors the opportunity for safe, growing income. Safety is derived from a Ground Lease's senior position in the commercial real estate capital structure. Growth is realized through long-term leases with contractual periodic increases in rent. Capital appreciation is realized though appreciation in the value of the land over time and through our typical rights as landlord to acquire the commercial buildings on our land at the end of a Ground Lease, which may yield substantial value to us. The diversification by geographic location, property type and sponsor in our portfolio further reduces risk and enhances potential upside. Under our Ground Leases we are typically not responsible for any operating or capital expenses over the life of the lease, making the management of our portfolio relatively simple, with limited working capital needs. We believe institutional owners of commercial real estate increasingly understand that the structure of our SafeholdTM Ground Lease allows owners of high quality properties to generate higher returns with less risk. We experienced significant customer demand for our SafeholdTM Ground Leases during the year ended December 31, 2019, and we expect that increased customer experience and market recognition should generate greater demand for SafeholdTM Ground Leases from building owners and acquirers going forward. Our Portfolio Our portfolio of properties is diversified by property type and region. Our portfolio is comprised of Ground Leases and a master lease (relating to five hotel assets that we refer to as our “Park Hotels Portfolio”) that has many of the characteristics of a Ground Lease, including length of lease term, percentage rent participations, triple net terms and strong Ground Rent Coverage (which was 4.0x as of December 31, 2019 on a weighted average basis). Below is an overview of the top 10 assets in our portfolio as of December 31, 2019 (based on gross book value):(1) _______________________________________________________________________________ (1) Gross book value represents the historical purchase price plus accrued interest on sales-type leases. (2) Gross book value for this property represents our pro rata share of the gross book value of our unconsolidated venture (refer to Note 6). (3) The Park Hotels Portfolio consists of five properties and is subject to a single master lease. A majority of the land underlying one of these properties is owned by a third party and is ground leased to us through 2044 subject to changes in the CPI; however, our tenant at the property pays this cost directly to the third party. The following charts show certain statistics of our portfolio as of December 31, 2019, excluding unfunded commitments: Unfunded Commitments In October 2017, we entered into a commitment to acquire land subject to a Ground Lease on which a luxury multi-family project is currently being constructed in San Jose, California. Pursuant to the purchase agreement, we will acquire the Ground Lease on November 1, 2020 from iStar for $34.0 million. iStar committed to provide a $80.5 million construction loan to the ground lessee. In August 2018, we entered into an aggregate $30.0 million commitment to acquire land for $12.5 million and provide a $17.5 million leasehold improvement allowance for the Ground Lease tenant's construction of a multi-family property in Washington, DC. We acquired the land in June 2019 and will fund the leasehold improvement allowance upon the completion of certain conditions. In January 2019, we acquired land for $13.0 million and simultaneously structured and entered into a Ground Lease as part of the Ground Lease tenant's acquisition of an existing office building located in Washington, DC that is to be converted into a multi-family building. We committed to provide the Ground Lease tenant a $10.5 million leasehold improvement allowance that will be funded upon the completion of certain conditions. In June 2019, we acquired land for $8.1 million and simultaneously structured and entered into a Ground Lease as part of the Ground Lease tenant's development of a to-be-built multi-family community located outside of Orlando, FL. We committed to provide the Ground Lease tenant a $21.4 million leasehold improvement allowance that will be funded upon the completion of certain conditions. As of December 31, 2019, $2.1 million of the leasehold improvement allowance had been funded. Results of Operations for the Year Ended December 31, 2019 compared to the Year Ended December 31, 2018 Operating lease income increased to $72.1 million during the year ended December 31, 2019 from $47.4 million for the same period in 2018. The increase in 2019 was primarily due to the origination and acquisition of Ground Leases classified as operating leases. Interest income from sales-type leases (refer to Note 3) was $18.5 million for the year ended December 31, 2019. On January 1, 2019, we adopted new accounting standards (refer to Note 3) and, as a result, now classify certain of our Ground Leases as sales-type leases. Under sales-type leases, we accrue interest income under the effective interest method as opposed to recognition of operating lease income under the straight-line rent method for our Ground Leases that do not qualify as sales-type leases. We expect a majority of our newly originated Ground Leases will be classified as sales-type leases. Other income for the year ended December 31, 2019 was $2.8 million and consists primarily of $2.4 million of interest income earned on our cash balances and $0.4 million of other income relating to a Ground Lease in which we are the lessee but our tenant at the property pays this expense directly under the terms of a master lease (refer to Note 3). Other income for the year ended December 31, 2018 was $2.3 million and consists of $1.5 million received by us in connection with the termination of a contract for the purchase of the leased fee interest in a property due to the exercise by another entity of a pre-existing pre-emptive right to acquire such property and $0.8 million of interest income earned on our cash balances During the year ended December 31, 2019, we incurred interest expense from our secured financings of $29.9 million compared to $15.4 million in 2018. The increase in 2019 was primarily the result of additional borrowings to fund our growing investment portfolio. Real estate expense was $2.7 million and $1.6 million during the years ended December 31, 2019 and 2018, respectively. Real estate expenses consisted primarily of the amortization of an operating lease right-of-use asset in 2019 and a below market lease asset in 2018 at one of our hotel properties, property taxes, property appraisal fees and insurance expense in both periods. In addition, during the year ended December 31, 2019, we also recorded $0.4 million of real estate expense relating to a Ground Lease in which we are the lessee but our tenant at the property pays this expense directly under the terms of a master lease (refer to Note 3). Depreciation and amortization was $9.4 million and $9.1 million during the years ended December 31, 2019 and 2018, respectively, and primarily relates to our ownership of the Park Hotels Portfolio and our ownership of the Buckler multi-family property. General and administrative includes management fees (which our Manager waived through June 30, 2018), stock-based compensation, costs of operating as a public company and an allocation of expenses to us from our Manager (which our Manager waived through June 30, 2018). Although we paid no management fee or expense reimbursements to our Manager through June 30, 2018, we are required under GAAP to record such expenses as non-cash capital contributions from iStar. The following table presents our general and administrative expenses for the years ended December 31, 2019 and 2018 ($ in thousands): During the year ended December 31, 2019, other expense consists primarily of investment pursuit costs, fees related to our derivative transactions and state and local taxes. During the year ended December 31, 2018, other expense consists primarily of costs related to an unsuccessful acquisition (but for which we received a $1.5 million termination fee - see Other Income section above), investment pursuit costs and fees related to our derivative transactions. During the year ended December 31, 2019, loss on early extinguishment of debt resulted from the refinancing of two mortgages on existing Ground Leases. During the year ended December 31, 2019, losses from equity method investments resulted from our share of costs attributable to transaction structuring activities from a venture that we entered into with an existing shareholder that acquired the existing Ground Lease at 425 Park Avenue in New York City, partially offset by rental income from the venture upon its acquisition in November 2019 (refer to Note 6). Liquidity and Capital Resources Liquidity is a measure of our ability to meet potential cash requirements, including to pay interest and repay borrowings, fund and maintain our assets and operations, complete acquisitions and originations of investments, make distributions to our stockholders and meet other general business needs. In order to qualify as a REIT, we are required under the Internal Revenue Code of 1986 to distribute to our stockholders, on an annual basis, at least 90% of our REIT taxable income, determined without regard to the deduction for dividends paid and excluding net capital gains. We expect to make quarterly cash distributions to our stockholders sufficient to meet REIT qualification requirements. As of December 31, 2019, we had $22.7 million of unrestricted cash, $359.0 million of undrawn capacity and the ability to borrow an additional $118.2 million on our 2017 Revolver, subject to the conditions set forth in the applicable loan agreement (refer to Note 8 for more information on our 2017 Revolver), without pledging any additional assets to the facility. We refer to this $140.9 million of unrestricted cash and additional borrowing capacity as our "equity" liquidity which can be used for general corporate purposes or leveraged (a maximum of 2:1 in the case of our 2017 Revolver) to acquire new Ground Lease assets. Our primary sources of cash to date have been proceeds from equity offerings and private placements (refer to Note 11), proceeds from our initial capitalization by iStar and two institutional investors (refer to Note 11) and borrowings from our debt facilities. Our primary uses of cash to date have been the acquisition/origination of Ground Leases, repayments on our debt facilities and distributions to our shareholders. We expect our future liquidity requirements to include debt service, distributions to our shareholders, working capital, acquisitions and originations of Ground Lease investments, including in respect of the unfunded commitments described above, debt maturities and payments of fees under our management agreement to the extent we do not elect to pay the fees in common stock. Our primary sources of liquidity going forward will generally consist of cash on hand and cash flows from operations, new financings, unused borrowing capacity under our 2017 Revolver (subject to the conditions set forth in the applicable loan agreement) and common and/or preferred equity issuances. Contractual Obligations-The following table outlines the contractual obligations related to our long-term debt obligations and certain other commitments as of December 31, 2019 (refer to Note 8 and Note 9 to the consolidated financial statements). _______________________________________________________________________________ (1) Assumes the extended maturity date for all debt obligations. (2) Variable-rate debt assumes one-month LIBOR of 1.76%. Interest payable does not include interest that may be payable under our derivatives. (3) Refer to Note 9 of the consolidated financial statements. (4) We are also obligated to pay the third-party owner of a property that is ground leased to us $0.4 million, subject to adjustment for changes in the CPI, per year through 2044; however, our tenant pays this expense directly under the terms of a master lease through 2035. Mortgages-Mortgages consist of asset specific non-recourse borrowings that are secured by our Ground Leases. As of December 31, 2019, our mortgages are full term interest only, bear interest at a weighted average interest rate of 4.06% (our combined weighted average interest rate of our consolidated mortgage debt and the mortgage debt of our unconsolidated venture, applying our percentage interest in the venture, was 4.00%) and have maturities between April 2027 and November 2069. 2017 Revolver-In June 2017, we entered into a recourse senior secured revolving credit facility with an initial maximum aggregate principal amount of up to $300.0 million (the "2017 Revolver") that has since been increased to $525.0 million. The 2017 Revolver provides an accordion feature to increase, subject to certain conditions, the maximum availability up to $1.0 billion. The 2017 Revolver has an initial maturity of November 2022 with two 12-month extension options exercisable by us, subject to certain conditions, and bears interest at an annual rate of applicable LIBOR plus 1.30%. An undrawn credit facility commitment fee ranges from 0.15% to 0.25%, based on utilization each quarter. The 2017 Revolver allows us to leverage Ground Leases up to a maximum 67%. As of December 31, 2019, there was $359.0 million of undrawn capacity on the 2017 Revolver and we had the ability to draw an additional $118.2 million without pledging any additional assets to the facility. Debt Covenants-We are subject to financial covenants under the 2017 Revolver, including maintaining: (i) a limitation on total consolidated leverage of not more than 70%, or 75% for no more than 180 days, of our total consolidated assets; (ii) a consolidated fixed charge coverage ratio of at least 1.40x; (iii) a consolidated tangible net worth of at least $632.8 million plus 75% of future issuances of net equity after September 30, 2019; (iv) a consolidated secured leverage ratio of not more than 70%, or 75% for no more than 180 days, of our total consolidated assets; and (v) a secured recourse debt ratio of not more than 5.0% of our total consolidated assets. In addition, we may make distributions without restriction as to amount so long as after giving effect to the dividend we remain in compliance with the financial covenants and no event of default has occurred and is continuing. Our other debt obligations contain no significant maintenance or ongoing financial covenants. As of December 31, 2019, we were in compliance with all of our financial covenants. Off-Balance Sheet Arrangements-We are not dependent on the use of any off-balance sheet financing arrangements for liquidity. Critical Accounting Estimates Basis of Presentation-The preparation of these consolidated financial statements in conformity with generally accepted accounting principles in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Real estate-Real estate assets are recorded at cost less accumulated depreciation and amortization, as follows: Capitalization and depreciation-Certain improvements and replacements are capitalized when they extend the useful life of the asset. Repair and maintenance costs are expensed as incurred. Depreciation is computed using the straight-line method over the estimated useful life, which is generally 40 years for facilities, the shorter of the remaining lease term or expected life for tenant improvements and the remaining useful life of the facility for facility improvements. Purchase price allocation-Upon acquisition of real estate, we determine whether the transaction is a business combination, which is accounted for under the acquisition method, or an acquisition of assets. For both types of transactions, we recognize and measure identifiable assets acquired, liabilities assumed and any noncontrolling interest in the acquiree based on their relative fair values. For business combinations, we recognize and measure goodwill or gain from a bargain purchase, if applicable, and expense acquisition-related costs in the periods in which the costs are incurred. For acquisitions of assets, acquisition-related costs are capitalized and recorded in "Real estate, net," "Real estate-related intangible assets, net" and "Real estate-related intangible liabilities, net" on our consolidated balance sheets. If we acquire real estate and simultaneously enter into a lease of the real estate, the acquisition will be accounted for as an asset acquisition. We account for our acquisition of properties by recording the purchase price of tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. The value of the tangible assets, consisting of land, buildings, building improvements and tenant improvements is determined as if these assets are vacant. Intangible assets may include the value of lease incentive assets, above-market leases, below-market Ground Lease assets and in-place leases, which are each recorded at their estimated fair values and included in "Real estate-related intangible assets, net" on our consolidated balance sheets. Intangible liabilities may include the value of below-market leases, which are recorded at their estimated fair values and included in "Real estate-related intangible liabilities, net" on our consolidated balance sheets. In-place leases are amortized over the remaining non-cancelable term of the lease and the amortization expense is included in "Depreciation and amortization" in our consolidated statements of operations. Lease incentive assets and above-market (or below-market) lease value are amortized as a reduction of (or, increase to) operating lease income over the remaining non-cancelable term of each lease plus any renewal periods with fixed rental terms that are considered to be below-market. We may also engage in sale/leaseback transactions whereby we execute a net lease with the occupant simultaneously with the purchase of the asset. Impairments-We review real estate assets for impairment in value whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. The value of a long-lived asset held for use is impaired if management's estimate of the aggregate future cash flows (undiscounted and without interest charges) to be generated by the asset (taking into account the anticipated holding period of the asset) are less than its carrying value. Such estimate of cash flows considers factors such as expected future operating income trends, as well as the effects of demand, competition and other economic factors. To the extent impairment has occurred, the loss will be measured as the excess of the carrying amount of the asset over the estimated fair value of the asset and reflected as an adjustment to the basis of the asset. Impairments of real estate assets, if any, are recorded in "Impairment of assets" in our consolidated statements of operations. Net Investment in Sales-type Leases and Ground Lease Receivables-Net investment in sales-type leases and Ground Lease receivables are recognized when our Ground Leases qualify as sales-type leases. The net investment in sales-type leases is initially measured at the present value of the fixed and determinable lease payments, including any guaranteed or unguaranteed residual value of the asset at the end of the lease, discounted at the rate implicit in the lease. Acquisition-related costs are capitalized and recorded in "Net Investment in Sales-type Leases" and "Ground Lease Receivables" on our consolidated balance sheets. For newly originated or acquired Ground Leases, our estimate of residual value equals the fair value of the land at lease commencement. If a lease qualifies as a sales-type lease, it is further evaluated to determine whether the transaction is considered a sale leaseback transaction. When we acquire land and enter into a Ground Lease directly with the seller that qualifies as a sales-type lease, the lease does not qualify as a sale leaseback transaction and the lease is considered a financing receivable and is recognized in accordance with ASC 310 and included in "Ground Lease receivables" on our consolidated balance sheets. Reserve for losses in net investment in sales-type leases and Ground Lease receivables- We evaluate our net investment in sales-type leases and Ground Lease receivables for impairment under ASC 310. As part of our process for monitoring the credit quality of our net investment in sales-type leases and Ground Lease receivables, we perform a quarterly assessment for each of our net investment in sales-type leases and Ground Lease receivables. We generally target Ground Lease investments in which the initial cost of the Ground Lease represents 30% to 45% of the Combined Property Value. As such, we believe our Ground Lease investments represent a safe position in a property's capital structure. This safety is derived from the typical structure of a Ground Lease under which the landlord has a residual right to regain possession of its land and take ownership of the buildings and improvements thereon upon a tenant default. The landlord's residual right provides a strong incentive for a Ground Lease tenant or its leasehold lender to make the required Ground Lease rent payments and, as such, we believe there is a low likelihood of default on our net investment in sales-type leases and Ground Lease receivables. We consider a net investment in sales-type lease or Ground Lease receivable to be impaired when, based upon current information and events, we believe that it is probable that we will be unable to collect all amounts due under the contractual terms of the Ground Lease. As of December 31, 2019, all of our net investment in sales-type leases and Ground Lease receivables were performing in accordance with the terms of the respective leases. Any potential reserve for losses in net investment in sales-type leases and Ground Lease receivables will reflect management's estimate of losses inherent in the portfolio as of the balance sheet date. If we determine that the collateral fair value less costs to sell is less than the carrying value of a collateral-dependent receivable, we will record a reserve. The reserve, if applicable, will be increased (decreased) through "Reserve for losses on receivables" in our consolidated statements of operations and will be decreased by charge-offs. Our policy is to charge off a receivable when we determine, based on a variety of factors, that all commercially reasonable means of recovering the receivable balance have been exhausted. This may occur at different times, including when we receive cash or other assets in a pre-foreclosure sale or take control of the underlying collateral in full satisfaction of the receivable upon foreclosure or deed-in-lieu, or when we have otherwise ceased significant collection efforts. We consider circumstances such as the foregoing to be indicators that the final steps in the receivable collection process have occurred and that a receivable is uncollectible. At this point, a loss is confirmed and the receivable and related reserve will be charged off. We have one portfolio segment represented by acquiring, managing and capitalizing Ground Leases, whereby we utilize a uniform process for determining our reserve for losses on our net investment in sales-type leases and Ground Lease receivables. Interest Income from Sales-type Leases-Interest income from sales-type leases is recognized under the effective interest method. The effective interest method produces a constant yield on the net investment in the sales-type lease and Ground Lease receivable over the term of the lease. Rent payments that are not fixed and determinable at lease inception, such as percentage rent and CPI adjustments, are not included in the effective interest method calculation and are recognized in "Interest income from sales-type leases" in our consolidated statements of operations in the period earned. A Ground Lease receivable is placed on non-accrual status if and when it becomes 90-days past due or we consider the Ground Lease receivable impaired. Equity Investments in Ground Leases-Equity investments in Ground Leases are accounted for pursuant to the equity method of accounting if we can significantly influence the operating and financial policies of the investee. We have a 54.8% noncontrolling equity interest in a venture and have shared voting power with our partner. We determined the entity to be a voting interest entity and our equity interest is accounted for pursuant to the equity method of accounting. Our periodic share of earnings and losses in equity method investees are included in "Earnings (losses) from equity method investments" in our consolidated statements of operations. Equity investments are included in "Equity investments in Ground Leases" on our consolidated balance sheets. Operating lease income-Operating lease income includes rent earned from leasing land and buildings owned by us to our tenants. Operating lease income is recognized on the straight-line method of accounting, generally from the later of the date the lessee takes possession of the space and it is ready for its intended use or the date of acquisition of the asset subject to existing leases. Accordingly, increases in contractual lease payments are recognized evenly over the term of the lease. The periodic difference between operating lease income recognized under this method and contractual lease payment terms is recorded as deferred operating lease income receivable and is included in ‘‘Deferred operating lease income receivable’’ on our consolidated balance sheets. We are also entitled to percentage rent, representing a portion of our lessee's gross revenues from the properties, pursuant to some of our leases and record percentage rent as operating lease income when earned. Operating lease income also includes the amortization of finite lived intangible assets and liabilities, which are amortized over the period during which the assets or liabilities are expected to contribute directly or indirectly to the future cash flows of the business acquired. We estimate losses within operating lease income receivable and deferred operating lease income receivable balances as of the balance sheet date and incorporate a reserve based on management's evaluation of the credit risks associated with these receivables. As of December 31, 2019 and 2018, we did not have an allowance for doubtful accounts related to real estate tenant receivables or deferred operating lease income. Fair Values-We are required to disclose fair value information with regard to our financial instruments, whether or not recognized in the consolidated balance sheets, for which it is practical to estimate fair value. The Financial Accounting Standards Board guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. We determine the estimated fair values of financial assets and liabilities based on a hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of us and our own assumptions about market participant assumptions. We determined the carrying values of our financial instruments including cash and cash equivalents; net investment in sales-type leases; Ground Lease receivables; restricted cash; deferred operating lease income receivable, net; deferred expenses and other assets, net; and accounts payable, accrued expenses, and other liabilities approximated their the fair values of the instruments. We determined the fair value of our debt obligations, net as of December 31, 2019 and 2018 was approximately $1.4 billion and $537.8 million, respectively. New Accounting Pronouncements-For a discussion of the impact of new accounting pronouncements on our financial condition or results of operations, refer to Note 3 to the consolidated financial statements.

<s>[INST] Executive Overview We acquire, manage and capitalize Ground Leases and report our business as a single reportable segment. We believe owning a portfolio of Ground Leases affords our investors the opportunity for safe, growing income. Safety is derived from a Ground Lease's senior position in the commercial real estate capital structure. Growth is realized through longterm leases with contractual periodic increases in rent. Capital appreciation is realized though appreciation in the value of the land over time and through our typical rights as landlord to acquire the commercial buildings on our land at the end of a Ground Lease, which may yield substantial value to us. The diversification by geographic location, property type and sponsor in our portfolio further reduces risk and enhances potential upside. Under our Ground Leases we are typically not responsible for any operating or capital expenses over the life of the lease, making the management of our portfolio relatively simple, with limited working capital needs. We believe institutional owners of commercial real estate increasingly understand that the structure of our SafeholdTM Ground Lease allows owners of high quality properties to generate higher returns with less risk. We experienced significant customer demand for our SafeholdTM Ground Leases during the year ended December 31, 2019, and we expect that increased customer experience and market recognition should generate greater demand for SafeholdTM Ground Leases from building owners and acquirers going forward. Our Portfolio Our portfolio of properties is diversified by property type and region. Our portfolio is comprised of Ground Leases and a master lease (relating to five hotel assets that we refer to as our “Park Hotels Portfolio”) that has many of the characteristics of a Ground Lease, including length of lease term, percentage rent participations, triple net terms and strong Ground Rent Coverage (which was 4.0x as of December 31, 2019 on a weighted average basis). Below is an overview of the top 10 assets in our portfolio as of December 31, 2019 (based on gross book value):(1) _______________________________________________________________________________ (1) Gross book value represents the historical purchase price plus accrued interest on salestype leases. (2) Gross book value for this property represents our pro rata share of the gross book value of our unconsolidated venture (refer to Note 6). (3) The Park Hotels Portfolio consists of five properties and is subject to a single master lease. A majority of the land underlying one of these properties is owned by a third party and is ground leased to us through 2044 subject to changes in the CPI; however, our tenant at the property pays this cost directly to the third party. The following charts show certain statistics of our portfolio as of December 31, 2019, excluding unfunded commitments: Unfunded Commitments In October 2017, we entered into a commitment to acquire land subject to a Ground Lease on which a luxury multifamily project is currently being constructed in San Jose, California. Pursuant to the purchase agreement, we will acquire the Ground Lease on November 1, 2020 from iStar for $34.0 million. iStar committed to provide a $80.5 million construction loan to the ground lessee. In August 2018, we entered into an aggregate $30.0 million commitment to acquire land for $12.5 million and provide a $17.5 million leasehold improvement allowance for the Ground Lease tenant's construction of a multifamily property in Washington, DC. We acquired the land in June 2019 and will fund the leasehold improvement allowance upon the completion of certain conditions. In January 2019, we acquired land for $13.0 million and simultaneously structured and entered into a Ground Lease as part of the Ground Lease tenant's acquisition of an existing office building located in Washington, DC that is to be converted into a multifamily building. We committed to provide the Ground Lease tenant a $10.5 million leasehold improvement allowance that will be funded upon the completion of certain conditions. In June 2019, we acquired land for $8.1 million and simultaneously structured and entered into a Ground Le [/INST] Positive. </s>

ADOMANI, INC.

2018-03-12

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with our financial statements and related notes included in Part IV of this Annual Report. This discussion contains forward-looking statements that reflect our plans, estimates, beliefs and expectations that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors including, but not limited to, those discussed in Item 1 (Business) and Item 1A (Risk Factors) of Part I of this Annual Report. Overview We are a provider of advanced zero-emission electric and hybrid vehicles and replacement drivetrains that is focused on reducing the total cost of vehicle ownership. Our drivetrain systems are designed to help fleet operators unlock the benefits of green technology and address the challenges of traditional fuel price cost instability and local, state and federal environmental regulatory compliance. We design and cause to be designed advanced zero-emission electric and hybrid drivetrain systems for integration in new school buses and medium to heavy-duty commercial fleet vehicles. We also design and cause to be designed patented conversion kits to replace conventional drivetrain systems for combustion powered vehicles with zero-emission electric or hybrid drivetrain systems. The hybrid drivetrain systems are available in both an assistive hybrid format and a full-traction format for use in private and commercial fleet vehicles of all sizes. We seek to expand our product offerings to include the sale of zero-emission systems in vehicles manufactured by outside OEM partners, but to be marketed, sold, warrantied and serviced through our developing distribution and service network. Our drivetrain systems can be built with options for remote monitoring, electric power-export and various levels of grid-connectivity. Our zero-emission systems may also grow to include automated charging infrastructure and “intelligent” stationary energy storage that enables fast vehicle charging, emergency back-up facility power, and access to the developing, grid-connected opportunities for the aggregate power available from groups of large battery packs. We generated virtually no revenue from inception through December 31, 2016, and generated $425,000 in 2017. For the years ended December 31, 2017, 2016, and 2015, our net losses were $21.9 million, $10.7 million, and $6 million, respectively. Factors Affecting Our Performance We believe that the growth and future success of our business depend on various opportunities, challenges and other factors, including the following. New Customers. We are competing with other companies and technologies to help fleet managers and their districts/companies more efficiently and cost-effectively manage their fleet operations. Once these fleet managers have decided they want to buy from us, we still face challenges helping them obtain financing options to reduce the cost barriers to purchasing. We may also encounter customers with inadequate electrical services at their facilities that may delay their ability to purchase from us. Investment in Growth. We plan to continue to invest for long-term growth. We anticipate that our operating expenses will increase in the foreseeable future as we invest in research and development to enhance our zero-emission systems; design, develop and manufacture our drivetrains and their components; increase our sales and marketing to acquire new customers; and increase our general and administrative functions to support our growing operations. We believe that these investments will contribute to our long-term growth, although they will adversely affect our results of operations in the near term. In addition, the timing of these investments can result in fluctuations in our annual and quarterly operating results. Zero-emission electric and hybrid drivetrain experience. Our dealer and service network is not currently established, although we do have certain agreements in place. One issue they may have, and we may encounter, is finding appropriately trained technicians with zero-emission electric and hybrid drivetrain experience. Our performance will depend on having a robust dealer and service network, which will require appropriately trained technicians to be successful. Because vehicles that utilize our technology are based on a different technology platform than traditional internal combustion engines, individuals with sufficient training in zero-emission electric and hybrid vehicles may not be available to hire, and we may need to expend significant time and expense training the employees we do hire. If we are not able to attract, assimilate, train or retain additional highly qualified personnel in the future, or do so cost-effectively, our performance would be significantly and adversely affected. Market Growth. We believe the market for all-electric and hybrid solutions for alternative fuel technology, specifically all-electric and hybrid vehicles will continue to grow as more purchases of new zero-emission vehicles and as more conversions of existing fleet vehicles to zero-emission vehicles are made. However, unless the costs to produce such vehicles decrease dramatically, purchases of our products will continue to depend in large part on financing subsidies from government agencies. We cannot be assured of the continued availability or the amounts of such assistance to our customers. Revenue Growth from Additional Products. We seek to add to our product offerings additional zero-emission vehicles of all sizes manufactured by outside OEM partners, to be marketed, sold, warrantied and serviced through our developing distribution and service network, as well as add other ancillary products discussed elsewhere in this report. Revenue Growth from Additional Geographic Markets. We believe that growth opportunities for our products exist internationally in addition to domestically, and through our wholly-owned subsidiary ADOMANI China, we will be pursuing international growth as well. Our future performance will depend in part upon the growth of these additional markets. Accordingly, our business and operating results will be significantly affected by our ability to timely enter and effectively address these emerging markets and the speed with which and extent to which demand for our products in these markets grows. Components of Our Results of Operations Sales Sales are recognized from the sales of advanced zero-emission electric and hybrid drivetrain systems for fleet vehicles and from the sale of new, purpose-built zero-emission electric or hybrid vehicles. Sales are recognized when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred and title has passed, (iii) the price is fixed or determinable and (iv) collectability is reasonably assured. Cost of Sales Cost of sales includes those costs related to the development, manufacture, and distribution of our products. Specifically, we include in cost of sales each of the following: material costs (including commodity costs); freight costs; labor and other costs related to the development and manufacture of our products; and other associated costs. Selling, General and Administrative Expenses Selling, general and administrative expenses include all corporate and administrative functions that support our company. These expenses also include stock-based compensation expense; warranty expense, including product recall and customer satisfaction program costs; consulting costs; and other costs that cannot be included in cost of sales. Consulting and Research and Development Expenses These expenses are related to our consulting and research and development activity. Other Income/Expenses, Net Other income/expenses include non-operating income and expenses, including interest expense. Provision for Income Taxes We account for income taxes in accordance with FASB ASC 740 “Income Taxes,” which requires the recognition of deferred income tax assets and liabilities for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under FASB ASC 740, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the enactment occurs. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that we will not realize tax assets through future operations. Because we have incurred only losses to this point, no provision for income taxes has been made. Results of Operations Comparison of the Years Ended December 31, 2017 and 2016 ADOMANI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) [1] Includes compensation-based stock expense as follows: Sales Sales were $425,000 and $68,000 for the years ended December 31, 2017 and 2016, respectively. The increase in sales was due to the sale of a zero-emission electric Type C bus to Blue Bird Corporation in November 2017 for use at the NAPT Expo and other future demonstrations. Cost of Goods Sold Cost of goods sold was $478,772 and $50,000 for the years ended December 31, 2017 and 2016, respectively. Cost of goods sold for 2017 includes $390,000 relating to the $425,000 in revenues recorded, plus $88,772 recorded as a valuation allowance against existing inventory that is unrelated to the revenue. Research and Development Expenses Research and development expenses have historically comprised a significant portion of our operating expenses. Research and development expense was $586,899 and $37,273 for the years ended December 31, 2017 and 2016, respectively. The increase in 2017 is primarily due to $420,000 incurred in the second quarter of 2017 to build and install our drivetrain system on a chassis of a Type D school bus, on a promotional basis, for a potential customer. The project also enabled us to evaluate a third party firm that performed the work. The balance of the increase occurred because we were required to pay other research and development consultants under the terms of an employment agreement with our former Chief Technology Officer. That employment agreement was terminated in early March 2018. General and Administrative Expenses General and administrative expenses were $18.7 million and $9.4 million for the years ended December 31, 2017 and 2016, respectively. The increase is primarily due to an increase in stock-based compensation expense of $7.5 million due to the additional options granted in March 2017 (see “Options to Purchase Common Stock” below and Note 9 to the consolidated financial statements included in this Annual Report) and also to the remeasurement of non-employee stock options, as required by ASC 718 and ASC 505. We anticipate stock-based compensation expense to continue to increase as we expand our infrastructure in order to begin generating revenue. Payroll and payroll-related expenses increased by $1.2 million due to increased staff hired during 2017; investor relations expenses increased by $224,493, taxes and licenses increased by $104,315 primarily due to an accrual for the Delaware franchise tax; advertising and marketing expense increased by $93,955; travel-related expenses increased by $69,156; insurance expense increased by $62,782; rent expense increased by $56,457; and other general and administrative expenses increased by $230,213, offset by a decrease in legal and professional fees of $200,267 as compared to the prior-year period. These increases are primarily due to our need to expand our sales and marketing infrastructure, as well as the incurrence of certain costs associated with our status as a public company. Interest Expense Interest expense consists of the following: · accrued third party finance charge amortization; · accrued benefit conversion features applicable to debt instruments; and · accrued interest on existing debt. Interest expense was $501,857 and $1.1 million for the years ended December 31, 2017 and 2016 respectively. This decrease is due to the full amortization of the beneficial conversion features, finance charges, and warrants early in 2017, the repayment of a portion of the principal balance of outstanding 9% notes, as well as the debt converted to equity on January 30, 2017 (see Note 6 to the consolidated financial statements included in this Annual Report). Cash Flows Operating Activities Cash used in operating activities is primarily the result of our operating losses, reduced by the impact of the non-cash stock-based compensation and warrant amounts. These numbers are further impacted by adjustments for non-cash interest expense. Net cash used by operating activities during the year ended December 31, 2017 was $5.6 million, as a result of a net loss of $21.9 million, stock-based compensation of $15.0 million, other non-cash charges of $1.6 million, and changes in operating assets and liabilities that used $367,124 in cash. Other current assets increased by $672,150 due primarily to increases in other receivables of $276,314, and prepaid expenses of $395,836, primarily relating to deposits for inventory; accrued liabilities increased by $359,265 due primarily to the accrual of employee bonuses of $105,594, accrued franchise taxes of $99,400, a current liability established relating to the new lease accounting standard of $70,492, and other accrued expenses of $83,779; non-current liabilities increased by $289,012 due to the addition of a non-current liability established in conjunction with the new lease accounting standard; other non-current assets increased by $266,904 due primarily to the $359,504 addition of a right-of-use asset established in conjunction with the new lease accounting standard , offset by a decrease in deposits of $92,600 primarily due to reclassifying payments to a third party manufacturer from deposits to prepaid expenses; and accounts payable decreased by $76,345. Net cash used in operating activities during the year ended December 31, 2016 was $2.9 million, as a result of a net loss of $10.7 million, stock-based compensation of $7.6 million, other non-cash charges of $672,511, and changes in operating assets and liabilities that used $460,689 in cash. Inventory increased by $313,772; accrued expenses decreased by $238,580 due to the payment of accrued compensation of $344,914, net of an increase in accrued interest on debt of $32,695; and other accruals of $73,639; accounts payable increased by $199,441; other non-current assets increased by $100,043 due to payment of several deposits; deferred revenue decreased by $68,000; and other current assets decreased by $60,265. We expect cash used by operating activities to fluctuate significantly in future periods as a result of a number of factors, some of which are outside of our control, including, among others: the success we achieve in generating revenue; the success we have in helping our customers obtain financing to subsidize their purchases of our products; our ability to efficiently develop our dealer and service network; the costs of batteries and other materials utilized to make our products; the extent to which we need to invest additional funds in research and development; and the amount of expense we incur to satisfy future warranty claims. Investing Activities Net cash used by investing activities during the year ended December 31, 2017 was $612,856. This was due to issuing a $500,000 note to a third party, and $112,856 for the acquisition of property and equipment relating to the lease of our new office facility. See Notes 4, 5, and 12 to the consolidated financial statements contained in this Annual Report. Net cash used by investing activities during the year ended December 31, 2016 was $871,474. This was due to the acquisition of $411,474 of property and equipment; $450,000 net proceeds of a loan to a third party; and $10,000 invested in Silicon Turbine Solutions. Financing Activities Net cash provided by financing activities during the year ended December 31, 2017 was $7.7 million due to net proceeds of $12.6 million received from the closing of our initial public offering under Regulation A of the Securities Act and net notes payable proceeds of $500,000, reduced by $3.6 million repayment of notes payable principal, and related interest of $346,736. The net increase was further offset by payments for costs related to our offering under Regulation A of $1,668,339 and payments made for our follow-on offering of $75,500. See Notes 7 and 12 to the consolidated financial statements contained in this Annual Report. Net cash provided by financing activities during the year ended December 31, 2016 was $180,236 due to net proceeds of $1.0 million from the issuance of debt, net proceeds of $187,900 from the sale of stock, payment for stock rescission of $54,000, and to a $7,500 repayment of convertible debt principal. Other non-current assets increased $988,324 due to the capitalization of costs from our offering of common stock. Comparison of the Years Ended December 31, 2016 and 2015 ADOMANI, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) (1) Includes compensation-based stock expense as follows: Sales Sales were $68,000 and $0 for the years ended December 31, 2016 and 2015. Research and Development Expenses Research and development expenses have historically comprised a significant portion of our operating expenses. Research and development expense was $37,273 and $548,889 for the years ended December 31, 2016 and 2015, respectively. A substantial amount of research and development expenditures made during 2016 were capitalized related to building a specific demonstration vehicle, which was the reason for lower expense in 2016. General and Administrative Expenses General and administrative expenses were $9.4 million and $4.6 million for the years ended December 31, 2016 and 2015, respectively. This increase is primarily due to an increase in stock-based compensation charges of $4.5 million; legal, accounting and other professional fees of $556,205 and decreases in other accounts of $322,205 during the year ended December 31, 2016. We anticipate the stock-based compensation expenses may continue to increase as we expand our infrastructure in order to begin generating revenues and due to our new status as a public company. Interest Expense Interest expense was $1.1 million and $702,134 for the years ended December 31, 2016 and 2015, respectively. This increase is due to the recognition of a beneficial conversion expense related to existing debt instruments, the amortization of finance charges incurred on debt issued during 2015, and the amortization of the fair market value of a warrant issued during 2016 that related to 2015. Cash Flows Operating Activities Cash used in operating activities is primarily the result of our operating losses, reduced by the impact of the non-cash stock-based compensation amounts. These numbers were further impacted by adjustments for non-cash interest expense and, in 2015, an increase in accrued liabilities. The increase in accrued liabilities is largely due to payroll-related accruals that were paid in 2016. Net cash used in operating activities during the year ended December 31, 2016 was $2.9 million, as a result of a net loss of $10.7 million, stock-based compensation of $7.6 million, other non-cash charges of $672,511, and changes in operating assets and liabilities that used $460,689 in cash. Inventory increased by $313,772; accrued expenses decreased by $238,580 due to the payment of accrued compensation of $344,914, net of an increase in accrued interest on debt of $32,695; and other accruals of $73,639; accounts payable increased by $199,441; other non-current assets increased by $100,043 due to payment of several deposits; deferred revenue decreased by $68,000; and other current assets decreased by $60,265. Net cash used by operating activities during the year ended December 31, 2015 was $2.1 million, as a result of a net loss of $6.035 million, stock-based compensation of $3.0 million, other non-cash charges of $430,722, and changes in operating assets and liabilities that provided $466,808 in cash. We expect cash used by operating activities to fluctuate significantly in future periods as a result of a number of factors, some of which are outside of our control, including, among others: the success we achieve in generating revenue; the success we have in helping our customers obtain financing to subsidize their purchases of our products; our ability to efficiently develop our dealer and service network; the costs of batteries and other materials utilized to make our products; the extent to which we need to invest additional funds in research and development; and the amount of expense we incur to satisfy future warranty claims. Investing Activities Net cash used by investing activities during the year ended December 31, 2016 was $871,474. This was due to the acquisition of $411,474 of property and equipment; $450,000 net proceeds of a loan to a third party; and $10,000 invested in Silicon Turbine Solutions. Net cash used by investing activities during the year ended December 31, 2015 was $113,332. This was primarily due to a $110,000 investment in Silicon Turbine Solutions. Financing Activities Net cash provided by financing activities during the year ended December 31, 2016 was $180,236 due to net proceeds of $1.0 million from the issuance of debt, net proceeds of $187,900 from the sale of stock, payment for stock rescission of $54,000, and to a $7,500 repayment of convertible debt principal. Other non-current assets increased $988,324 due to the capitalization of costs from our offering of common stock. Net cash provided by financing activities during the year ended December 31, 2015 was $6.6 million, primarily due to net proceeds of $4.7 million from the issuance of convertible debt, net proceeds of $2.0 million in sales of stock, and to a $70,000 repayment of convertible debt principal. Quarterly Results of Operations The following table set forth selected, unaudited, quarterly consolidated statements of operations for each of the eight quarters beginning with the three months ended March 31, 2016. The information for each of these quarters has been prepared on the same basis as the audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K and, in the opinion of management, reflects normal recurring adjustments necessary for the fair treatment of our consolidated results of operations for these periods. This data should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report. These quarterly results are not necessarily indicative of our results of operations to be expected for any future period. Liquidity and Capital Resources From our incorporation in 2012 until the completion of our initial public offering of common stock under Regulation A of the Securities Act in June 2017, we financed our operations and capital expenditures through issuing equity capital, convertible notes and notes payable. A significant portion of this funding has been provided by affiliated stockholders, although significant equity capital was also raised in late 2015, and the majority of the convertible notes outstanding were issued in 2015 to non-affiliated third parties, as discussed below and in Note 6 to the consolidated financial statements contained elsewhere in this Annual Report. As of December 31, 2017, we had cash and cash equivalents of $2.4 million. On January 9, 2018, we completed a public offering of 3,666,667 units for gross proceeds of $11.0 million. Net proceeds received, after deducting commissions, expenses and fees of approximately $1.2 million, were approximately $9.8 million. We believe that our existing cash and cash equivalents will be sufficient to fund our operations at least through the end of April 2019. However, we may not successfully execute our business plan, and if we do not, we may need additional capital to continue our operations. While we have not generated any material revenues to date and do not expect to be able to satisfy our cash requirements solely through product sales in the near future, we received several purchase orders for zero-emission electric school buses in the second half of 2017 and we recorded revenue of $425,000 in the fourth quarter of 2017. The sale of additional equity securities in the future could result in additional dilution to our stockholders and those securities may have rights senior to those of our common stock. The incurrence of additional indebtedness in the future would result in increased debt service obligations and could result in operating and financial covenants that would restrict our operations. Such capital, if required, may not be available on terms that are favorable to us or at all. We are currently incurring operating deficits that are expected to continue for the foreseeable future, and as we begin to execute our marketing plan, we expect our operating deficit will continue to grow until we begin to generate a sufficient level of revenue from our sales and marketing efforts. Debt As of December 31, 2016, we had borrowed $645,000 from Acaccia Family Trust, formerly a related party, and other parties by issuing notes convertible into our common stock at prices ranging from $0.10 per share to $0.50 per share. On January 30, 2017, the notes plus accrued interest, a total of $725,584, converted into 6,868,578 shares of our common stock. As of December 31, 2016, we also had outstanding a total of $4,255,325 of secured promissory notes, net of $884,700 principal amount of these secured notes that were exchanged for 884,700 shares of common stock on September 1, 2016. In November 2016, we borrowed $500,000 from an unaffiliated stockholder for working capital needs and, in March 2017, borrowed an additional $500,000 from the same stockholder for additional working capital required due to delays in completing our offering under Regulation A. In December 2016, we borrowed $500,000 from a third party pursuant to a secured promissory note, and immediately made a $500,000 loan to another third party who operates in the zero-emissions drivetrain technology industry. All notes referenced in this paragraph were scheduled to mature in 2017. In connection with the initial closing of our offering under Regulation A, on May 12, 2017, we repaid the $1,500,000 outstanding under the three unsecured notes that we issued in November 2016, December 2016 and March 2017, respectively. See Note 6 to the consolidated financial statements contained elsewhere in this report. Regulation A Offering On June 9, 2017, we completed a public offering of our common stock under Regulation A of the Securities Act. We sold 2,852,275 shares of our common stock for gross proceeds of approximately $14.6 million, of which approximately $1.7 million was paid to the selling stockholders for 342,273 shares of common stock they sold in the offering. Net proceeds, after deducting commissions, expenses, and fees of approximately $2.5 million, amounted to approximately $10.0 million. Follow-On Public Offering On January 9, 2018, we completed a public offering of 3,666,667 units for gross proceeds of $11.0 million. For each unit sold in the offering, we issued one share of our common stock and a warrant to purchase 1.5 shares of our common stock at an exercise price of $4.50. Net proceeds, after deducting commissions, expenses, and fees of approximately $1.2 million, amounted to approximately $9.8 million. 2015 Note Financing and Warrants to Purchase Common Stock During 2015, we issued two-year secured promissory notes to third party lenders in an aggregate principal amount of $5,147,525 (Note Financing). As of December 31, 2017, we had repaid $2,106,325 of principal outstanding under such notes, and related cumulative interest of $986,007. The secured promissory notes were due initially on various dates between January 31 and November 30, 2017. Prior to the maturity dates of the notes, we exercised our option to extend the maturity dates six months pursuant to the provisions of such notes. The notes bear interest at an annual rate of 9%, payable monthly in arrears. The note obligations are secured by a lien on all of our assets. On September 1, 2016, holders of $884,700 of principal amount of the notes exchanged their notes for 884,700 shares of our common stock, thereby reducing the principal amount outstanding under the notes to $3,195,325. The remaining outstanding balance of $2,149,000 at December 31, 2017 was repaid in early January 2018 from the proceeds of the follow-on offering discussed above. In connection with the Note Financing, in 2015, we agreed to issue a warrant to a third party to purchase 1,250,000 shares of our common stock at $4.00 per share, exercisable through September 1, 2021. On September 1, 2016, we issued the warrant to such third party. Credit Facilities We do not have any credit facilities or other access to bank credit. If, however, we believe that making an acquisition is appropriate, or see that sales of product are more rapidly using working capital than anticipated, we may seek to obtain a credit facility to address these issues. Capital Expenditures We do not have any contractual obligations for ongoing capital expenditures at this time. We do, however, purchase equipment necessary to conduct our operations on an as needed basis. Going Concern As of December 31, 2017, we had working capital of $1.8 million and stockholders’ equity of approximately $2.3 million. During the year ended December 31, 2017, we incurred a net loss attributable to holders of our common stock of approximately $21.9 million. Of the $21.9 million loss incurred for the year ended December 31, 2017, approximately $15.0 million is attributable to non-cash stock-based compensation expense, and another $1.2 million is related to non-cash consulting expense discussed above. The foregoing non-cash expenses had no impact on our cash flows during the year ended December 31, 2017. Stock-based compensation expense represents the amortization of the fair market value of stock options granted over their respective vesting period. The fair market value for both items is determined using the Black-Scholes model. Because some of these stock options were granted to non-employees, Accounting Standards Codification (ASC) 505 also require that we remeasure the fair market value of each of these options for each interim vesting period based on the market value of our stock on the interim vesting date. Therefore, the expense associated with these options is sensitive to changes in our stock price. We have not generated any material revenues and have incurred net losses since inception. Our recurring operating losses and our need for additional sources of capital to fund our ongoing operations raise substantial doubt about our ability to continue as a going concern. As a result, our independent registered public accounting firm included an explanatory paragraph in its report on our audited consolidated financial statements as of December 31, 2016 and 2015 and for the years then ended with respect to this uncertainty. However, on June 9, 2017, we completed our offering under Regulation A. We sold 2,852,275 shares of our common stock for gross proceeds of $14,261,375, of which $1,711,365 was paid to the selling stockholders for 342,273 shares they sold in the offering. Furthermore, on January 9, 2018, we received approximately $9.8 million net proceeds from the follow-on offering discussed above. Based on the significant capital then raised and in the follow-on offering, that substantial doubt has been resolved. Contractual Obligations At December 31, 2017, our operating lease obligations and other contractual financial obligations that will affect our future liquidity were as follows: The contractual commitment amounts in the table above are associated with agreements that are enforceable and legally binding. Obligations under contracts that we can cancel without a significant penalty are not included in the table above. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Indemnification Agreements As we begin producing revenue, we will provide customers with indemnification of varying scope against claims of intellectual property infringement by third parties arising from the use of our products. We do not estimate the costs related to these indemnification provisions to be significant and are unable to determine the maximum potential impact of these indemnification provisions on our future results of operations. In addition, we have directors and officers liability coverage to further mitigate our indemnification exposure. No demands have been made upon us to provide indemnification and there are no claims that we are aware of that could have a material effect on our consolidated balance sheet, consolidated statement of operations, or consolidated cash flows. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. We believe that the assumptions and estimates associated with the preparation of the financial statement information presented in this report are not significant because we have not generated any appreciable revenue. Therefore, we have not had to make assumptions or estimates related to a reserve for bad debt expense. As to future warranty costs to be incurred, we recorded a warranty reserve against 2017 revenue and will continue to evaluate the provision for such expenses in the future. These two items will have significant potential impact on our consolidated financial statements in the future. We also have no significant current litigation on which we have to provide reserves or estimate accruals and our investment to date in property, plant and equipment has not been significant. We therefore have not had to rely on estimates related to impairment. We have not generated any taxable income to date, so have not had to make any decisions about future profitability that would impact recording income tax expense. Assuming we are able to generate future profits by executing our business plan, these areas, among others, will most likely be our critical accounting policies and estimates. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). This amendment supersedes Topic 605 by establishing core principles that an entity should follow when recognizing revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU No. 2015-14 amended the guidance to be effective for annual reporting periods after December 15, 2017, including interim periods within that reporting period. We will adopt ASU 2014-09 in the first quarter of 2018. Because we are currently a party to only one contract, and the contract provides for a single performance obligation, we anticipate no impact on our consolidated financial statements. We have early-adopted ASU No. 2016-02, Leases (Topic 842). The amendment requires companies to recognize leased assets and liabilities on the balance sheet and to disclose key information regarding leasing arrangements. This guidance is effective for annual periods, and interim periods within those annual periods, after December 15, 2018. Early application of this amendment is permitted for all entities. While we do not anticipate that, going forward, leases will be material to our balance sheet, we chose to early-adopt as of December 31, 2017 due to our entering into new leases during the year. These new leases are the only leases required to be included on our balance sheet under the new standard. Consequently, the adoption of the new lease standard did not have any impact to prior period information. Further, these leases are operating leases and, therefore, have no income statement impact resulting from the adoption of this standard. Contingencies Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to us, but which will only be resolved when one or more future events occur or fail to occur. Our management, in consultation with its legal counsel as appropriate, assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against us or unasserted claims that may result in such proceedings, we, in consultation with legal counsel, evaluates the perceived merits of any legal proceedings or unasserted claims, as well as the perceived merits of the amount of relief sought or expected to be sought therein. If the assessment of a contingency indicates it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in our financial statements. If the assessment indicates a potentially material loss contingency is not probable, but is reasonably possible, or is probable, but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss, if determinable and material, would be disclosed. Loss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Stock-Based Compensation We measure the cost of services received in exchange for an award of equity instruments based on the fair value of the award. For employees, the fair value of the award is measured on the grant date and for non-employees, the fair value of the award is generally re-measured on vesting dates and interim financial reporting dates until the service period is complete. The fair value amount is then recognized over the period during which services are required to be provided in exchange for the award, usually the vesting period. The fair value of our common stock was estimated by management based on observations of the cash sales prices of its common shares. Awards granted to directors are treated on the same basis as awards granted to employees. Fair Value Measurement The carrying values of our financial instruments, including cash, notes receivable and accounts payable approximate their fair value due to the short-term nature of these financial instruments. Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) No. 820, “Fair Value Measurement” defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. It also establishes a three-tier fair value hierarchy, which prioritizes 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. We do not have any assets or liabilities that are required to be measured and recorded at fair value on a recurring basis. Jumpstart Our Business Startups Act of 2012 (JOBS Act) We are an “emerging growth company,” as defined in the JOBS Act. The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for emerging growth companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards, and, therefore, will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. We have chosen to rely on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, as an emerging growth company we are not required to, among other things, (i) being permitted to provide only two years of audited financial statements, in addition to any required unaudited interim financial statements, with correspondingly reduced “Management’s Discussion and Analysis of Financial Condition and Results of Operations” disclosure, (ii) not being required to comply with the auditor attestation requirements in the assessment of our internal control over financial reporting, (iii) not being required to comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, (iv) reduced disclosure obligations regarding executive compensation or (v) exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We will retain our emerging growth company status until the first to occur of: (i) the end of the fiscal year in which the fifth anniversary of the completion of our initial public offering occurs, (ii) the end of the fiscal year in which our annual revenues exceed $1.07 billion, (iii) the date on which we issue more than $1 billion in non-convertible debt during any three-year period or (iv) the date on which we qualify as a “large accelerated filer.” Recent Accounting Pronouncements In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). This amendment supersedes Topic 605 by establishing core principles that an entity should follow when recognizing revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU No. 2015-14 amended the guidance to be effective for annual reporting periods after December 15, 2017, including interim periods within that reporting period. We will adopt ASU 2014-09 in the first quarter of 2018. Because we are currently a party to only one contract, and the contract provides for a single performance obligation, we anticipate no impact on our consolidated financial statements. In May 2017, the FASB issued ASU No. 201 7-09, Compensation-Stock Compensation (Topic 718): “Scope of Modification Accounting. “The amendments provide guidance on determining which changes to the terms and conditions of share-based payment awards require an entity to apply modification accounting under Topic 718. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2017. Early adoption is permitted, including any interim period, for reporting periods for which financial statements have not been issued. We have implemented all other new accounting pronouncements that are in effect and that may impact our financial statements and we do not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on our consolidated financial position or results of operations.

<s>[INST] Overview We are a provider of advanced zeroemission electric and hybrid vehicles and replacement drivetrains that is focused on reducing the total cost of vehicle ownership. Our drivetrain systems are designed to help fleet operators unlock the benefits of green technology and address the challenges of traditional fuel price cost instability and local, state and federal environmental regulatory compliance. We design and cause to be designed advanced zeroemission electric and hybrid drivetrain systems for integration in new school buses and medium to heavyduty commercial fleet vehicles. We also design and cause to be designed patented conversion kits to replace conventional drivetrain systems for combustion powered vehicles with zeroemission electric or hybrid drivetrain systems. The hybrid drivetrain systems are available in both an assistive hybrid format and a fulltraction format for use in private and commercial fleet vehicles of all sizes. We seek to expand our product offerings to include the sale of zeroemission systems in vehicles manufactured by outside OEM partners, but to be marketed, sold, warrantied and serviced through our developing distribution and service network. Our drivetrain systems can be built with options for remote monitoring, electric powerexport and various levels of gridconnectivity. Our zeroemission systems may also grow to include automated charging infrastructure and “intelligent” stationary energy storage that enables fast vehicle charging, emergency backup facility power, and access to the developing, gridconnected opportunities for the aggregate power available from groups of large battery packs. We generated virtually no revenue from inception through December 31, 2016, and generated $425,000 in 2017. For the years ended December 31, 2017, 2016, and 2015, our net losses were $21.9 million, $10.7 million, and $6 million, respectively. Factors Affecting Our Performance We believe that the growth and future success of our business depend on various opportunities, challenges and other factors, including the following. New Customers. We are competing with other companies and technologies to help fleet managers and their districts/companies more efficiently and costeffectively manage their fleet operations. Once these fleet managers have decided they want to buy from us, we still face challenges helping them obtain financing options to reduce the cost barriers to purchasing. We may also encounter customers with inadequate electrical services at their facilities that may delay their ability to purchase from us. Investment in Growth. We plan to continue to invest for longterm growth. We anticipate that our operating expenses will increase in the foreseeable future as we invest in research and development to enhance our zeroemission systems; design, develop and manufacture our drivetrains and their components; increase our sales and marketing to acquire new customers; and increase our general and administrative functions to support our growing operations. We believe that these investments will contribute to our longterm growth, although they will adversely affect our results of operations in the near term. In addition, the timing of these investments can result in fluctuations in our annual and quarterly operating results. Zeroemission electric and hybrid drivetrain experience. Our dealer and service network is not currently established, although we do have certain agreements in place. One issue they may have, and we may encounter, is finding appropriately trained technicians with zeroemission electric and hybrid drivetrain experience. Our performance will depend on having a robust dealer and service network, which will require appropriately trained technicians to be successful. Because vehicles that utilize our technology are based on a different technology platform than traditional internal combustion engines, individuals with sufficient training in zeroemission electric and hybrid vehicles may not be available to hire, and we may need to expend significant time and expense training the employees we do hire. If we are not able to attract, assimilate, train or retain additional highly qualified personnel in the future, or do so costeffectively, our performance would be significantly and adversely affected. Market Growth. We believe the market for allelectric and hybrid solutions for alternative fuel technology, specifically allelectric and hybrid vehicles will continue to grow as more purchases of new zeroemission vehicles and as more conversions of existing fleet vehicles to zeroemission vehicles are made. However, unless the costs to produce such vehicles decrease dramatically, purchases of our products will continue to depend in large part on financing subsidies from government agencies. We cannot be assured of the continued availability or the amounts of [/INST] Negative. </s>

ADOMANI, INC.

2019-02-19

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with our financial statements and related notes included in Part IV of this Annual Report. This discussion contains forward-looking statements that reflect our plans, estimates, beliefs and expectations that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors including, but not limited to, those discussed in Item 1 (Business) and Item 1A (Risk Factors) of Part I of this Annual Report. Overview We design and cause to be designed advanced zero-emission electric and hybrid drivetrain systems for integration in new school buses and medium to heavy-duty commercial fleet vehicles. We also design and cause to be designed re-power conversion kits to replace conventional drivetrain systems for combustion powered vehicles with zero-emission electric or hybrid drivetrain systems. We expect to expand our product offerings to include the sale of zero-emission systems in vehicles manufactured by outside, OEM partners located in China, Malaysia and the Philippines, that can be marketed, sold, warrantied and serviced through our developing distribution and service network. Our drivetrain systems can include options for telemetrics for remote monitoring, electric power-export and various levels of grid-connectivity. Our zero-emission systems may also grow to include automated charging infrastructure and “intelligent” stationary energy storage that enables fast vehicle charging, emergency back-up facility power, and access to the developing, grid-connected opportunities for the aggregate power available from groups of large battery packs. In addition to providing the zero-emission all-electric and hybrid drivetrain systems and re-power conversion kits mentioned above, we are also a provider of new zero-emission electric and hybrid vehicles focused on total cost of ownership. Our drivetrain systems and vehicles are designed to help fleet operators unlock the benefits of green technology and address the challenges of local, state and federal regulatory compliance and traditional-fuel price cost instability, in addition to the health benefits that are a benefit of this technology. We generated minimal revenue from inception through June 30, 2018. For the year ended December 31, 2018, we generated $5.0 million, most of which we generated in the second half of 2018. For the years ended December 31, 2018 and 2017, our net losses were $11.0 million and $21.9 million, respectively. Factors Affecting Our Performance We believe that the growth and future success of our business depend on various opportunities, challenges and other factors, including the following. New Customers. We are competing with other companies and technologies to help fleet managers and their districts/companies more efficiently and cost-effectively manage their fleet operations. Once these fleet managers have decided they want to buy from us, we still face challenges helping them obtain financing options to reduce the cost barriers to purchasing. We may also encounter customers with inadequate electrical services at their facilities that may delay their ability to purchase from us. Investment in Growth. We plan to continue to invest for long-term growth. We anticipate that our operating expenses will increase in the foreseeable future as we invest in research and development to enhance our zero-emission systems; design, develop and manufacture our drivetrain systems and their components; increase our sales and marketing to acquire new customers; and increase our general and administrative functions to support our growing operations. We believe that these investments will contribute to our long-term growth, although they will adversely affect our results of operations in the near term. In addition, the timing of these investments can result in fluctuations in our annual and quarterly operating results. Zero-emission electric and hybrid drivetrain system experience. Our dealer and service network is not currently established, although we do have certain agreements in place. One issue they may have, and we may encounter, is finding appropriately trained technicians with zero-emission electric and hybrid drivetrain systems experience. Our performance will depend on having a robust dealer and service network, which will require appropriately trained technicians to be successful. Because vehicles that utilize our technology are based on a different technology platform than traditional internal combustion engines, individuals with sufficient training in zero-emission electric and hybrid vehicles may not be available to hire, and we may need to expend significant time and expense training the employees we do hire. If we are not able to attract, assimilate, train or retain additional highly qualified personnel in the future, or do so cost-effectively, our performance would be significantly and adversely affected. Market Growth. We believe the market for all-electric and hybrid solutions for alternative fuel technology, specifically all-electric and hybrid vehicles will continue to grow as more purchases of new zero-emission vehicles and as more conversions of existing fleet vehicles to zero-emission vehicles are made. However, unless the costs to produce such vehicles decrease dramatically, purchases of our products will continue to depend in large part on financing subsidies from government agencies. We cannot be assured of the continued availability or the amounts of such assistance to our customers. Revenue Growth from Additional Products. We seek to add to our product offerings additional zero-emission vehicles of all sizes manufactured by outside OEM partners, to be marketed, sold, warrantied and serviced through our developing distribution and service network, as well as add other ancillary products discussed elsewhere in this report. Revenue Growth from Additional Geographic Markets. We believe that growth opportunities for our products exist internationally, as well. Our future performance will depend in part upon the growth of these additional markets. Accordingly, our business and operating results will be significantly affected by our ability to timely enter and effectively address these emerging markets and the speed with which and extent to which demand for our products in these markets grows. Components of Our Results of Operations Sales Sales are recognized from the sales of advanced zero-emission electric and hybrid drivetrain systems for fleet vehicles, from the sale of new, purpose-built zero-emission electric or hybrid vehicles, and from contracting to provide engineering services. Sales are recognized in accordance with Accounting Standards Codification (“ASC”) Topic 606, as discussed in Note 2 to our consolidated financial statements included in Part IV of this Annual Report. Cost of Sales Cost of sales includes those costs related to the development, manufacture, and distribution of our products. Specifically, we include in cost of sales each of the following: material costs (including commodity costs); freight costs; labor and other costs related to the development and manufacture of our products; and other associated costs. Cost of sales for long-term contracts are recognized proportionate to the prescribed gross profit of each contract. Cost of sales also includes costs related to the valuation of inventory due to impairment, obsolescence, or shrinkage. Selling, General and Administrative Expenses Selling, general and administrative expenses include all corporate and administrative functions that support our company, including personnel-related expense and stock-based compensation costs; costs related to investor relations activities; warranty costs, including product recall and customer satisfaction program costs; consulting costs; marketing-related expenses; and other expenses that cannot be included in cost of sales. Consulting and Research and Development Expenses These expenses are related to our consulting and research and development activity. Other Income/Expenses, Net Other income/expenses include non-operating income and expenses, including interest income and expense. Provision for Income Taxes We account for income taxes in accordance with Financial Accounting Standards Board (“FASB”) ASC 740 “Income Taxes,” which requires the recognition of deferred income tax assets and liabilities for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under FASB ASC 740, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period the enactment occurs. A valuation allowance is provided for certain deferred tax assets if it is more likely than not that we will not realize tax assets through future operations. Because we have incurred only losses to this point, no provision for income taxes has been made. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 Sales Sales were $5.0 million and $425,000 for the years ended December 31, 2018 and 2017, respectively. The increase in sales is primarily due to products and services sold to Blue Bird, and work performed under a DOE grant awarded to Blue Bird for which we were selected to provide products and services. Cost of Goods Sold Cost of goods sold was $4.9 million and $478,772 for the years ended December 31, 2018 and 2017, respectively. The increase is primarily due to costs related to products and services sold to Blue Bird, and work performed under the DOE grant discussed in “Sales” above, as well as a $15,000 write-down of inventory carrying cost recorded during the three months ended March 31, 2018. Operating Expenses 1 Includes stock-based compensation expense as follows: General and Administrative Expenses General and administrative expenses were $10.7 million and $18.7 million for the years ended December 31, 2018 and 2017, respectively. The decrease is primarily due to decreases of $8.6 million in non-cash stock-based compensation expense and in other general and administrative expenses, offset by increases of $351,266 in legal and professional fees, $130,000 in bad debt expense, and $119,670 in insurance expense. The decrease in stock-based compensation expense primarily relates to an expense reduction resulting from the forfeiture of options to purchase an aggregate of 3,450,000 shares of common stock previously issued to certain employees and directors in March 2017. Consulting Consulting expenses were $170,824 and $2.3 million for the years ended December 31, 2018 and 2017, respectively. The decrease is primarily due to the issuance of a warrant to purchase 350,000 shares of common stock, which was valued at $1.2 million, and the payment of $800,000, in each case pursuant to the terms of a settlement agreement we entered into during the six months ended June 30, 2017. Research and Development Expenses Research and development expenses were $686,367 and $586,899 for the years ended December 31, 2018 and 2017, respectively. The increase is primarily due to expanded product development in 2018. Interest Expense Interest expense consists of the following: • accrued third party finance charge amortization; • accrued benefit conversion features applicable to debt instruments; and • accrued interest on existing debt. Interest expense was $46,362 and $501,857 for the years ended December 31, 2018 and 2017, respectively. The decrease is primarily due to the repayment of the $2,149,000 of remaining principal and accrued and unpaid interest outstanding under our 9% secured notes, originally issued during 2015, upon receipt of the proceeds from our follow-on offering in January 2018 (see Note 6 to the consolidated financial statements included in this Annual Report). Cash Flows A summary of our operating, investing and financing activities is shown in the following table: Cash Used in Operating Activities Cash used in operating activities is primarily the result of our operating losses, reduced by the impact of the non-cash stock-based compensation and warrant amounts. These numbers are further impacted by adjustments for non-cash interest expense. Net cash used in operating activities during the year ended December 31, 2018 was $4.5 million, as a result of a net loss of $11.0 million, stock-based compensation expense of $6.4 million, other non-cash charges of $643,415, and changes in operating assets and liabilities that used $516,738 in cash. Accounts receivable increased by $996,622 due to 2018 sales activity and the timing of accounts receivable receipts. Other current assets increased by $496,118, primarily due to increases in deposits for inventory and prepaid insurance premiums. Inventory decreased by $210,000 due to the sale of a bus, previously held in inventory as of December 31, 2017, and sold during 2018. Other non-current assets increased by $70,977 due primarily to the amortization of the right-of-use asset established in conjunction with the new lease accounting standard. Accounts payable increased by $312,280, primarily due to 2018 sales activity and the timing of payment for product purchases. Accrued liabilities increased by $453,605, due primarily to production costs of $365,420 and increases in other ongoing accrual accounts. Other non-current liabilities decreased by $70,500 due to reclassification as current liabilities in conjunction with the new lease accounting standard. Net cash used in operating activities during the year ended December 31, 2017 was $5.6 million, as a result of a net loss of $21.9 million, stock-based compensation expense of $15.0 million, other non-cash charges of $1.6 million, and changes in operating assets and liabilities that used $367,124 in cash. Other current assets increased by $672,150 due primarily to increases in other receivables of $276,314 and prepaid expenses of $395,836, primarily relating to deposits for inventory. Accrued liabilities increased by $359,265 due primarily to the accrual of employee bonuses of $105,594, accrued franchise taxes of $99,400, a current liability established relating to the new lease accounting standard of $70,492, and other accrued expenses of $83,779. Non-current liabilities increased by $289,012 due to the addition of a non-current liability established in conjunction with the new lease accounting standard. Other non-current assets increased by $266,904 due primarily to the $359,504 addition of a right-of-use asset established in conjunction with the new lease accounting standard, offset by a decrease in deposits of $92,600. Additionally, accounts payable decreased by $76,345. We expect cash used in operating activities to fluctuate significantly in future periods as a result of a number of factors, some of which are outside of our control, including, among others: the success we achieve in generating revenue; the success we have in helping our customers obtain financing to subsidize their purchases of our products; our ability to efficiently develop our dealer and service network; the costs of batteries and other materials utilized to make our products; the extent to which we need to invest additional funds in research and development; and the amount of expense we incur to satisfy future warranty claims. Cash Used in Investing Activities Net cash used in investing activities during the year ended December 31, 2018 was $3.7 million, due to the purchase of liquid marketable securities in the amount of $3.9 million, the repayment of a $500,000 note receivable from a third party, the issuance of a $200,000 note receivable to another third party, and $79,739 for the acquisition of property and equipment. Net cash used in investing activities during the year ended December 31, 2017 was $612,856, due to the issuance of a $500,000 note to a third party, and $112,856 for the acquisition of property and equipment relating to the lease of our new office facility. Cash Provided by Financing Activities Net cash provided by financing activities during the year ended December 31, 2018 was $9.5 million, due to approximately $9.8 million in net proceeds from the closing of our follow-on offering on January 9, 2018, $1.7 million in net proceeds received under our line of credit with Morgan Stanley and $99,470 in proceeds received from the exercise of stock options, offset by the $2.1 million repayment of notes payable principal and related accrued and unpaid interest. Net cash provided by financing activities during the year ended December 31, 2017 was $7.7 million due to net proceeds of $12.6 million received from the closing of our initial public offering under Regulation A and net notes payable proceeds of $500,000, reduced by a $3.6 million repayment of notes payable principal, and related interest of $346,736. The net increase was further offset by payments for costs related to our offering under Regulation A of $1.7 million and payments made for our follow-on offering of $75,500. Liquidity and Capital Resources From our incorporation in 2012 until the completion of our offerings of common stock under Regulation A in June 2017 and units in January 2018, we financed our operations and capital expenditures through issuing equity capital, convertible notes and notes payable. Prior to 2015, a significant portion of this funding was provided by affiliated stockholders, as discussed below and in Note 6 to the consolidated financial statements contained elsewhere in this Annual Report, although we raised significant equity capital in late 2015, and also raised the majority of our previously outstanding notes in 2015 from non-affiliated third parties. As of December 31, 2018, we had cash and cash equivalents of $3.8 million, and short-term liquid marketable securities of $3.9 million. We believe that our existing cash and cash equivalents and short-term investments will be sufficient to fund our operations during the next eighteen months. However, we may not successfully execute our business plan, and if we do not, we may need additional capital to continue our operations and support the increased working capital requirements associated with the fulfillment of purchase orders. The sale of additional equity securities in the future could result in additional dilution to our stockholders and those securities may have rights senior to those of our common stock. The incurrence of additional indebtedness in the future would result in increased debt service obligations and could result in operating and financial covenants that would restrict our operations. Such capital, if required, may not be available on terms that are favorable to us or at all. We are currently incurring operating deficits that are expected to continue for the foreseeable future, and as we begin to execute our marketing plan, we expect our operating deficit will continue to grow until we begin to generate a sufficient level of sales revenue from our sales and marketing efforts. The sale of additional equity securities in the future could result in additional dilution to our stockholders and those securities may have rights senior to those of our common stock. The incurrence of additional indebtedness in the future would result in increased debt service obligations and could result in operating and financial covenants that would restrict our operations. Such capital, if required, may not be available on terms that are favorable to us or at all. We are currently incurring operating deficits that are expected to continue for the foreseeable future, and as we begin to execute our marketing plan, we expect our operating deficit will continue to grow until we begin to generate a sufficient level of sales revenue from our sales and marketing efforts. Debt As of December 31, 2016, we had borrowed $645,000 from Acaccia Family Trust, formerly a related party, and other parties by issuing notes convertible into our common stock at prices ranging from $0.10 per share to $0.50 per share. On January 30, 2017, the notes plus accrued interest, a total of $725,584, converted into 6,868,578 shares of our common stock. As of December 31, 2016, we also had outstanding a total of $4,255,325 of secured promissory notes, net of $884,700 principal amount of these secured notes that were exchanged for 884,700 shares of common stock on September 1, 2016. In November 2016, we borrowed $500,000 from an unaffiliated stockholder for working capital needs and, in March 2017, borrowed an additional $500,000 from the same stockholder for additional working capital required due to delays in completing our offering under Regulation A. In December 2016, we borrowed $500,000 from a third party pursuant to a secured promissory note, and immediately made a $500,000 loan to another third party who operates in the zero-emissions drivetrain system technology industry. All notes referenced in this paragraph were scheduled to mature in 2017. In connection with the initial closing of our offering under Regulation A, on May 12, 2017, we repaid the $1,500,000 outstanding under the three unsecured notes that we issued in November 2016, December 2016 and March 2017, respectively. Regulation A Offering On June 9, 2017, we completed an offering of common stock under Regulation A. We sold 2,852,275 shares of common stock for gross proceeds of approximately $14.6 million, of which approximately $1.7 million was paid to certain selling stockholders for 342,273 shares of common stock they sold in the offering. Net proceeds, after deducting commissions, expenses, and fees of approximately $2.5 million, were approximately $10.0 million. Follow-On Public Offering On January 9, 2018, we completed a public offering of 3,666,667 units for gross proceeds of $11.0 million. For each unit sold in the offering, we issued one share of our common stock and a warrant to purchase 1.5 shares of our common stock at an exercise price of $4.50. Net proceeds, after deducting commissions, expenses, and fees of approximately $1.2 million, were approximately $9.8 million. 2015 Note Financing and Warrants to Purchase Common Stock During 2015, we issued two-year secured promissory notes to third party lenders in an aggregate principal amount of $5,147,525 (the “Note Financing”). As of December 31, 2017, we had repaid $2,106,325 of principal outstanding under such notes, and related cumulative interest of $986,007. The secured promissory notes were due initially on various dates between January 31 and November 30, 2017. Prior to the maturity dates of the notes, we exercised our option to extend the maturity dates six months pursuant to the provisions of such notes. The notes bore interest at an annual rate of 9%, payable monthly in arrears. The note obligations were secured by a lien on all of our assets. On September 1, 2016, holders of $884,700 of principal amount of the notes exchanged their notes for 884,700 shares of our common stock, thereby reducing the principal amount outstanding under the notes to $3,195,325. The remaining outstanding balance of $2,149,000 at December 31, 2017 was repaid in early January 2018 from the proceeds of the follow-on offering discussed above. In connection with the Note Financing, in 2015, we agreed to issue a warrant to a third party to purchase 1,250,000 shares of our common stock at $4.00 per share, exercisable through September 1, 2021. On September 1, 2016, we issued the warrant to such third party. Credit Facilities Effective May 2, 2018, we secured a line of credit from Morgan Stanley Private Bank, National Association (“Morgan Stanley”). Borrowings under the line of credit bear interest at 30-day LIBOR plus 2.0%. There is no maturity date for the line, but Morgan Stanley may at any time, in its sole discretion and without cause, demand that we immediately repay any and all outstanding obligations under the line of credit in whole or in part. The line is secured by cash and cash equivalents maintained by us in our Morgan Stanley accounts, which was approximately $7.6 million at December 31, 2018, and borrowings under the line may not exceed 95% of our cash and cash equivalent balances, subject to a maximum of $7 million. Such borrowing threshold, however, is subject to change at Morgan Stanley’s discretion and depends upon the holdings in our accounts, the maturity dates of the securities in the accounts and the credit quality of the underlying insurers. As of December 31, 2018, the principal amount outstanding under this line of credit was $1.7 million, and the undrawn borrowing availability was $5.3 million. Capital Expenditures We do not have any contractual obligations for ongoing capital expenditures at this time. We do, however, purchase equipment necessary to conduct our operations on an as needed basis. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined in the rules and regulations of the SEC. Indemnification Agreements As we have generated sales, we have provided customers with indemnification of varying scope against claims of intellectual property infringement by third parties arising from the use of our products. We do not estimate the costs related to these indemnification provisions to be significant and are unable to determine the maximum potential impact of these indemnification provisions on our future results of operations. In addition, we have directors and officers liability coverage to further mitigate our indemnification exposure. No demands have been made upon us to provide indemnification and there are no claims that we are aware of that could have a material effect on our consolidated balance sheet, consolidated statement of operations, or consolidated cash flows. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. We evaluate our estimates and assumptions on an ongoing basis. Our estimates are based on historical experience and various other assumptions that we believe to be reasonable under the circumstances. Our actual results could differ from these estimates. We believe that the assumptions and estimates associated with the preparation of the financial statement information presented in this report are not significant because we have not generated any appreciable revenue. Therefore, we have not had to make assumptions or estimates related to a reserve for bad debt expense. As to future warranty costs to be incurred, we recorded a warranty reserve against 2018 revenue and will continue to evaluate the provision for such expenses in the future. These two items will have significant potential impact on our consolidated financial statements in the future. We also have no significant current litigation on which we have to provide reserves or estimate accruals and our investment to date in property, plant and equipment has not been significant. We therefore have not had to rely on estimates related to impairment. We have not generated any taxable income to date, so have not had to make any decisions about future profitability that would impact recording income tax expense. Assuming we are able to generate future profits by executing our business plan, these areas, among others, will most likely be our critical accounting policies and estimates. On January 1, 2018, we adopted ASC Topic 606 using the modified retrospective method applied to those contracts which were not completed as of January 1, 2018. Results for reporting periods beginning after January 1, 2018 are presented under ASC Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historic accounting under ASC Topic 605. The adoption of ASC Topic 606 did not result in a cumulative impact on us as of January 1, 2018 and the application of ASC Topic 606 had no impact on our statement of operations for the year ended December 31, 2018. We have early-adopted ASU No. 2016-02, Leases (Topic 842). The amendment requires companies to recognize leased assets and liabilities on the balance sheet and to disclose key information regarding leasing arrangements. This guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018. Early application of this amendment is permitted for all entities. While we do not anticipate that, going forward, leases will be material to our balance sheet, we chose to early-adopt as of December 31, 2017 due to our entering into new leases during the year. These new leases are the only leases required to be included on our balance sheet under the new standard. Consequently, the adoption of the new lease standard did not have any impact to prior period information. Further, these leases are operating leases and, therefore, have no income statement impact resulting from the adoption of this standard. Contingencies Certain conditions may exist as of the date the financial statements are issued, which may result in a loss to us, but which will only be resolved when one or more future events occur or fail to occur. Our management, in consultation with its legal counsel as appropriate, assesses such contingent liabilities, and such assessment inherently involves an exercise of judgment. In assessing loss contingencies related to legal proceedings that are pending against us or unasserted claims that may result in such proceedings, we, in consultation with legal counsel, evaluates the perceived merits of any legal proceedings or unasserted claims, as well as the perceived merits of the amount of relief sought or expected to be sought therein. If the assessment of a contingency indicates it is probable that a material loss has been incurred and the amount of the liability can be estimated, then the estimated liability would be accrued in our financial statements. If the assessment indicates a potentially material loss contingency is not probable, but is reasonably possible, or is probable, but cannot be estimated, then the nature of the contingent liability, together with an estimate of the range of possible loss, if determinable and material, would be disclosed. Loss contingencies considered remote are generally not disclosed unless they involve guarantees, in which case the guarantees would be disclosed. Stock-Based Compensation We measure the cost of services received in exchange for an award of equity instruments based on the fair value of the award. For employees, the fair value of the award is measured on the grant date and for non-employees, the fair value of the award is generally re-measured on vesting dates and interim financial reporting dates until the service period is complete. The fair value amount is then recognized over the period during which services are required to be provided in exchange for the award, usually the vesting period. The fair value of our common stock was estimated by management based on observations of the cash sales prices of its common shares. Awards granted to directors are treated on the same basis as awards granted to employees. Fair Value Measurement The carrying values of our financial instruments, including cash, notes receivable and accounts payable approximate their fair value due to the short-term nature of these financial instruments. FASB ASC No. 820, “Fair Value Measurement” defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. It also establishes a three-tier fair value hierarchy, which prioritizes 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. We do not have any assets or liabilities that are required to be measured and recorded at fair value on a recurring basis. Jumpstart Our Business Startups Act of 2012 (JOBS Act) We are an “emerging growth company,” as defined in the JOBS Act. The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for emerging growth companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards, and, therefore, will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. We have chosen to rely on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, as an emerging growth company we are not required to, among other things, (i) being permitted to provide only two years of audited financial statements, in addition to any required unaudited interim financial statements, with correspondingly reduced “Management’s Discussion and Analysis of Financial Condition and Results of Operations” disclosure, (ii) not being required to comply with the auditor attestation requirements in the assessment of our internal control over financial reporting, (iii) not being required to comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements, (iv) reduced disclosure obligations regarding executive compensation or (v) exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We will retain our emerging growth company status until the first to occur of: (i) the end of the fiscal year in which the fifth anniversary of the completion of our initial public offering occurs, (ii) the end of the fiscal year in which our annual revenues exceed $1.07 billion, (iii) the date on which we issue more than $1 billion in non-convertible debt during any three-year period or (iv) the date on which we qualify as a “large accelerated filer.” Recent Accounting Pronouncements In June 2018, the FASB issued Accounting Standards Update (“ASU”) No. 2018-07, Compensation-Stock Compensation (Topic 718): “Improvements to Nonemployee Share-Based Payment Accounting.” The amendment simplifies several aspects of the accounting for nonemployee share-based payment transactions resulting from expanding the scope of ASC Topic 718, Compensation-Stock Compensation to include share-based payment transactions for acquiring goods and services from nonemployees. The guidance is effective for annual periods, and interim periods within those annual periods, beginning after December 15, 2018. Early adoption is permitted, including any interim period, for reporting periods for which financial statements have not been issued, but no earlier than an entity’s adoption date of ASC Topic 606. The Company will implement this change beginning in 2019, however, the Company believes it will have minimal impact to its consolidated financial statements. In July 2017, the FASB issued Accounting Standards Update (“ASU”) No. 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): “(Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Companies and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception.” Part I of this amendment addresses complexities of accounting for certain financial instruments with down round features, and Part II addresses the difficulty of navigating Topic 480, Distinguishing Liabilities from Equity. For public entities, this guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted, including adoption in an interim period. The amendments in Part II require no transition guidance, as the amendments have no accounting effect. The Company has chosen to early-adopt this ASU, effective January 1, 2018, however, this amendment has no impact on our financial statements as of December 31, 2017. We have implemented all other new accounting pronouncements that are in effect and that may impact our financial statements and we do not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on our consolidated financial position or results of operations.

<s>[INST] The following discussion should be read in conjunction with our financial statements and related notes included in Part IV of this Annual Report. This discussion contains forwardlooking statements that reflect our plans, estimates, beliefs and expectations that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forwardlooking statements as a result of various factors including, but not limited to, those discussed in Item 1 (Business) and Item 1A (Risk Factors) of Part I of this Annual Report. Overview We design and cause to be designed advanced zeroemission electric and hybrid drivetrain systems for integration in new school buses and medium to heavyduty commercial fleet vehicles. We also design and cause to be designed repower conversion kits to replace conventional drivetrain systems for combustion powered vehicles with zeroemission electric or hybrid drivetrain systems. We expect to expand our product offerings to include the sale of zeroemission systems in vehicles manufactured by outside, OEM partners located in China, Malaysia and the Philippines, that can be marketed, sold, warrantied and serviced through our developing distribution and service network. Our drivetrain systems can include options for telemetrics for remote monitoring, electric powerexport and various levels of gridconnectivity. Our zeroemission systems may also grow to include automated charging infrastructure and “intelligent” stationary energy storage that enables fast vehicle charging, emergency backup facility power, and access to the developing, gridconnected opportunities for the aggregate power available from groups of large battery packs. In addition to providing the zeroemission allelectric and hybrid drivetrain systems and repower conversion kits mentioned above, we are also a provider of new zeroemission electric and hybrid vehicles focused on total cost of ownership. Our drivetrain systems and vehicles are designed to help fleet operators unlock the benefits of green technology and address the challenges of local, state and federal regulatory compliance and traditionalfuel price cost instability, in addition to the health benefits that are a benefit of this technology. We generated minimal revenue from inception through June 30, 2018. For the year ended December 31, 2018, we generated $5.0 million, most of which we generated in the second half of 2018. For the years ended December 31, 2018 and 2017, our net losses were $11.0 million and $21.9 million, respectively. Factors Affecting Our Performance We believe that the growth and future success of our business depend on various opportunities, challenges and other factors, including the following. New Customers. We are competing with other companies and technologies to help fleet managers and their districts/companies more efficiently and costeffectively manage their fleet operations. Once these fleet managers have decided they want to buy from us, we still face challenges helping them obtain financing options to reduce the cost barriers to purchasing. We may also encounter customers with inadequate electrical services at their facilities that may delay their ability to purchase from us. Investment in Growth. We plan to continue to invest for longterm growth. We anticipate that our operating expenses will increase in the foreseeable future as we invest in research and development to enhance our zeroemission systems; design, develop and manufacture our drivetrain systems and their components; increase our sales and marketing to acquire new customers; and increase our general and administrative functions to support our growing operations. We believe that these investments will contribute to our longterm growth, although they will adversely affect our results of operations in the near term. In addition, the timing of these investments can result in fluctuations in our annual and quarterly operating results. Zeroemission electric and hybrid drivetrain system experience. Our dealer and service network is not currently established, although we do have certain agreements in place. One issue they may have, and we may encounter, is finding appropriately trained technicians with zeroemission electric and hybrid drivetrain systems experience. Our performance will depend on having a robust dealer and service network, which will require appropriately trained technicians to be successful. Because vehicles that utilize our technology are based on a different technology platform than traditional internal combustion engines, individuals with sufficient training in zeroemission electric and hybrid vehicles may not be available to hire, and we may need to expend significant time and expense training the employees we do hire. If we are not able to attract, assimilate, train or retain [/INST] Positive. </s>

scPharmaceuticals Inc.

2018-03-21

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and the related notes appearing at the end of this Annual Report on Form 10-K. This discussion includes forward-looking statements that involve risks, uncertainties and assumptions such as our plans, objectives, expectations and intentions. You should read the “Forward-Looking Statements” and “Risk Factors” sections of this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. OVERVIEW We are a pharmaceutical company focused on developing and commercializing products that have the potential to transform the way therapy is delivered, advance patient care and reduce healthcare costs. Our proprietary platform is designed to enable the subcutaneous administration of therapies that have previously been limited to intravenous, or IV, delivery. By moving delivery away from the high-cost healthcare settings typically required for IV administration, we believe our technology reduces overall healthcare costs and advances the quality and convenience of care. Our lead product candidate, Furoscix, consists of our novel subcutaneous formulation of furosemide delivered via our sc2Wear Infusor and is under development for treatment of worsening, or decompensated, heart failure outside of the inpatient setting. We filed a new drug application, or NDA, for Furoscix, with the U.S. Food and Drug Administration, or FDA, in August 2017. The FDA notified us in October 2017 that it had accepted our NDA for review and assigned us a June 23, 2018 Prescription Drug User Fee Act, or PDUFA, date which is the goal date for the FDA to complete its review of our NDA. We believe Furoscix, if approved by the FDA, would allow heart failure patients to receive IV-strength diuresis with earlier discharge from, or potentially without admission to, the high-cost hospital setting. Since our inception in February 2013, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, planning for commercialization, and conducting discovery, research and development activities for our product candidates. We do not have any products approved for sale and have not generated any revenue from product sales. Prior to November 2017, we have funded our operations primarily with proceeds from the sale of preferred stock and borrowings under convertible notes and a term loan. As of December 31, 2017, we had received net cash proceeds of $56.7 million from sales of our preferred stock, net cash proceeds of $13.5 million from sales of convertible notes and net proceeds of $9.7 million from borrowings under our term loan. In November 2017, we closed our initial public offering with aggregate proceeds of $95.0 million, net of underwriters’ discounts and commissions, before deduction of offering expenses of approximately $2.3 million. For the years ended December 31, 2015, 2016 and 2017, our net loss was $10.5 million, $24.4 million and $23.8 million, respectively. We have not been profitable since inception, and as of December 31, 2017, our accumulated deficit was $67.0 million. We expect to continue to incur net losses for the foreseeable future as we develop the infrastructure to commercialize our products, if approved, in the United States, including building our sales and marketing organization, continue research and development efforts, scale-up manufacturing, and seek regulatory approval for new product candidates and product enhancements. We will need additional funding to pay expenses relating to our operating activities, including selling, general and administrative expenses and research and development expenses. Adequate funding may not be available to us on acceptable terms, or at all. Our failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations or financial condition. COMPONENTS OF OUR RESULTS OF OPERATIONS Research and Development Expenses Research and development, or R&D, expenses consist of the cost of engineering, clinical trials, regulatory and medical affairs and quality assurance associated with developing our proprietary technology and product candidates. R&D expenses consist primarily of: • employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense; • cost of outside consultants who assist with technology development, regulatory affairs, clinical trials and medical affairs, and quality assurance; • cost of clinical trial activities performed by third parties; and • cost of facilities and supplies used for internal research and development and clinical activities. We expense R&D costs as incurred. Given the emphasis to date on our lead product candidate Furoscix, our R&D expenses have not been allocated on a program-specific basis. In the future, we expect R&D expenses to increase in absolute dollars as we continue to develop new products and enhance existing products and technologies. We anticipate that our expenses will increase significantly as we: • continue to advance our pipeline programs beyond Furoscix; • continue our current research and development activity; • seek to identify additional research programs and additional product candidates; • initiate preclinical testing and clinical trials for any product candidates we identify and develop, maintain, expand and protect our intellectual property portfolio; and • hire additional research, clinical and scientific personnel. General and Administrative Expenses General and administrative, or G&A, expenses consist of employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense for personnel in executive, finance, commercial, human resources, facility operations and administrative functions. Other G&A expenses include pre-approval promotional activities, marketing, conferences and trade shows, professional services fees, including legal, audit and tax fees, insurance costs, general corporate expenses and allocated facilities-related expenses. If we receive FDA approval for Furoscix, we anticipate that our G&A expenses will increase as we continue to build our corporate and commercial infrastructure to support the development and commercial launch of Furoscix in the United States. Additionally, we anticipate increased expenses related to the audit, legal and compliance, regulatory, investor relations and tax-related services associated with maintaining compliance with the requirements of the Securities and Exchange Commission and the Nasdaq Stock Market, as well as healthcare laws and compliance requirements, director and officer insurance premiums and other costs associated with operating as a publicly-traded company. RESULTS OF OPERATIONS Comparison of Years Ended December 31, 2016 and 2017 The following table summarizes our results of operations for the years ended December 31, 2016 and 2017: Research and development expenses. R&D expenses increased $2.5 million to $14.3 million during the year ended December 31, 2017, compared to $11.9 million during the year ended December 31, 2016. This increase was primarily attributable to a $0.4 million increase related to contract services for device engineering, a $1.1 million increase in regulatory consulting costs, a $0.3 million increase in supplies, storage and packaging costs related to clinical trials and development and a $1.7 million increase in employee-related expenses associated with additional headcount during the year ended December 31, 2017. This increase was partially offset by a $1.0 million decrease in outsourced clinical and medical affairs activity. General and administrative expenses. G&A expenses increased $3.1 million to $9.1 million during the year ended December 31, 2017, compared to $6.1 million during the year ended December 31, 2016. This increase was primarily attributable to a $2.4 million increase in employee-related expenses associated with additional headcount and recruiting, a $0.7 million increase in consulting and professional services due to the expansion of our commercial organization, a $0.2 million increase in strategic and information technology consulting and $0.4 million related to costs incurred as a public company during the year ended December 31, 2017. This increase was partially offset by a $0.6 million decrease in market research and tradeshows. Other income. Other income increased $37,000 to $75,000 during the year ended December 31, 2017, compared to $38,000 during the year ended December 31, 2016. This increase was primarily attributable to foreign exchange gains due to increased activity denominated in foreign currency combined with foreign currency fluctuations. Interest income. Interest income increased $334,000 to $341,000 during the year ended December 31, 2017, compared to $7,000 during the year ended December 31, 2016. This increase was primarily attributable to higher cash balances during the year ended December 31, 2017 following our initial public offering in November 2017. Interest expense. Interest expense decreased $5.7 million from the year ended December 31, 2016 to $0.8 million during the year ended December 31, 2017. This decrease was primarily attributable to the conversion of convertible notes issued in January 2016 to Series A preferred stock in August 2016. We expect interest expense to continue to increase due to the $10.0 million loan entered into in May 2017 with Solar Capital Ltd. and Silicon Valley Bank. Comparison of the Years Ended December 31, 2015 and 2016 The following table summarizes our results of operations for the years ended December 31, 2015 and 2016: Research and development expenses. R&D expenses increased $3.6 million to $11.9 million during the year ended December 31, 2016, compared to $8.3 million during the year ended December 31, 2015. This increase was primarily attributable to a $2.8 million increase in device engineering costs related to the sc2Wear Infusor, an increase of $0.4 million in clinical trial supplies, an increase of $0.4 million in employee-related expenses associated with additional headcount, and an increase of $0.2 million in quality assurance consulting. These increases were offset by a decrease in pharmaceutical development costs of $0.2 million. General and administrative expenses. G&A expenses increased $3.5 million to $6.1 million during the year ended December 31, 2016, compared to $2.6 million during the year ended December 31, 2015. This increase was primarily attributable to a $1.8 million increase in employee-related expenses associated with additional headcount and recruiting, a $1.0 million increase in outsourced services to support the expansion of our commercial organization, a $0.1 million increase in tradeshows and symposiums and a $0.5 million increase in legal fees. Fair value adjustments to Series A purchase rights. Fair value adjustments to Series A purchase rights decreased $0.4 million to $0 during the year ended December 31, 2016, compared to $0.4 million during the year ended December 31, 2015. This decrease was due to the exercise of the Series A purchase rights in April 2015. Other (expense) income. Other income increased $106,000 to $38,000 during the year ended December 31, 2016, compared to an expense of $68,000 during the year ended December 31, 2015. This increase was primarily attributable to foreign exchange gains due to activity denominated in foreign currency combined with foreign currency fluctuations. Interest income. Interest income increased $7,000 to $7,000 during the year ended December 31, 2016, compared to $0 during the year ended December 31, 2015. This increase was primarily attributable to higher cash balances following our Series B preferred stock financing in December 2016. Interest expense. Interest expense increased $6.5 million to $6.5 million during the year ended December 31, 2016. The increase in interest expense was attributable to non-cash interest related to convertible notes issued and converted into shares of our Series A preferred stock in August 2016. LIQUIDITY AND CAPITAL RESOURCES Overview We have funded our operations from inception through December 31, 2017 primarily through the sale of shares of our common stock in our initial public offering and, prior to that, through the private placement of our preferred stock and the incurrence of debt. As of December 31, 2017, we had received net cash proceeds of $92.7 million from our initial public offering, $56.7 million from sales of our preferred stock, and $13.5 million in net proceeds from convertible notes payable. Additionally, in May 2017 we incurred $10.0 million of debt under a loan and security agreement with Solar Capital Ltd. and Silicon Valley Bank. As of December 31, 2017, we had cash and restricted cash of $118.5 million. Initial Public Offering On November 16, 2017, we completed an initial public offering ("IPO"), in which we issued and sold 6,400,000 shares of common stock at a public offering price of $14.00 per share, resulting in net proceeds to us of $81.0 million after deducting $6.3 million of underwriting discounts and commissions and offering costs of $2.3 million. On November 29, 2017, we completed the sale of an additional 894,968 shares of our common stock to the underwriters under the underwriters' option in the IPO to purchase additional shares of our common stock resulting in net proceeds to us of $11.7 million after deducting underwriting discounts and commissions of $0.9 million. The shares began trading on the Nasdaq Global Select Market on November 17, 2017. Upon the closing of the IPO, all of the outstanding shares of convertible preferred stock automatically converted into 10,126,771 shares of common stock at the applicable conversion ratio then in effect. We expect to incur substantial additional expenditures in the next twelve months to support our ongoing activities and the commercial launch of Furoscix, if approved, in the United States. We believe our existing unrestricted cash is sufficient to fund these operations through 2019. We expect our costs and expenses to increase in the future as we prepare for and, if approved, commence U.S. commercialization of Furoscix, including the development of a direct sales force, and as we continue to make substantial expenditures on research and development, including to increase our manufacturing capacity and for conducting clinical trials of our product candidates. Additionally, we will incur additional costs as a result of operating as a public company. Our future capital requirements will depend on many factors, including: • the potential FDA approval of Furoscix; • the costs and expenses of establishing our U.S. sales and marketing infrastructure; • the degree of success we experience in commercializing Furoscix, if approved; • the revenue generated by sales of Furoscix, if approved and other products that may be approved; • the pricing and reimbursement of Furoscix, if approved, and of other product candidates that may be approved; • the costs, timing and outcomes of clinical trials and regulatory reviews associated with our product candidates; • the costs and timing of developing variations of our sc2Wear Infusor and, if necessary, obtaining FDA approval of such variations; • the emergence of competing or complementary technological developments; • the extent to which Furoscix, if approved, is adopted by the healthcare community; • the number and types of future products we develop and commercialize; • the costs of preparing, filing and prosecuting patent applications and maintaining, enforcing and defending intellectual property-related claims; and • the extent and scope of our general and administrative expenses. Additional financing may not be available on a timely basis on terms acceptable to us, or at all. We may raise funds in equity, royalty-based or debt financings or enter into additional credit facilities in order to access funds for our capital needs. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. If we raise additional funds through royalty-based financing arrangements, we will likely agree to relinquish rights to potentially valuable future revenue streams and may agree to covenants that restrict our operations or strategic flexibility. Any debt financing obtained by us in the future would cause us to incur additional debt service expenses and could include restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and pursue business opportunities. If we are unable to obtain adequate financing or financing on terms satisfactory to us when we require it, we may terminate or delay the development of one or more of our products, delay clinical trials necessary to market our products, or delay establishment or expansion of sales and marketing capabilities or other activities necessary to commercialize our products. Loan and Security Agreement In May 2017, we entered into a $10.0 million loan and security agreement, or the 2017 Loan Agreement, with Solar Capital Ltd. and Silicon Valley Bank. The interest rate under the 2017 Loan Agreement is LIBOR plus 8.45%, and there is an interest-only period until November 30, 2018, followed by a 30-month principal and interest period. Pursuant to the 2017 Loan Agreement, we provided a first priority security interest in all existing and after-acquired assets, excluding intellectual property, owned by us. As of December 31, 2017, unpaid borrowings under the 2017 Loan Agreement totaled $10.0 million. For the year ended December 31, 2017, we recorded $146,000 related to the amortization of debt discount associated with the 2017 Loan Agreement. The 2017 Loan Agreement allows us to voluntarily prepay all (but not less than all) of the outstanding principal at any time. A prepayment premium of 3% or 1% through the one year anniversary and thereafter, respectively, would be assessed on the outstanding principal. A final payment fee of $250,000 is due upon the earlier to occur of the maturity date of the 2017 Loan Agreement, prepayment of such borrowings or the acceleration of payment due to an event of default. For the year ended December 31, 2017, we recorded $52,000 related to the amortization of the final payment fee associated with the 2017 Loan Agreement. In an event of default under the 2017 Loan Agreement, the interest rate will be increased by 5% and the balance under the loan may become immediately due and payable at the option of the lenders. We entered into an exit fee agreement in connection with the 2017 Loan Agreement which provides for a payment to the lenders upon the occurrence of an exit event, as defined in the agreement, including an initial public offering, equal to 4% of the loan commitment, or $400,000. We paid this fee in November 2017 concurrent with our initial public offering. The 2017 Loan Agreement includes restrictions on, among other things, our ability to incur additional indebtedness, change the name or location of our business, merge with or acquire other entities, pay dividends or make other distributions to holders of our capital stock, make certain investments, engage in transactions with affiliates, create liens, sell assets or pay subordinated debt. CASH FLOWS The following table summarizes our sources and uses of cash for each of the periods presented: Net Cash Used in Operating Activities During the year ended December 31, 2017, net cash used in operating activities was $22.7 million, consisting primarily of a net loss of $23.8 million. This was offset by non-cash charges of $1.1 million. The non-cash charges primarily consisted of depreciation, stock-based compensation expense and non-cash interest expense related to amortization of debt discount associated with the 2017 Loan Agreement. During the year ended December 31, 2016, net cash used in operating activities was $15.5 million, consisting primarily of a net loss of $24.4 million, offset by a decrease in net operating assets of $1.5 million and non-cash charges of $7.4 million. The decrease in net operating assets primarily consisted of increased accruals for pharmaceutical development and accounts payable for clinical trials, device engineering costs, the expansion of our commercial organization, and legal costs associated with our Series B preferred stock financing. The non-cash charges primarily consisted of depreciation, stock-based compensation expense and non-cash interest expense related to convertible notes payable. During the year ended December 31, 2015, net cash used in operating activities was $9.6 million, consisting primarily of a net loss of $10.5 million, offset by a decrease in net operating assets of $0.9 million. The decrease in net operating assets was primarily attributable to increased accruals for device engineering costs and employee-related costs. Net Cash Used in Investing Activities During the years ended December 31, 2015, 2016 and 2017, net cash used in investing activities consisted of purchases of property and equipment. Net Cash Provided by Financing Activities During the year ended December 31, 2017, net cash provided by financing activities was $102.1 million, consisting primarily of net proceeds of $92.7 million from our initial public offering, $9.3 million in borrowings under the 2017 Loan Agreement, and $0.1 million from stock option exercises. During the year ended December 31, 2016, net cash provided by financing activities was $53.2 million, consisting primarily of net proceeds of $40.6 million from the issuance of Series B convertible preferred stock and net proceeds of $12.5 million from convertible notes payable. During the year ended December 31, 2015, net cash provided by financing activities was $8.0 million, consisting of net proceeds of $8.0 million from the issuance of Series A convertible preferred stock. OFF-BALANCE SHEET ARRANGEMENTS We currently have no off-balance sheet arrangements. CONTRACTUAL OBLIGATIONS The following table summarizes our contractual obligations as of December 31, 2017 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods. (1) Consists of obligations under multi-year, non-cancelable building leases for our facilities in Burlington, Massachusetts and Lexington, Massachusetts. The leases expire on November 30, 2022 and December 31, 2022, respectively. We have drawn down an aggregate of $10.0 million from our 2017 Loan Agreement, as of December 31, 2017. Our contractual commitments under the 2017 Loan Agreement as of December 31, 2017 consist of an aggregate of $12.4 million in repayment obligations, inclusive of related interest amounts and the $250,000 final fee. See “-Loan and Security Agreement” for additional information regarding the 2017 Loan Agreement. We enter into contracts in the normal course of business with clinical trial sites and manufacturing organizations and with vendors for preclinical studies, research supplies and other services and products for operating purposes. These contracts generally provide for termination after a notice period, and, therefore, are cancelable contracts and not included in the table above. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions for the reported amounts of assets, liabilities, revenue, expenses and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions and any such differences may be material. While our significant accounting policies are more fully described in the notes to our financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following discussion addresses our most critical accounting policies, which are those that are most important to our financial condition and results of operations and require our most difficult, subjective and complex judgments. Stock-Based Compensation Expense We are required to determine the fair value of equity incentive awards and recognize compensation expense for all equity incentive awards, including employee stock options. We recognize this expense over the requisite service period. In addition, we recognize stock-based compensation expense in the statements of operations based on awards expected to vest and, therefore, the amount of expense has been reduced for estimated forfeitures. We use the ratable straight-line method for expense attribution. The valuation model we used for calculating the fair value of awards for stock-based compensation expense is the Black-Scholes option-pricing model, or the Black-Scholes model. The Black-Scholes model requires us to make assumptions and judgments about the variables used in the calculation, including: • Expected term. We do not believe we are able to rely on our historical exercise and post-vesting termination activity to provide accurate data for estimating the expected term for use in determining the fair value-based measurement of our options. Therefore, we have opted to use the “simplified method” for estimating the expected term of options, which is the average of the weighted-average vesting period and contractual term of the option. • Expected volatility. Due to the lack of a public market for the trading of our common stock prior to our IPO and a lack of company specific historical volatility, we have determined the share price volatility for options granted based on an analysis of the volatility of a peer group of publicly traded companies. In evaluating similarity, we consider factors such as stage of development, risk profile, enterprise value and position within the industry. • Risk-free interest rate. The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of the grant for zero-coupon U.S. Treasury notes with remaining terms similar to the expected term of the options. • Dividend rate. We assumed the expected dividend to be zero as we have never paid dividends and have no current plans to do so. • Expected forfeiture rate. We are required to estimate forfeitures at the time of grant, and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. • Service period. We amortize all stock-based compensation over the requisite service period of the awards, which is generally the same as the vesting period of the awards. We amortize the stock-based compensation cost on a straight-line basis over the expected service periods. • Fair value of common stock. Prior to the IPO, the estimated fair value of our common stock was determined by our board of directors as of the date of each option grant, with input from management, considering our most recently available third-party valuations of common stock and our board of directors’ assessment of additional objective and subjective factors that it believed were relevant and which may have changed from the date of the most recent valuation through the date of the grant. These third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. In addition to considering the results of these third-party valuations, our board of directors considered various objective and subjective factors to determine the fair value of our common stock as of each grant date, which may be a date later than the most recent third-party valuation date, including: o the prices at which we sold shares of preferred stock and the superior rights and preferences of the preferred stock relative to our common stock at the time of each grant; o the progress of our research and development programs, including the status of preclinical studies and planned clinical trials for our product candidates; o our stage of development and commercialization and our business strategy; o external market conditions affecting the pharmaceutical and biotechnology industries, and trends within the biotechnology industry; o our financial position, including cash on hand, and our historical and forecasted performance and operating results; o the lack of an active public market for our common stock and our preferred stock; o the likelihood of achieving a liquidity event, such as an initial public offering, or IPO, or a sale of our company in light of prevailing market conditions; and o the analysis of IPOs and the market performance of similar companies in the biopharmaceutical industry. Consequently, after the IPO, the fair value of the shares of common stock underlying the stock options is the closing price on the option grant date. Research and Development Expenses As part of the process of preparing our financial statements, we are required to estimate our accrued R&D expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed or when contractual milestones are met. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued R&D expenses include the costs incurred for services performed by our vendors in connection with R&D activities for which we have not yet been invoiced. We base our expenses related to R&D activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct R&D on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the R&D expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid accordingly. Advance payments for goods and services that will be used in future R&D activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there has been no material differences between our estimates of such expenses and the amounts actually incurred. JOBS ACT ACCOUNTING ELECTION In April 2012, the Jumpstart Our Business Startups Act of 2012, or JOBS Act, was enacted. Section 107 of the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies. This election is irrevocable. NEW ACCOUNTING PRONOUNCEMENTS From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board, or FASB, or other standard setting bodies that are adopted by us as of the specified effective date. Unless otherwise discussed, we believe that the impact of recently issued standards that are not yet effective will not have a material impact on our financial position or results of operations upon adoption. A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our financial statements appearing at the end of this Annual Report on Form 10-K.

<s>[INST] OVERVIEW We are a pharmaceutical company focused on developing and commercializing products that have the potential to transform the way therapy is delivered, advance patient care and reduce healthcare costs. Our proprietary platform is designed to enable the subcutaneous administration of therapies that have previously been limited to intravenous, or IV, delivery. By moving delivery away from the highcost healthcare settings typically required for IV administration, we believe our technology reduces overall healthcare costs and advances the quality and convenience of care. Our lead product candidate, Furoscix, consists of our novel subcutaneous formulation of furosemide delivered via our sc2Wear Infusor and is under development for treatment of worsening, or decompensated, heart failure outside of the inpatient setting. We filed a new drug application, or NDA, for Furoscix, with the U.S. Food and Drug Administration, or FDA, in August 2017. The FDA notified us in October 2017 that it had accepted our NDA for review and assigned us a June 23, 2018 Prescription Drug User Fee Act, or PDUFA, date which is the goal date for the FDA to complete its review of our NDA. We believe Furoscix, if approved by the FDA, would allow heart failure patients to receive IVstrength diuresis with earlier discharge from, or potentially without admission to, the highcost hospital setting. Since our inception in February 2013, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, planning for commercialization, and conducting discovery, research and development activities for our product candidates. We do not have any products approved for sale and have not generated any revenue from product sales. Prior to November 2017, we have funded our operations primarily with proceeds from the sale of preferred stock and borrowings under convertible notes and a term loan. As of December 31, 2017, we had received net cash proceeds of $56.7 million from sales of our preferred stock, net cash proceeds of $13.5 million from sales of convertible notes and net proceeds of $9.7 million from borrowings under our term loan. In November 2017, we closed our initial public offering with aggregate proceeds of $95.0 million, net of underwriters’ discounts and commissions, before deduction of offering expenses of approximately $2.3 million. For the years ended December 31, 2015, 2016 and 2017, our net loss was $10.5 million, $24.4 million and $23.8 million, respectively. We have not been profitable since inception, and as of December 31, 2017, our accumulated deficit was $67.0 million. We expect to continue to incur net losses for the foreseeable future as we develop the infrastructure to commercialize our products, if approved, in the United States, including building our sales and marketing organization, continue research and development efforts, scaleup manufacturing, and seek regulatory approval for new product candidates and product enhancements. We will need additional funding to pay expenses relating to our operating activities, including selling, general and administrative expenses and research and development expenses. Adequate funding may not be available to us on acceptable terms, or at all. Our failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations or financial condition. COMPONENTS OF OUR RESULTS OF OPERATIONS Research and Development Expenses Research and development, or R&D, expenses consist of the cost of engineering, clinical trials, regulatory and medical affairs and quality assurance associated with developing our proprietary technology and product candidates. R&D expenses consist primarily of: employeerelated expenses, including salaries, benefits, travel expense and stockbased compensation expense; cost of outside consultants who assist with technology development, regulatory affairs, clinical trials and medical affairs, and quality assurance; cost of clinical trial activities performed by third parties; and cost of facilities and supplies used for internal research and development and clinical activities. We expense R&D costs as incurred. Given the emphasis to date on our lead product candidate Furoscix, [/INST] Negative. </s>

scPharmaceuticals Inc.

2019-03-21

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes appearing at the end of this Annual Report on Form 10-K. This discussion includes forward-looking statements that involve risks, uncertainties and assumptions such as our plans, objectives, expectations and intentions. You should read the “Forward-Looking Statements” and “Risk Factors” sections of this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. OVERVIEW We are a pharmaceutical company focused on developing and commercializing products that have the potential to transform the way therapy is delivered, advance patient care and reduce healthcare costs. Our proprietary platform is designed to enable the subcutaneous administration of therapies that have previously been limited to intravenous, or IV, delivery. By moving delivery away from the high-cost healthcare settings typically required for IV administration, we believe our technology has the potential to reduce overall healthcare costs and advance the quality and convenience of care. Our lead product candidate, FUROSCIX, consists of our novel, buffered formulation of furosemide delivered subcutaneously via an on-body infusor and is under development for treatment of congestion in patients with worsening heart failure who display reduced responsiveness to oral diuretics and do not require hospitalization. We filed a new drug application, or NDA, for FUROSCIX, with the U.S. Food and Drug Administration, or FDA, in August 2017. The FDA notified us in October 2017 that it had accepted our NDA. On June 11, 2018 we received a Complete Response Letter, or CRL, from the FDA, which indicated that, among other things, certain device modifications to our infusor were required. We conducted a post-action meeting with the FDA on September 24, 2018 and a Type C meeting with the FDA on January 9, 2019. Based on the outcome of our interactions with the FDA, including clarification on an additional dose validation study and proposed device modifications necessary to advance FUROSCIX using the existing delivery technology, we have decided to discontinue use of the sc2Wear Infusor being developed in partnership with Sensile, and transition to our next generation device developed in partnership with West with their proprietary, wearable, SmartDose drug delivery system. Since our inception in February 2013, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, planning for commercialization, and conducting discovery, research and development activities for our product candidates. We do not have any products approved for sale and have not generated any revenue from product sales. Prior to November 2017, we have funded our operations primarily with proceeds from the sale of preferred stock and borrowings under convertible notes and a term loan. As of December 31, 2018, we had received net cash proceeds of $56.7 million from sales of our preferred stock, net cash proceeds of $13.5 million from sales of convertible notes and net proceeds of $9.2 million from borrowings under our term loan. In November 2017, we closed our initial public offering with aggregate proceeds of $95.0 million, net of underwriters’ discounts and commissions, before deduction of offering expenses of approximately $2.3 million. For the years ended December 31, 2016, 2017 and 2018, our net loss was $24.4 million, $23.8 million and $29.4 million, respectively. We have not been profitable since inception, and as of December 31, 2018, our accumulated deficit was $96.5 million. We expect to continue to incur net losses for the foreseeable future as we develop the infrastructure to commercialize our products, if approved, in the United States, including building our sales and marketing organization, continue research and development efforts, scale-up manufacturing, and seek regulatory approval for new product candidates and product enhancements. We will need additional funding to pay expenses relating to our operating activities, including selling, general and administrative expenses and research and development expenses. Adequate funding may not be available to us on acceptable terms, or at all. Our failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations or financial condition. COMPONENTS OF OUR RESULTS OF OPERATIONS Research and Development Expenses Research and development, or R&D, expenses consist of the cost of engineering, clinical trials, regulatory and medical affairs and quality assurance associated with developing our proprietary technology and product candidates. R&D expenses consist primarily of: • employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense; • cost of outside consultants who assist with technology development, regulatory affairs, clinical trials and medical affairs, and quality assurance; • cost of clinical trial activities performed by third parties; and • cost of facilities and supplies used for internal research and development and clinical activities. We expense R&D costs as incurred. Given the emphasis to date on our lead product candidate FUROSCIX, our R&D expenses have not been allocated on a program-specific basis. In the future, we expect R&D expenses to increase in absolute dollars as we continue to develop new products and enhance existing products and technologies. We anticipate that our expenses will increase significantly as we: • pursue regulatory approval of FUROSCIX incorporating the SmartDose drug delivery system; • continue to advance our pipeline programs beyond FUROSCIX; • continue our current research and development activity; • seek to identify additional research programs and additional product candidates; • initiate preclinical testing and clinical trials for any product candidates we identify and develop, maintain, expand and protect our intellectual property portfolio; and • hire additional research, clinical and scientific personnel. General and Administrative Expenses General and administrative, or G&A, expenses consist of employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense for personnel in executive, finance, commercial, human resources, facility operations and administrative functions. Other G&A expenses include pre-approval promotional activities, marketing, conferences and trade shows, professional services fees, including legal, audit and tax fees, insurance costs, general corporate expenses and allocated facilities-related expenses. If we receive FDA approval for FUROSCIX incorporating the next generation SmartDose drug delivery system, we anticipate that our G&A expenses will increase as we continue to build our corporate and commercial infrastructure to support the development and commercial launch of FUROSCIX in the United States. RESULTS OF OPERATIONS Comparison of Years Ended December 31, 2017 and 2018 The following table summarizes our results of operations for the years ended December 31, 2017 and 2018: Research and development expenses. R&D expenses increased $1.6 million to $15.9 million during the year ended December 31, 2018, compared to $14.3 million during the year ended December 31, 2017. This increase was primarily attributable to a $1.0 million increase in employee-related costs due to growth within our clinical and medical affairs teams, a $1.1 million increase in clinical and medical affairs program activity, a $0.7 million increase in pharmaceutical development costs associated with batch manufacturing and testing, and a $0.2 million increase in facility costs during the year ended December 31, 2018. This increase was partially offset by a $0.7 million decrease in device development costs and a $0.7 million decrease in regulatory and quality assurance consulting. General and administrative expenses. G&A expenses increased $4.6 million to $13.7 million during the year ended December 31, 2018, compared to $9.1 million during the year ended December 31, 2017. This increase was primarily attributable to a $1.1 million increase in employee-related expenses associated with the commercial organization growth in the first half of 2018 and stock-based compensation, a $1.2 million increase in consulting and professional services associated with preparation for the commercialization of FUROSCIX, if approved, and $2.2 million related to costs incurred as a public company, including expenses related to audit, legal, investor relations, board fees and director and officer insurance premiums, during the year ended December 31, 2018. Other income (expense). Other income decreased $131,000 to $56,000 in other expense during the year ended December 31, 2018, compared to income of $75,000 during the year ended December 31, 2017. This decrease was primarily attributable to foreign exchange losses due to foreign currency fluctuations. Interest income. Interest income increased $1.4 million to $1.7 million during the year ended December 31, 2018, compared to $341,000 during the year ended December 31, 2017. This increase was primarily attributable to higher cash balances during the year ended December 31, 2018 following our initial public offering in November 2017. Interest expense. Interest expense increased $0.6 million from the year ended December 31, 2017 to $1.4 million during the year ended December 31, 2018. This increase was due to the $10.0 million loan entered into in May 2017 with Solar Capital Ltd. and Silicon Valley Bank which was outstanding for the full year in 2018. Comparison of the Years Ended December 31, 2016 and 2017 The following table summarizes our results of operations for the years ended December 31, 2016 and 2017: Research and development expenses. R&D expenses increased $2.5 million to $14.3 million during the year ended December 31, 2017, compared to $11.9 million during the year ended December 31, 2016. This increase was primarily attributable to a $0.4 million increase related to contract services for device engineering, a $1.1 million increase in regulatory consulting costs, a $0.3 million increase in supplies, storage and packaging costs related to clinical trials and development and a $1.7 million increase in employee-related expenses associated with additional headcount during the year ended December 31, 2017. This increase was partially offset by a $1.0 million decrease in outsourced clinical and medical affairs activity. General and administrative expenses. G&A expenses increased $3.1 million to $9.1 million during the year ended December 31, 2017, compared to $6.1 million during the year ended December 31, 2016. This increase was primarily attributable to a $2.4 million increase in employee-related expenses associated with additional headcount and recruiting, a $0.7 million increase in consulting and professional services to support the expansion of our commercial organization, a $0.2 million increase in strategic and information technology consulting and $0.4 million related to costs incurred as a public company during the year ended December 31, 2017. This increase was partially offset by a $0.6 million decrease in market research and tradeshows. Other income. Other income increased $37,000 to $75,000 during the year ended December 31, 2017, compared to $38,000 during the year ended December 31, 2016. This increase was primarily attributable to foreign exchange gains due to increased activity denominated in foreign currency combined with foreign currency fluctuations. Interest income. Interest income increased $334,000 to $341,000 during the year ended December 31, 2017, compared to $7,000 during the year ended December 31, 2016. This increase was primarily attributable to higher cash balances during the year ended December 31, 2017 following our initial public offering in November 2017. Interest expense. Interest expense decreased $5.7 million from the year ended December 31, 2016 to $0.8 million during the year ended December 31, 2017. This decrease was primarily attributable to the conversion of convertible notes issued in January 2016 into Series A preferred stock in August 2016. LIQUIDITY AND CAPITAL RESOURCES Overview We have funded our operations from inception through December 31, 2018 primarily through the sale of shares of our common stock in our initial public offering and, prior to that, through the private placement of our preferred stock and the incurrence of debt. As of December 31, 2018, we had received net cash proceeds of $92.7 million from our initial public offering, $56.7 million from sales of our preferred stock, and $13.5 million in net proceeds from convertible notes payable. Additionally, in May 2017 we incurred $10.0 million of debt under a loan and security agreement with Solar Capital Ltd. and Silicon Valley Bank. As of December 31, 2018, we had cash, cash equivalents and restricted cash of $89.7 million. We expect to incur substantial additional expenditures in the next twelve months to support our ongoing activities and our plans to obtain regulatory approval for FUROSCIX incorporating the next generation SmartDose drug delivery system. We believe our existing unrestricted cash is sufficient to fund these operations through 2020. We expect our costs and expenses to increase in the future as we prepare for and, if approved, commence U.S. commercialization of FUROSCIX, including the development of a direct sales force, and as we continue to make substantial expenditures on research and development, including to increase our manufacturing capacity and for conducting clinical trials of our product candidates. Additionally, we will incur additional costs as a result of operating as a public company. Our future capital requirements will depend on many factors, including: • the time and expense required to refile an NDA for FUROSCIX incorporating the next generation SmartDose drug delivery system; • the potential FDA approval of FUROSCIX; • the costs and expenses of establishing our U.S. sales and marketing infrastructure; • the degree of success we experience in commercializing FUROSCIX, if approved; • the revenue generated by sales of FUROSCIX, if approved and other products that may be approved; • the pricing and reimbursement of FUROSCIX, if approved, and of other product candidates that may be approved; • the costs, timing and outcomes of clinical trials and regulatory reviews associated with our product candidates; • the emergence of competing or complementary technological developments; • the extent to which FUROSCIX, if approved, is adopted by the healthcare community; • the number and types of future products we develop and commercialize; • the costs of preparing, filing and prosecuting patent applications and maintaining, enforcing and defending intellectual property-related claims; and • the extent and scope of our general and administrative expenses. Additional financing may not be available on a timely basis on terms acceptable to us, or at all. We may raise funds in equity, royalty-based or debt financings or enter into additional credit facilities in order to access funds for our capital needs. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. If we raise additional funds through royalty-based financing arrangements, we will likely agree to relinquish rights to potentially valuable future revenue streams and may agree to covenants that restrict our operations or strategic flexibility. Any debt financing obtained by us in the future would cause us to incur additional debt service expenses and could include restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and pursue business opportunities. If we are unable to obtain adequate financing or financing on terms satisfactory to us when we require it, we may terminate or delay the development of one or more of our products, delay clinical trials necessary to market our products, or delay establishment or expansion of sales and marketing capabilities or other activities necessary to commercialize our products. Loan and Security Agreement In May 2017, we entered into a $10.0 million loan and security agreement, or the 2017 Loan Agreement, with Solar Capital Ltd. and Silicon Valley Bank. In November 2018 and December 2018, we entered into the First Amendment to the Loan and Security Agreement and the Second Amendment to the Loan and Security Agreement, respectively, collectively the “Amendments”. Upon execution of the First Amendment to the Loan and Security Agreement, we paid the lenders an Amendment Fee of $35,000. Additional fees incurred by the lenders for the Amendments, totaling $27,000, were paid subsequent to the execution of such Amendments. The interest rate under the 2017 Loan Agreement is LIBOR plus 8.45%. The initial interest-only period was until November 30, 2018, followed by a 30-month principal and interest period. The First Amendment to the Loan and Security Agreement extended the interest-only period, which currently runs through May 2019. If and when certain conditions are met, the interest-only period may be extended to August or November 2019. Pursuant to the 2017 Loan Agreement, we provided a first priority security interest in all existing and after-acquired assets, excluding intellectual property, owned by us. As of December 31, 2018, unpaid borrowings under the 2017 Loan Agreement totaled $10.0 million. For the year ended December 31, 2018, we recorded $280,000 related to the amortization of debt discount associated with the 2017 Loan Agreement. The 2017 Loan Agreement allows us to voluntarily prepay all (but not less than all) of the outstanding principal at any time. A prepayment premium of 1% would be assessed on the outstanding principal. A final payment fee of $250,000 was due upon the earlier to occur of the maturity date of the 2017 Loan Agreement, prepayment of such borrowings or the acceleration of payment due to an event of default. The final payment fee was increased to $325,000 in the First Amendment to the Loan and Security Agreement. For the year ended December 31, 2018, we recorded $94,000 related to the amortization of the final payment fee associated with the 2017 Loan Agreement. In an event of default under the 2017 Loan Agreement, the interest rate will be increased by 5% and the balance under the loan may become immediately due and payable at the option of the lenders. We entered into an exit fee agreement in connection with the 2017 Loan Agreement which provides for a payment to the lenders upon the occurrence of an exit event, as defined in the agreement, including an initial public offering, equal to 4% of the loan commitment, or $400,000. We paid this fee in November 2017 concurrent with our initial public offering. The 2017 Loan Agreement includes restrictions on, among other things, our ability to incur additional indebtedness, change the name or location of our business, merge with or acquire other entities, pay dividends or make other distributions to holders of our capital stock, make certain investments, engage in transactions with affiliates, create liens, sell assets or pay subordinated debt. CASH FLOWS The following table summarizes our sources and uses of cash for each of the periods presented: Net Cash Used in Operating Activities During the year ended December 31, 2018, net cash used in operating activities was $28.8 million, consisting primarily of a net loss of $29.4 million and $2.2 million decrease in working capital. This was offset by non-cash charges of $2.8 million. The non-cash charges primarily consisted of depreciation, stock-based compensation expense, amortization of right-of-use leased assets and non-cash interest expense related to amortization of debt discount associated with the 2017 Loan Agreement. During the year ended December 31, 2017, net cash used in operating activities was $22.7 million, consisting primarily of a net loss of $23.8 million and $0.2 million decrease in working capital. This was offset by non-cash charges of $1.3 million. The non-cash charges primarily consisted of depreciation, stock-based compensation expense, amortization of right-of-use leased assets and non-cash interest expense related to amortization of debt discount associated with the 2017 Loan Agreement. During the year ended December 31, 2016, net cash used in operating activities was $15.5 million, consisting primarily of a net loss of $24.4 million, offset by a decrease in net operating assets of $1.4 million and non-cash charges of $7.5 million. The decrease in net operating assets primarily consisted of increased accruals for pharmaceutical development and accounts payable for clinical trials, device engineering costs, the expansion of our commercial organization, and legal costs associated with our Series B preferred stock financing. The non-cash charges primarily consisted of depreciation, stock-based compensation expense, amortization of right-of-use leased assets and non-cash interest expense related to convertible notes payable. Net Cash Used in Investing Activities During the years ended December 31, 2016 and 2017, net cash used in investing activities consisted of purchases of property and equipment. Net Cash Provided by (Used in) Financing Activities During the year ended December 31, 2018, net cash used by financing activities was $8,000, consisting of debt and equity issuance costs offset by proceeds from stock option exercises. During the year ended December 31, 2017, net cash provided by financing activities was $102.1 million, consisting primarily of net proceeds of $92.7 million from our initial public offering, $9.3 million in borrowings under the 2017 Loan Agreement, and $0.1 million in proceeds from stock option exercises. During the year ended December 31, 2016, net cash provided by financing activities was $53.2 million, consisting primarily of net proceeds of $40.6 million from the issuance of Series B convertible preferred stock and net proceeds of $12.5 million from convertible notes payable. OFF-BALANCE SHEET ARRANGEMENTS We currently have no off-balance sheet arrangements. CONTRACTUAL OBLIGATIONS The following table summarizes our contractual obligations as of December 31, 2018 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods. (1) Consists of obligations under multi-year, non-cancelable building and equipment leases for our facilities in Burlington, Massachusetts and Lexington, Massachusetts. The building leases expire on November 30, 2022 and December 31, 2022, respectively. We have drawn down an aggregate of $10.0 million from our 2017 Loan Agreement, as of December 31, 2018. Our contractual commitments under the 2017 Loan Agreement as of December 31, 2018 consist of an aggregate of $11.9 million in repayment obligations, inclusive of related interest amounts and a $325,000 final fee. See “-Loan and Security Agreement” for additional information regarding the 2017 Loan Agreement. We enter into contracts in the normal course of business with clinical trial sites and manufacturing organizations and with vendors for preclinical studies, research supplies and other services and products for operating purposes. These contracts generally provide for termination after a notice period, and, therefore, are cancelable contracts and not included in the table above. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions for the reported amounts of assets, liabilities, revenue, expenses and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions and any such differences may be material. While our significant accounting policies are more fully described in the notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following discussion addresses our most critical accounting policies, which are those that are most important to our financial condition and results of operations and require our most difficult, subjective and complex judgments. Stock-Based Compensation Expense We are required to determine the fair value of equity incentive awards and recognize compensation expense for all equity incentive awards, including employee stock options. We recognize this expense over the requisite service period. In addition, we recognize stock-based compensation expense in the statements of operations based on awards expected to vest and, therefore, the amount of expense has been reduced for estimated forfeitures. We use the ratable straight-line method for expense attribution. The valuation model we used for calculating the fair value of awards for stock-based compensation expense is the Black-Scholes option-pricing model, or the Black-Scholes model. The Black-Scholes model requires us to make assumptions and judgments about the variables used in the calculation, including: • Expected term. We do not believe we are able to rely on our historical exercise and post-vesting termination activity to provide accurate data for estimating the expected term for use in determining the fair value-based measurement of our options. Therefore, we have opted to use the “simplified method” for estimating the expected term of options, which is the average of the weighted-average vesting period and contractual term of the option. • Expected volatility. Due to the lack of a public market for the trading of our common stock prior to our IPO and a lack of company specific historical volatility, we have determined the share price volatility for options granted based on an analysis of the volatility of a peer group of publicly traded companies. In evaluating similarity, we consider factors such as stage of development, risk profile, enterprise value and position within the industry. • Risk-free interest rate. The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of the grant for zero-coupon U.S. Treasury notes with remaining terms similar to the expected term of the options. • Dividend rate. We assumed the expected dividend to be zero as we have never paid dividends and have no current plans to do so. • Expected forfeiture rate. We are required to estimate forfeitures at the time of grant, and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. • Service period. We amortize all stock-based compensation over the requisite service period of the awards, which is generally the same as the vesting period of the awards. We amortize the stock-based compensation cost on a straight-line basis over the expected service periods. • Fair value of common stock. Prior to the IPO, the estimated fair value of our common stock was determined by our board of directors as of the date of each option grant, with input from management, considering our most recently available third-party valuations of common stock and our board of directors’ assessment of additional objective and subjective factors that it believed were relevant and which may have changed from the date of the most recent valuation through the date of the grant. These third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. In addition to considering the results of these third-party valuations, our board of directors considered various objective and subjective factors to determine the fair value of our common stock as of each grant date, which may be a date later than the most recent third-party valuation date, including: o the prices at which we sold shares of preferred stock and the superior rights and preferences of the preferred stock relative to our common stock at the time of each grant; o the progress of our research and development programs, including the status of preclinical studies and planned clinical trials for our product candidates; o our stage of development and commercialization and our business strategy; o external market conditions affecting the pharmaceutical and biotechnology industries, and trends within the biotechnology industry; o our financial position, including cash on hand, and our historical and forecasted performance and operating results; o the lack of an active public market for our common stock and our preferred stock; o the likelihood of achieving a liquidity event, such as an initial public offering, or IPO, or a sale of our company in light of prevailing market conditions; and o the analysis of IPOs and the market performance of similar companies in the biopharmaceutical industry. Consequently, after the IPO, the fair value of the shares of common stock underlying the stock options is the closing price on the option grant date. Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued R&D expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed or when contractual milestones are met. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued R&D expenses include the costs incurred for services performed by our vendors in connection with R&D activities for which we have not yet been invoiced. We base our expenses related to R&D activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct R&D on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the R&D expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid accordingly. Advance payments for goods and services that will be used in future R&D activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there has been no material differences between our estimates of such expenses and the amounts actually incurred. JOBS ACT ACCOUNTING ELECTION In April 2012, the Jumpstart Our Business Startups Act of 2012, or JOBS Act, was enacted. Section 107 of the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies. This election is irrevocable. NEW ACCOUNTING PRONOUNCEMENTS From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board, or FASB, or other standard setting bodies that are adopted by us as of the specified effective date. Unless otherwise discussed, we believe that the impact of recently issued standards that are not yet effective will not have a material impact on our financial position or results of operations upon adoption. A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K.

<s>[INST] OVERVIEW We are a pharmaceutical company focused on developing and commercializing products that have the potential to transform the way therapy is delivered, advance patient care and reduce healthcare costs. Our proprietary platform is designed to enable the subcutaneous administration of therapies that have previously been limited to intravenous, or IV, delivery. By moving delivery away from the highcost healthcare settings typically required for IV administration, we believe our technology has the potential to reduce overall healthcare costs and advance the quality and convenience of care. Our lead product candidate, FUROSCIX, consists of our novel, buffered formulation of furosemide delivered subcutaneously via an onbody infusor and is under development for treatment of congestion in patients with worsening heart failure who display reduced responsiveness to oral diuretics and do not require hospitalization. We filed a new drug application, or NDA, for FUROSCIX, with the U.S. Food and Drug Administration, or FDA, in August 2017. The FDA notified us in October 2017 that it had accepted our NDA. On June 11, 2018 we received a Complete Response Letter, or CRL, from the FDA, which indicated that, among other things, certain device modifications to our infusor were required. We conducted a postaction meeting with the FDA on September 24, 2018 and a Type C meeting with the FDA on January 9, 2019. Based on the outcome of our interactions with the FDA, including clarification on an additional dose validation study and proposed device modifications necessary to advance FUROSCIX using the existing delivery technology, we have decided to discontinue use of the sc2Wear Infusor being developed in partnership with Sensile, and transition to our next generation device developed in partnership with West with their proprietary, wearable, SmartDose drug delivery system. Since our inception in February 2013, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, planning for commercialization, and conducting discovery, research and development activities for our product candidates. We do not have any products approved for sale and have not generated any revenue from product sales. Prior to November 2017, we have funded our operations primarily with proceeds from the sale of preferred stock and borrowings under convertible notes and a term loan. As of December 31, 2018, we had received net cash proceeds of $56.7 million from sales of our preferred stock, net cash proceeds of $13.5 million from sales of convertible notes and net proceeds of $9.2 million from borrowings under our term loan. In November 2017, we closed our initial public offering with aggregate proceeds of $95.0 million, net of underwriters’ discounts and commissions, before deduction of offering expenses of approximately $2.3 million. For the years ended December 31, 2016, 2017 and 2018, our net loss was $24.4 million, $23.8 million and $29.4 million, respectively. We have not been profitable since inception, and as of December 31, 2018, our accumulated deficit was $96.5 million. We expect to continue to incur net losses for the foreseeable future as we develop the infrastructure to commercialize our products, if approved, in the United States, including building our sales and marketing organization, continue research and development efforts, scaleup manufacturing, and seek regulatory approval for new product candidates and product enhancements. We will need additional funding to pay expenses relating to our operating activities, including selling, general and administrative expenses and research and development expenses. Adequate funding may not be available to us on acceptable terms, or at all. Our failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations or financial condition. COMPONENTS OF OUR RESULTS OF OPERATIONS Research and Development Expenses Research and development, or R&D, expenses consist of the cost of engineering, clinical trials, regulatory and medical affairs and quality assurance associated with developing our proprietary technology and product candidates. R&D expenses consist primarily of: employeerelated exp [/INST] Negative. </s>

scPharmaceuticals Inc.

2020-03-24

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes appearing at the end of this Annual Report on Form 10-K. This discussion includes forward-looking statements that involve risks, uncertainties and assumptions such as our plans, objectives, expectations and intentions. You should read the “Forward-Looking Statements” and “Risk Factors” sections of this Annual Report on Form 10-K for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. OVERVIEW We are a pharmaceutical company focused on developing and commercializing products that have the potential to optimize the delivery of infused therapies, advance patient care and reduce healthcare costs. Our strategy is designed to enable the subcutaneous administration of therapies that have previously been limited to intravenous, or IV, delivery. By moving delivery away from the high-cost healthcare settings typically required for IV administration, we believe our technology has the potential to reduce overall healthcare costs and advances the quality and convenience of care. Our lead product candidate, FUROSCIX, consists of our novel formulation of furosemide delivered subcutaneously via an on-body infusor and is under development for treatment of congestion in patients with worsening heart failure who display reduced responsiveness to oral diuretics and do not require hospitalization. We filed a new drug application, or NDA, for FUROSCIX, with the U.S. Food and Drug Administration, or FDA, in August 2017. On June 11, 2018 we received a Complete Response Letter, or CRL, from the FDA for our NDA, which indicated that, among other things, certain device modifications to our infusor were required. Based on our interactions with the FDA, which required clarification on an additional dose validation study and device modifications necessary to advance FUROSCIX using the existing technology, we decided to transition to our next generation device. Our next generation device is being developed through a partnership with West Pharmaceutical Services, Inc., or West, using its proprietary, wearable, SmartDose drug delivery system. We held a Type C meeting with the FDA on June 18, 2019 and based on the results of that meeting we anticipate resubmission of the FUROSCIX NDA with the SmartDose drug delivery system by mid-year 2020. Since our inception in February 2013, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, planning for commercialization, and conducting discovery, research and development activities for our product candidates. We do not have any products approved for sale and have not generated any revenue from product sales. From inception through December 31, 2019, we had received net cash proceeds of $92.7 million from our initial public offering in November 2017, net cash proceeds of $56.7 million from sales of our preferred stock, net cash proceeds of $18.8 million from borrowings under our term loan, net cash proceeds of $13.5 million from sales of convertible notes and net cash proceeds of $4.0 million from the sale of common stock in our 2019 at-the-market offering. For the years ended December 31, 2018 and 2019, our net losses were $29.4 million and $33.0 million, respectively. We have not been profitable since inception, and as of December 31, 2019, our accumulated deficit was $129.5 million. We expect to continue to incur net losses for the foreseeable future as we develop the infrastructure to commercialize our products, if approved, in the United States, including building our sales and marketing organization, continuing research and development efforts, engaging in scale-up manufacturing and seeking regulatory approval for new product candidates and enhancements. We will need additional funding to pay expenses related to our operating activities, including selling, general and administrative expenses and research and development expenses. Adequate funding may not be available to us on acceptable terms, or at all. Our failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations or financial condition. COMPONENTS OF OUR RESULTS OF OPERATIONS Research and Development Expenses Research and development, or R&D, expenses consist of the cost of engineering, clinical trials, regulatory and medical affairs and quality assurance associated with developing our proprietary technology and product candidates. R&D expenses consist primarily of: • employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense; • cost of outside consultants who assist with technology development, regulatory affairs, clinical trials and medical affairs, and quality assurance; • cost of clinical trial activities performed by third parties; and • cost of facilities and supplies used for internal research and development and clinical activities. We expense R&D costs as incurred. Given the emphasis to date on our lead product candidate FUROSCIX, our R&D expenses have not been allocated on a program-specific basis. In the future, we expect R&D expenses to increase in absolute dollars as we continue to develop new products and enhance existing products and technologies. We anticipate that our expenses will increase significantly as we: • pursue regulatory approval of FUROSCIX incorporating the SmartDose drug delivery system; • continue to advance our pipeline programs beyond FUROSCIX; including ceftriaxone; • continue our current research and development activity; • seek to identify additional research programs and additional product candidates; • initiate preclinical testing and clinical trials for any product candidates we identify and develop, maintain, expand and protect our intellectual property portfolio; and • hire additional research, clinical and scientific personnel. General and Administrative Expenses General and administrative, or G&A, expenses consist of employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense for personnel in executive, finance, commercial, human resources, facility operations and administrative functions. Other G&A expenses include pre-approval promotional activities, marketing, conferences and trade shows, professional services fees, including legal, audit and tax fees, insurance costs, general corporate expenses and allocated facilities-related expenses. If we receive FDA approval for FUROSCIX incorporating the next generation SmartDose drug delivery system, we anticipate that our G&A expenses will increase as we continue to build our corporate and commercial infrastructure to support the development and commercial launch of FUROSCIX in the United States. RESULTS OF OPERATIONS Comparison of Years Ended December 31, 2018 and 2019 The following table summarizes our results of operations for the years ended December 31, 2018 and 2019 (in thousands): Research and development expenses. R&D expenses increased $8.7 million to $24.6 million during the year ended December 31, 2019, compared to $15.9 million during the year ended December 31, 2018. This increase was primarily attributable to a $5.3 million increase in device development costs, a $5.0 million increase in pharmaceutical development costs, $1.7 million in unrecoverable component costs related to the sc2Wear Infusor, and a $0.8 million increase in severance costs. The increase was partially offset by a $2.0 million decrease in employee-related costs, a $1.5 million decrease in supplies and contract services for clinical and medical affairs, a $0.4 million decrease in quality and regulatory consulting and a $0.1 million decrease in facility costs. General and administrative expenses. G&A expenses decreased $5.4 million to $8.3 million during the year ended December 31, 2019, compared to $13.7 million during the year ended December 31, 2018. This decrease was primarily attributable to a $2.9 million decrease in employee-related costs, a $2.0 million decrease in costs related to commercial preparation, a $0.3 million decrease in severance costs and a $0.4 million decrease in legal and professional service costs. The decrease was partially offset by an increase of $0.2 million in public company costs primarily related to directors & officers insurance. Other (expense) income. Other income increased $72,000 to $16,000 in other income during the year ended December 31, 2019, compared to expense of $56,000 during the year ended December 31, 2018. This increase was primarily attributable to foreign exchange gains due to foreign currency fluctuations. Interest income. Interest income decreased $52,000 to $1.7 million during the year ended December 31, 2019 compared to the year ended December 31, 2018. This decrease was primarily attributable to lower cash balances during the year ended December 31, 2019. Interest expense. Interest expense increased $0.3 million from the year ended December 31, 2018 to $1.8 million during the year ended December 31, 2019. This increase was due to the restructuring of the term loan in September 2019 with Solar Capital Ltd. and Silicon Valley Bank which increased the principal from $10.0 million to $20.0 million. LIQUIDITY AND CAPITAL RESOURCES Overview We have funded our operations from inception through December 31, 2019 primarily through the sale of shares of our common stock and, prior to that, through the private placement of our preferred stock and the incurrence of debt. From inception through December 31, 2019, we had received net cash proceeds of $92.7 million from our initial public offering in November 2017, net cash proceeds of $56.7 million from sales of our preferred stock, net cash proceeds of $18.8 million from borrowings under our term loan, net cash proceeds of $13.5 million from sales of convertible notes and net cash proceeds of $4.0 million from the sale of common stock in our at-the-market offering. As of December 31, 2019, we had cash, cash equivalents and restricted cash of $72.8 million. We expect to incur substantial additional expenditures in the next 12 months to support our ongoing activities and our plans to obtain regulatory approval for FUROSCIX incorporating the next generation SmartDose drug delivery system. We believe our existing unrestricted cash is sufficient to fund these operations through at least the next 12 months from the date of this annual report. We expect our costs and expenses to increase in the future as we prepare for and, if approved, commence U.S. commercialization of FUROSCIX, including the development of a direct sales force, and as we continue to make substantial expenditures on research and development, including to increase our manufacturing capacity and for conducting clinical trials of our product candidates. Additionally, we will incur additional costs as a result of operating as a public company. Our future capital requirements will depend on many factors, including: • the time and expense required to resubmit the NDA for FUROSCIX incorporating the next generation SmartDose drug delivery system; • the potential FDA approval of FUROSCIX; • the costs and expenses of establishing our U.S. sales and marketing infrastructure; • the degree of success we experience in commercializing FUROSCIX, if approved; • the revenue generated by sales of FUROSCIX, if approved and other products that may be approved; • the pricing and reimbursement of FUROSCIX, if approved, and of other product candidates that may be approved; • the costs, timing and outcomes of clinical trials and regulatory reviews associated with our product candidates; • the emergence of competing or complementary technological developments; • the extent to which FUROSCIX, if approved, is adopted by the healthcare community; • the number and types of future products we develop and commercialize; • the costs of preparing, filing and prosecuting patent applications and maintaining, enforcing and defending intellectual property-related claims; and • the extent and scope of our general and administrative expenses. Additional financing may not be available on a timely basis on terms acceptable to us, or at all. We may raise funds in equity, royalty-based or debt financings or enter into additional credit facilities in order to access funds for our capital needs. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. If we raise additional funds through royalty-based financing arrangements, we will likely agree to relinquish rights to potentially valuable future revenue streams and may agree to covenants that restrict our operations or strategic flexibility. Any debt financing obtained by us in the future would cause us to incur additional debt service expenses and could include restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and pursue business opportunities. If we are unable to obtain adequate financing or financing on terms satisfactory to us when we require it, we may terminate or delay the development of one or more of our products, delay clinical trials necessary to market our products, or delay establishment or expansion of sales and marketing capabilities or other activities necessary to commercialize our products. Loan and Security Agreement In May 2017, we entered into a $10.0 million loan and security agreement, or the 2017 Loan Agreement, with Solar Capital Ltd. and Silicon Valley Bank (the Lenders). In November 2018, December 2018 and May 2019, we entered into the First Amendment to the Loan and Security Agreement, the Second Amendment to the Loan and Security Agreement and the Third Amendment to the Loan and Security Agreement, respectively (collectively, the Amendments). Upon execution of the First Amendment to the Loan and Security Agreement and the Third Amendment to the Loan and Security Agreement, we paid the Lenders Amendment Fees of $35,000 and $30,000 respectively. Additional fees incurred by the Lenders for the Amendments, totaling $40,000, were paid subsequent to the execution of such Amendments. The interest rate under the 2017 Loan Agreement was LIBOR plus 8.45%. The initial interest-only period was until November 30, 2018, followed by a 30-month principal and interest period. The First Amendment to the Loan and Security Agreement extended the interest-only period through May 2019. The Third Amendment to the Loan and Security Agreement extended the interest-only period through August 2019, with the ability to further extend the interest-only period to November 2019. Pursuant to the 2017 Loan Agreement, we provided a first priority security interest in all existing and after-acquired assets, excluding intellectual property, owned by us. The 2017 Loan Agreement allowed us to voluntarily prepay all, but not less than all, of the outstanding principal at any time with a prepayment premium of 1% of the outstanding principal. The 2017 Loan Agreement included a final payment fee of $250,000 upon the earlier of the maturity date or prepayment of such borrowings. The final payment fee was increased to $325,000 in the First Amendment to the 2017 Loan Agreement. For the year ended December 31, 2019, the Company recorded $80,000 related to the amortization of the final payment fee associated with the 2017 Loan Agreement. In September 2019, we restructured the 2017 Loan Agreement and entered into the 2019 Loan Agreement, which provided for a $20.0 million term loan with the Lenders. The restructured four-year term loan facility allowed for an expansion of the 2017 Loan Agreement. Some of the proceeds from the 2019 Loan Agreement were used to pay off the 2017 Loan Agreement, including the final fee of $325,000. The 2019 Loan Agreement extends the term of the credit facility until September 17, 2023. The interest rate under the 2019 Loan Agreement is the higher of (i) LIBOR plus 7.95% or (ii) 10.18% and there is an interest-only period until September 30, 2021. The rate at December 31, 2019 was 10.18%. Pursuant to the 2019 Loan Agreement, we provided a first priority security interest in substantially all of our assets, including intellectual property, subject to certain exceptions. As of December 31, 2019, unpaid borrowings under the 2019 Loan Agreement totaled $20.0 million. For the year ended December 31, 2019, we recorded $169,000 and $90,000 related to the amortization of debt discount associated with the 2017 Loan Agreement and the 2019 Loan Agreement, respectively. Similar to the 2017 Loan Agreement, the 2019 Loan Agreement allows us to voluntarily prepay all, but not less than all, of the outstanding principal at any time. A prepayment premium of 3% or 1% through the one-year anniversary and the two-year anniversary, respectively, would be assessed on the outstanding principal. After the two-year anniversary, a 0.5% prepayment premium would be assessed on the outstanding principal. A final payment fee of $500,000 is due upon the earlier to occur of the maturity date or prepayment of such borrowings. For the year ended December 31, 2019, we recorded $46,000 related to the amortization of the final payment fee associated with the 2019 Loan Agreement. In an event of default under the 2019 Loan Agreement, the interest rate will be increased by 5% and the balance under the loan may become immediately due and payable at the option of the lenders. We entered into an exit fee agreement with the Lenders in connection with the 2019 Loan Agreement which provides for an aggregate payment of 4% of the loan commitment, or $800,000, to the Lenders upon the occurrence of an exit event, as defined in the agreement. The 2019 Loan Agreement includes restrictions on, among other things, our ability to incur additional indebtedness, change the name or location of our business, merge with or acquire other entities, pay dividends or make other distributions to holders of our capital stock, make certain investments, engage in transactions with affiliates, create liens, sell assets or pay subordinated debt. At-the-Market Issuance Sales Agreement On August 23, 2019, we entered into an Open Market Sale AgreementSM, (the ATM Agreement), with Jefferies LLC, Jefferies, with respect to an at-the-market offering program under which the Company may offer and sell, from time to time at its sole discretion, shares of its common stock, par value $0.0001 per share, or (the ATM Shares), up to an aggregate amount of $15.0 million through Jefferies as its sales agent. The offering and sale of ATM Shares by us under the ATM Agreement will be and is being made pursuant to our shelf registration statement on Form S-3, which was declared effective by the SEC on February 11, 2019 (Registration Statement No. 333-229120). Subject to the terms and conditions of the ATM Agreement, Jefferies will use its commercially reasonable efforts to sell the ATM Shares, based upon instructions from us, consistent with its normal trading and sales practices. We will pay Jefferies a commission equal to 3.0% of the gross sales proceeds of such ATM Shares. During the year ended December 31, 2019, we sold a total of 827,525 ATM Shares under the ATM Agreement at an average gross selling price of $5.19 per share for proceeds of $4.2 million, net of commissions. We incurred $189,000 of legal, accounting and other costs to establish and activate the ATM program. We charged $54,000 of these costs against additional paid in capital upon issuance of shares during the year ended December 31, 2019. In the period beginning January 1, 2020 through the date of this Annual Report on Form 10-K, we issued and sold an additional 1,502,892 shares of our common stock under the ATM program, resulting in our receipt of $10.4 million in net proceeds. With the shares sold in 2020, the ATM program is complete. CASH FLOWS The following table summarizes our sources and uses of cash for each of the periods presented: Net Cash Used in Operating Activities During the year ended December 31, 2019, net cash used in operating activities was $30.4 million, consisting primarily of a net loss of $33.0 million. This was offset by $0.4 million increase in net operating liabilities and non-cash charges of $2.2 million. The non-cash charges primarily consisted of depreciation, stock-based compensation expense, amortization of right-of-use leased assets and non-cash interest expense related to amortization of debt discount associated with the 2017 and 2019 Loan Agreements. During the year ended December 31, 2018, net cash used in operating activities was $28.8 million, consisting primarily of a net loss of $29.4 million and $2.2 million increase in net operating assets. This was offset by non-cash charges of $2.8 million. The non-cash charges primarily consisted of depreciation, stock-based compensation expense, amortization of right-of-use leased assets and non-cash interest expense related to amortization of debt discount associated with the 2017 Loan Agreement. Net Cash (Used in) Provided by Financing Activities During the year ended December 31, 2019, net cash provided by financing activities was $13.6 million, consisting primarily of $9.6 million in borrowings under the 2019 Loan Agreement, net proceeds of $4.0 million from the at-the-market offering, and $60,000 in proceeds from stock option exercises. During the year ended December 31, 2018, net cash used by financing activities was $8,000, consisting of debt and equity issuance costs offset by proceeds from stock option exercises. OFF-BALANCE SHEET ARRANGEMENTS We currently have no off-balance sheet arrangements. CONTRACTUAL OBLIGATIONS The following table summarizes our contractual obligations as of December 31, 2019 and the effects that such obligations are expected to have on our liquidity and cash flows in future periods. (1) Consists of obligations under multi-year, non-cancelable building and equipment leases for our facilities in Burlington, Massachusetts and Lexington, Massachusetts. The building leases expire on November 30, 2022 and December 31, 2022, respectively. We have drawn down an aggregate of $20.0 million from our 2019 Loan Agreement as of December 31, 2019. Our contractual commitments under the 2019 Loan Agreement as of December 31, 2019 consist of an aggregate of $27.1 million in repayment obligations, inclusive of related interest amounts and final and exit fees in the amounts of $500,000 and $800,000, respectively. See “-Loan and Security Agreement” for additional information regarding the 2019 Loan Agreement. We enter into contracts in the normal course of business with clinical trial sites and manufacturing organizations and with vendors for preclinical studies, research supplies and other services and products for operating purposes. These contracts generally provide for termination after a notice period, and, therefore, are cancelable contracts and not included in the table above. Due to the discontinuation of use of the Company’s first generation product candidate, sc2Wear Infusor, we have received notice of termination costs from vendors related to the program. We have accrued all costs for which we either believe we are contractually liable or for which we have negotiated settlement agreements in good faith. However, certain of our vendors have claimed or billed for additional costs for which we believe we are not obligated. At this time, we estimate that additional termination costs, if any, will be immaterial to our financial statements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. The preparation of these consolidated financial statements requires us to make estimates and assumptions for the reported amounts of assets, liabilities, revenue, expenses and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions and any such differences may be material. While our significant accounting policies are more fully described in the notes to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following discussion addresses our most critical accounting policies, which are those that are most important to our financial condition and results of operations and require our most difficult, subjective and complex judgments. Stock-Based Compensation Expense We are required to determine the fair value of equity incentive awards and recognize compensation expense for all equity incentive awards, including employee stock options and restricted stock units. We recognize this expense over the requisite service period. In addition, we recognize stock-based compensation expense in the statements of operations based on awards expected to vest and, therefore, the amount of expense has been reduced for estimated forfeitures. We use the ratable straight-line method for expense attribution. The valuation model we used for calculating the fair value of stock options for stock-based compensation expense is the Black-Scholes option-pricing model, or the Black-Scholes model. The Black-Scholes model requires us to make assumptions and judgments about the variables used in the calculation, including: • Expected term. We do not believe we are able to rely on our historical exercise and post-vesting termination activity to provide accurate data for estimating the expected term for use in determining the fair value-based measurement of our options. Therefore, we have opted to use the “simplified method” for estimating the expected term of options, which is the average of the weighted-average vesting period and contractual term of the option. • Expected volatility. Due to the lack of a public market for the trading of our common stock prior to our IPO and a lack of company specific historical volatility, we have determined the share price volatility for options granted based on an analysis of the volatility of a peer group of publicly traded companies. In evaluating similarity, we consider factors such as stage of development, risk profile, enterprise value and position within the industry. • Risk-free interest rate. The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of the grant for zero-coupon U.S. Treasury notes with remaining terms similar to the expected term of the options. • Dividend rate. We assumed the expected dividend to be zero as we have never paid dividends and have no current plans to do so. • Expected forfeiture rate. We estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures and record share-based compensation expense only for those awards that are expected to vest. • Service period. We amortize all stock-based compensation over the requisite service period of the awards, which is generally the same as the vesting period of the awards. We amortize the stock-based compensation cost on a straight-line basis over the expected service periods. Restricted stock units are valued at the fair market value per share of our common stock on the date of grant. Research and Development Expenses As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued R&D expenses as of each balance sheet date. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed or when contractual milestones are met. We make estimates of our accrued expenses as of each balance sheet date based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued R&D expenses include the costs incurred for services performed by our vendors in connection with R&D activities for which we have not yet been invoiced. We base our expenses related to R&D activities on our estimates of the services received and efforts expended pursuant to quotes and contracts with vendors that conduct R&D on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the R&D expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid accordingly. Advance payments for goods and services that will be used in future R&D activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there has been no material differences between our estimates of such expenses and the amounts actually incurred. JOBS ACT ACCOUNTING ELECTION In April 2012, the Jumpstart Our Business Startups Act of 2012, or JOBS Act, was enacted. Section 107 of the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies. This election is irrevocable. NEW ACCOUNTING PRONOUNCEMENTS From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board, or FASB, or other standard setting bodies that are adopted by us as of the specified effective date. Unless otherwise discussed, we believe that the impact of recently issued standards that are not yet effective will not have a material impact on our financial position or results of operations upon adoption. A description of recently issued accounting pronouncements that may potentially impact our financial position and results of operations is disclosed in Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K.

<s>[INST] OVERVIEW We are a pharmaceutical company focused on developing and commercializing products that have the potential to optimize the delivery of infused therapies, advance patient care and reduce healthcare costs. Our strategy is designed to enable the subcutaneous administration of therapies that have previously been limited to intravenous, or IV, delivery. By moving delivery away from the highcost healthcare settings typically required for IV administration, we believe our technology has the potential to reduce overall healthcare costs and advances the quality and convenience of care. Our lead product candidate, FUROSCIX, consists of our novel formulation of furosemide delivered subcutaneously via an onbody infusor and is under development for treatment of congestion in patients with worsening heart failure who display reduced responsiveness to oral diuretics and do not require hospitalization. We filed a new drug application, or NDA, for FUROSCIX, with the U.S. Food and Drug Administration, or FDA, in August 2017. On June 11, 2018 we received a Complete Response Letter, or CRL, from the FDA for our NDA, which indicated that, among other things, certain device modifications to our infusor were required. Based on our interactions with the FDA, which required clarification on an additional dose validation study and device modifications necessary to advance FUROSCIX using the existing technology, we decided to transition to our next generation device. Our next generation device is being developed through a partnership with West Pharmaceutical Services, Inc., or West, using its proprietary, wearable, SmartDose drug delivery system. We held a Type C meeting with the FDA on June 18, 2019 and based on the results of that meeting we anticipate resubmission of the FUROSCIX NDA with the SmartDose drug delivery system by midyear 2020. Since our inception in February 2013, we have devoted substantially all of our resources to organizing and staffing our company, business planning, raising capital, planning for commercialization, and conducting discovery, research and development activities for our product candidates. We do not have any products approved for sale and have not generated any revenue from product sales. From inception through December 31, 2019, we had received net cash proceeds of $92.7 million from our initial public offering in November 2017, net cash proceeds of $56.7 million from sales of our preferred stock, net cash proceeds of $18.8 million from borrowings under our term loan, net cash proceeds of $13.5 million from sales of convertible notes and net cash proceeds of $4.0 million from the sale of common stock in our 2019 atthemarket offering. For the years ended December 31, 2018 and 2019, our net losses were $29.4 million and $33.0 million, respectively. We have not been profitable since inception, and as of December 31, 2019, our accumulated deficit was $129.5 million. We expect to continue to incur net losses for the foreseeable future as we develop the infrastructure to commercialize our products, if approved, in the United States, including building our sales and marketing organization, continuing research and development efforts, engaging in scaleup manufacturing and seeking regulatory approval for new product candidates and enhancements. We will need additional funding to pay expenses related to our operating activities, including selling, general and administrative expenses and research and development expenses. Adequate funding may not be available to us on acceptable terms, or at all. Our failure to obtain sufficient funds on acceptable terms when needed could have a material adverse effect on our business, results of operations or financial condition. COMPONENTS OF OUR RESULTS OF OPERATIONS Research and Development Expenses Research and development, or R&D, expenses consist of the cost of engineering, clinical trials, regulatory and medical affairs and quality assurance associated with developing our proprietary technology and product candidates. R&D expenses consist primarily of: employeerelated expenses, including salaries, benefits, travel expense and stockbased compensation expense; cost of outside consultants who assist with technology development, regulatory affairs, clinical trials and medical affairs, and quality assurance; [/INST] Positive. </s>

Victory Capital Holdings, Inc.

2018-03-29

2017-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the "Selected Financial Data" and our consolidated financial statements and related notes thereto included elsewhere in this report. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management's expectations. Factors that could cause such differences are discussed in the sections entitled "Forward-Looking Statements" and "Risk Factors." We are not undertaking any obligation to update any forward-looking statements or other statements we may make in the following discussion or elsewhere in this document even though these statements may be affected by events or circumstances occurring after the forward-looking statements or other statements were made. Therefore, no reader of this document should rely on these statements being current as of any time other than the date of this report. Overview We are an independent investment management firm operating a next generation, integrated multi-boutique model with $61.8 billion in AUM as of December 31, 2017. Our differentiated model features a scalable operating platform that provides centralized distribution, marketing and operations infrastructure to our select group of Franchises. Our earnings are primarily driven by asset-based fees charged for services related to the investment strategies we deliver and consist of investment management, fund administration and distribution fees. We sell our products through our centralized distribution model with 96 professionals across both our institutional and retail distribution channels and marketing organization. We distribute our products through broker-dealers, retirement platforms and RIA networks. Our institutional sales team focuses on cultivating relationships with institutional consultants, who account for the majority of the institutional market, as well as mutual fund complexes seeking sub-advisers. Our retail sales team offers intermediary and retirement platform clients mutual funds and ETFs as well as SMAs through wrap fee programs and access to our investment models through UMAs. We have grown our AUM from $17.9 billion following the management-led buyout with Crestview GP from KeyCorp in August 2013 to $61.8 billion at December 31, 2017. We attribute this growth to our success in sourcing and executing acquisitions, generating strong investment returns, and developing retail and institutional distribution channels with deep penetration. Company History On August 1, 2013, our management team and employees along with Crestview GP purchased all of the outstanding stock of VCM and VCA from KeyCorp. Following the acquisition, taking into account post-closing outflows, Victory had $17.9 billion in AUM, consisting of $13.7 billion in U.S. equities, $1.3 billion in international and global equities and $2.9 billion in fixed income. The investment teams consisted of the Sycamore, Expedition, NewBridge Asset Management, or NewBridge, and Diversified Franchises and included short government and investment grade convertible capabilities, which are currently part of the INCORE Capital Management, or INCORE, Franchise. On October 31, 2014, we acquired Munder Capital. Munder Capital was an institutional investment management firm providing domestic and international equity, as well as fixed income investment solutions. The Munder Acquisition increased our AUM by $18.1 billion. The Munder Capital AUM consisted of $14.4 billion in U.S. equities, $0.7 billion in international and global equities and $3.0 billion in fixed income. The Munder, Integrity and Trivalent Franchises joined us as a result of the Munder Acquisition. In addition, Munder Capital had a core fixed income team that we combined with our short government and investment grade convertible teams to form the current INCORE Franchise. As a result of integrating the Munder Capital business onto our operating platform, we achieved approximately $23 million in annualized expense synergies. On April 30, 2015, we acquired the business of CEMP. CEMP provided rules-based investment products that combine fundamental criteria with a long-term volatility-weighted investment philosophy through a series of mutual funds and ETF offerings. With CEMP, we acquired $1.0 billion of rules-based AUM. The CEMP Acquisition also marked our entry into the ETF marketplace. For each year during the four-year period following the closing, the CEMP sellers are entitled to future payments in fixed amounts, with the fixed amounts increasing over the four-year period, and variable amounts in respect of investment management revenue attributable to the CEMP business. The first earn-out payments were made in 2016. See "-Contractual Obligations" and Note 3 of our audited financial statements included elsewhere in this report. On July 29, 2016, we acquired RS Investments, an SEC-registered investment adviser, and RS Investments' wholly owned subsidiaries. RS Investments provided investment advisory and related services to institutional and retail clients. The RS Acquisition increased our AUM by $16.7 billion at closing. The RS Investments AUM at closing consisted of $10.4 billion in U.S. equities, $0.9 billion in international and global equities, $3.3 billion in fixed income and $2.1 billion in commodities. We added the RS Investments and Sophus Capital Franchises as a result of the acquisition. In addition, the INCORE Franchise began managing two of RS Investments' fixed income strategies that had been sub-advised by a third-party prior to the RS Acquisition, and we acquired two significant sub-advising relationships. As a result of integrating the RS Investments business onto our operating platform, we achieved approximately $52 million in annualized net expense synergies as of December 31, 2017 ($2.5 million of which was not reflected in our earnings as of such date). On February 12, 2018, we issued 11,700,000 shares of Class A common stock in the IPO at a price of $13.00 per share. On March 13, 2018, the Company issued an additional 1,110,860 shares of Class A common stock pursuant to the underwriters' exercise of their option. The net proceeds totaled $156.5 million: $143.0 million received at the closing of the IPO and $13.5 million received at the subsequent closing of the underwriters' exercise of their option, after deducting in each case underwriting discounts. Net proceeds received from the IPO and the Credit Agreement of $143.0 million and $355.9 million, respectively, were used concurrent with the closing of the IPO, together with $0.8 million of cash on hand, to repay the $499.7 million of outstanding term loans under the 2014 Credit Agreement. On February 21, 2018, the Company repaid $10.0 million of outstanding term loans under the Credit Agreement, and on March 19, 2018, the Company used the net proceeds from the underwriters' exercise of their option and cash on hand to repay an additional $27.0 million of the outstanding term loans under the Credit Agreement. See Note 20 of our audited financial statements included elsewhere in this report. Highlights for 2017 2017 business and financial highlights included: • AUM was $61.8 billion at December 31, 2017 compared to $55.0 billion at December 31, 2016, up 12% driven primarily by market appreciation. We had strong growth in gross flows and saw negative net flows primarily due to the decision to exit the Diversified Equity Franchise and client reallocations due to strong investment performance. We generated $16.9 billion in gross flows and ($1.5) billion in negative net flows for the year ended December 31, 2017 compared to $16.0 billion and $0.9 billion, respectively, for the year ended December 31, 2016. • Our Franchises had strong investment performance. As of December 31, 2017, 24 of our mutual funds and ETFs have overall Morningstar ratings of four or five stars and 66% of our fund AUM was rated four or five stars by Morningstar. As of December 31, 2017, 80% of our strategies by AUM had returns in excess of their respective benchmarks over a ten-year period, 84% over a five-year period and 84% over a three-year period. On an equal-weighted basis, 75% of our strategies have outperformed their benchmarks over a ten-year period, 77% over a five-year period and 72% over a three-year period. • The industry recognized us for our achievements. We were ranked #1 for Institutional Brand Awareness among asset managers with between $25 billion and $50 billion in AUM in 2015 and #4 for Institutional Brand Awareness among asset managers with between $50 billion and $100 billion in both 2016 and 2017 by eVestment. We ranked 10th in Barron's Best Fund Families for 2017. This is the fourth consecutive year that we have been ranked among the top 25 fund families by Barron's. • We completed the integration of the RS Investments business onto our operating platform and we achieved approximately $52 million in net annualized expense synergies as of December 31, 2017 ($2.5 million of which was not reflected in our earnings as of such date). • Total revenue for the year ended December 31, 2017 was $409.6 million compared to $297.9 million for the year ended December 31, 2016. • Net income was $25.8 million for the year ended December 31, 2017 compared to net loss of ($6.1) million for the year ended December 31, 2016. • Adjusted EBITDA was $149.1 million for the year ended December 31, 2017 compared to $98.1 million for the year ended December 31, 2016. See "-Supplemental Non-GAAP Financial Information" for more information about how we calculate Adjusted EBITDA and a reconciliation of net income to Adjusted EBITDA. • Adjusted Net Income was $61.9 million for the year ended December 31, 2017 compared to $39.0 million for the year ended December 31, 2016. See "-Supplemental Non-GAAP Financial Information" for more information about how we calculate Adjusted Net Income and a reconciliation of net income to Adjusted Net Income. Key Performance Indicators When we review our performance we focus on the indicators described below: (1)Total net flows including Diversified were ($1,471), $875, ($2,776) for the years ended December 31, 2017, 2016 and 2015. See "Business-Our Franchises-Munder Capital Management." (2)Our management uses Adjusted EBITDA and Adjusted Net Income to measure the operating profitability of the business. These measures eliminate the impact of one-time acquisition, restructuring and integration costs and demonstrate the ongoing operating earnings metrics of the business. These measures are explained in more detail and reconciled to net income calculated in accordance with GAAP in "-Supplemental Non-GAAP Financial Information." (3)Adjusted EBITDA margin represents Adjusted EBITDA as a percentage of total revenue. (4)Represents the tax benefits associated with deductions allowed for intangibles and goodwill generated from prior acquisitions in which we received a step-up in basis for tax purposes. Acquired intangible assets and goodwill may be amortized for tax purposes, generally over a 15-year period. The tax benefit from amortization on these assets is included to show the full economic benefit of deductions for all acquired intangibles with a step-up in tax basis. Due to our acquisitive nature, tax deductions allowed on acquired intangible assets and goodwill provide us with a significant supplemental economic benefit. On December 22, 2017, the Tax Cuts and Jobs Act ("Tax Act") was enacted. The Tax Act significantly revises the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. As a result of the reduction in the corporate income tax rate, we are required to remeasure our U.S. net deferred taxes at December 31, 2017. The impact of the remeasurement resulted in a one-time credit to income tax expense of $2.4 million for the three months and year ended December 31, 2017. Effective January 1, 2018, we estimate the impact of the Tax Act will lower our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 24% thus lowering our income tax expense beginning in calendar year 2018. The reduction in our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 24% will also reduce the tax benefit of goodwill and acquired intangible assets beginning in 2018. Assets Under Management Our profitability is largely affected by the level and composition of our AUM (including asset class and distribution channel) and the effective fee rates on our products. The amount and composition of our AUM are, and will continue to be, influenced by a number of factors, including: • investment performance, including fluctuations in the financial markets and the quality of our investment decisions; • client flows into and out of our various strategies and investment vehicles; • industry trends toward products or strategies that we either do or do not offer; • our ability to attract and retain high quality investment, distribution, marketing and management personnel; • our decision to close strategies or limit growth of assets in a strategy when we believe it is in the best interest of our clients or conversely to re-open strategies in part or entirely; and • general investor sentiment and confidence. Our goal is to establish and maintain a client base that is diversified by Franchise and Solutions Platform, asset class, distribution channel and vehicle. The chart below sets forth our AUM by Franchise and Solutions Platform as of December 31, 2017: (1)Includes assets managed by Diversified, which were transferred to Munder on May 15, 2017. See "Business-Our Franchises-Munder Capital Management." The following table presents our AUM by asset class as of the dates indicated: (1)Includes the impact of the RS Acquisition, which closed on July 29, 2016, and increased our AUM by $16.7 billion. (2)Includes the impact of the CEMP Acquisition, which closed on April 30, 2015, and increased our AUM by $1.0 billion. (3)Includes the impact of the Munder Acquisition, which closed on October 31, 2014, and increased our AUM by $18.1 billion. (4)Represents the AUM acquired in our management-led buyout with Crestview GP from KeyCorp, which closed on July 31, 2013, taking into account post-closing outflows. The following table summarizes our asset flows by asset class for the periods indicated: (1)Includes Diversified. See "Business-Our Franchises-Munder Capital Management." (2)Reflects transfer of $5.0 million in assets from U.S. mid cap Equity to Other effective January 1, 2016. (3)Includes the impact of the RS Acquisition, which closed on July 29, 2016, and increased our AUM by $16.7 billion. (4)Reflects the impact of the CEMP Acquisition, which closed on April 30, 2015, and increased our AUM by $1.0 billion. In connection with the retirement of our two CIOs at Diversified, we made the strategic decision to exit this Franchise and move the remaining AUM into our Munder Franchise, which was completed as of May 15, 2017. The following table presents the impact of Diversified on net client cash flows for the periods indicated. Given this decision, we believe this presentation is a better representation of our business on a going-forward basis. The following table presents our AUM by distribution channel as of the dates indicated: (1)The allocation of AUM by distribution channel involves the use of estimates and the exercise of judgment. The following table summarizes our asset flows by vehicle for the periods indicated: (1)Includes institutional and retail share classes. (2)Includes institutional separate accounts, collective trust funds, wrap program separate accounts and UMAs. (3)Includes the impact of the RS Acquisition, which closed on July 29, 2016, and increased our AUM by $16.7 billion. (4)Reflects the impact of the CEMP Acquisition, which closed on April 30, 2015, and increased our AUM by $1.0 billion. At December 31, 2017, our total AUM was $61.8 billion, an increase of $6.8 billion, or 12% compared to $55.0 billion at December 31, 2016. The change in AUM during the year ended December 31, 2017 reflects net market appreciation of $8.4 billion, net outflows of ($1.5) billion and a ($0.1) billion reduction primarily related to mutual fund liquidation. Excluding the impact of outflows from Diversified, net outflows would have been ($0.9) billion for the period. The net outflows were primarily a result of ($1.5) billion net outflows in our U.S. large cap equity strategies, ($1.1) billion in our U.S. small cap equity strategies, ($0.5) billion in our commodity strategies, ($0.4) billion in our global / non-U.S. equity strategies and ($0.4) billion in our fixed income strategies, which was partially offset by $1.3 billion of net inflows in our U.S. mid cap equity strategies and $1.1 billion in our Solutions Platform. At December 31, 2016, our total AUM was $55.0 billion, an increase of $21.9 billion, or 66%, compared to $33.1 billion at December 31, 2015. In addition to the RS Acquisition, which accounted for an increase in AUM of $16.7 billion as of the closing on July 29, 2016, the change in AUM during the year ended December 31, 2016 reflects net market appreciation of $4.4 billion and net inflows of $0.9 billion. The change in AUM during the year ended December 31, 2015 reflects net market depreciation of ($1.0) billion and net outflows of ($2.8) billion partially offset by the addition of $1.0 billion of AUM as a result of the CEMP Acquisition. For the year ended December 31, 2016, our net inflows were $0.9 billion. Excluding the impact of outflows from Diversified, net inflows would have been $2.3 billion in 2016. The net inflows were primarily a result of $3.1 billion of net inflows in our U.S. mid cap equity strategies, $0.5 billion in our global / non-U.S. equity strategies and $0.2 billion in our Solutions Platform, which was largely offset by ($1.7) billion net outflows in our U.S. large cap equity strategies, ($0.8) billion in our fixed income strategies and ($0.3) billion in our commodity strategies. For the year ended December 31, 2015, our net outflows were ($2.8) billion primarily due to ($2.9) billion net outflows in our U.S. large cap equity strategies. Excluding the impact of outflows from Diversified, net outflows would have been ($0.9) billion in 2015. GAAP Results of Operations Our GAAP revenues principally consist of: i.Investment management fees, which are based on our overall weighted average fee rate charged to our clients and our level of AUM; and ii.Fund administration and distribution fees, which are asset-based fees earned from open-end mutual funds for administration and distribution services. Investment Management Fees Investment management fees are earned from managing clients' assets. Our investment management fee revenue fluctuates based on a number of factors, including the total value of our AUM, the composition of AUM across investment strategies and vehicles, changes in the investment management fee rates on our products and the extent to which we enter into fee arrangements that differ from our standard fee schedule. Investment management fees are earned based on a percentage of AUM as delineated in the respective investment management agreements. Approximately 87% of our management fees are calculated based on daily average AUM with the remainder calculated based on monthly average AUM or point in time AUM. Fund Administration and Distribution Fees Fund administration fees are asset-based fees earned from open-end funds for administration services. Fund administration fees fluctuate based on the level of average open-end AUM and the fee rates charged for these services. Fund distribution fees are asset-based fees earned from open-end funds for distribution services. Fund distribution fees fluctuate based on the level of average open-end AUM and the composition of those assets across share classes that pay varying levels of fund distribution fees. Our GAAP expenses principally consist of: i.Personnel compensation and benefits; ii.Distribution and other asset-based expenses; iii.General and administration expenses; iv.Depreciation and amortization charges; and v.Acquisition-related costs and restructuring / integration costs. Personnel Compensation and Benefits Personnel compensation and benefits is our most significant category of expense. Personnel compensation and benefits consists of (i) salaries, payroll related taxes and employee benefits, (ii) incentive compensation, (iii) sales-based compensation, (iv) compensation expense related to equity awards granted to employees and (v) acquisition-related compensation in the form of cash retention bonuses. Incentive compensation is the largest component of the total compensation of our employees. The aggregate amount of cash incentive compensation is funded by a pool that is based on a percentage of total Company earnings (before taking into account incentive compensation). This incentive pool is used to pay the investment teams a percentage of the revenue earned by their respective Franchise on a quarterly basis. This incentive pool is also used to pay incentive compensation to senior management and other non-investment employees on an annual basis. Incentive compensation paid to senior management and to other non-investment employees is discretionary and subjectively determined based on Company and individual performance and the total amount of the incentive compensation pool. Distribution and Other Asset-based Expenses Distribution and other asset-based expenses consists of (i) broker-dealer distribution fees and platform distribution fees, (ii) fund expense reimbursements to affiliates and (iii) sub-administration, sub-advisory and middle-office expenses. Broker-dealer distribution fees are paid by VCA as the broker-dealer for the Victory Funds to third-party distributors. The Victory Funds pay VCA for distribution services and VCA, in turn, pays third-party distributors. Platform distribution fees are paid by VCM as the investment adviser to the Victory Funds. Platform distribution fees are paid to financial advisors, retirement plan providers and intermediaries for servicing and administering accounts invested in shares of the Victory Funds. Distribution fees typically vary based on the level of AUM and the composition of those assets across share classes. Fund expense reimbursements result from VCM, as investment adviser for the Victory Funds and VictoryShares, agreeing to cap the annual operating expenses for certain share classes of the Victory Funds and VictoryShares. VCM has contractually agreed to reimburse the Victory Funds and VictoryShares for expenses in excess of these caps but may recoup these reimbursements for a period of time if the applicable Fund's share class expenses and/or VictoryShares ETF expenses fall below the cap. Sub-administration, sub-advisory and middle-office expenses consist of fees paid to our sub-administrator of the Victory Funds, fees paid to sub-advisers on certain Victory Funds and fees paid to vendors to which we outsource middle-office functions. • VCM acts as the administrator to the Victory Funds and VictoryShares. VCM has hired a sub-administrator, the fees for which are captured in sub-administration expense. As administrator, VCM supervises the operations of the Victory Funds and VictoryShares, including the services provided by the sub-administrator. The sub-administrator is paid through a contractual arrangement based on a percentage of the average open-end mutual fund AUM. • VCM, as the investment adviser for the Victory Funds, has hired unaffiliated sub-advisers to manage funds for which we do not have in-house capabilities. The fees paid to the sub-advisers are contractual based on a percentage of assets that they manage. • We have outsourced middle-office operations to achieve a scalable operational infrastructure that utilizes a variable-cost model. We have selected to partner with top-tier vendors who perform trade operations, portfolio accounting and performance measurement with oversight from our operations team. The fees paid to these vendors are variable and structured based on the number of accounts, assets and specific services performed. General and Administrative Expenses General and administrative expenses primarily consist of investment research and technology costs, professional and marketing fees, travel, rent and insurance expenses. Depreciation and Amortization Depreciation and amortization expense consists primarily of the depreciation of property and equipment as well as the amortization of acquired intangibles that have a definite life. These intangibles include customer relationships, investment advisory contracts, intellectual property and non-compete clauses acquired in connection with a business or asset acquisition. Both depreciation and amortization are recorded ratably over the assets' useful lives. Acquisition-Related Costs Acquisition-related costs include legal fees, advisory services, mutual fund proxy voting costs and other one-time expenses related to acquisitions. Restructuring and Integration Costs Restructuring and integration costs include costs incurred in connection with business combinations, asset purchases and changes in business strategy. These include severance related expenses related to one-time benefit arrangements, contract termination and other costs to integrate investment platforms, products and personnel into existing systems, processes and service provider arrangements and restructure the business to capture operating expenses synergies. Other non-operating items of income and expense consist of: i.Interest expense and other financing costs; and ii.Income tax (expense)/benefit. Interest Expense and Other Financing Costs Interest expense and other financing costs consists primarily of interest expense attributable to long-term debt. See "-Liquidity and Capital Resources" for more information. Income Tax (Expense)/Benefit The provision for income taxes includes U.S. federal, state and local taxes, and following the RS Acquisition in 2016, foreign income taxes payable by certain of our subsidiaries. The effective tax rate is primarily driven by state and local taxes and permanent differences related to meals and entertainment. The portion of the effective income tax rate attributable to state and local income taxes varies from year to year depending on amounts of income apportioned to each jurisdiction, whether we file income tax returns on a unitary or separate return basis and with changes in tax laws. Our GAAP results of operations were as follows for the years ended December 31, 2017 and 2016. Investment Management Fees Investment management fees increased $95.3 million, or 38%, for the year ended December 31, 2017 compared to the year ended December 31, 2016 due to an increase in AUM year over year. AUM increased by $6.8 billion to $61.8 billion at December 31, 2017 from $55.0 billion at December 31, 2016, due to $8.4 billion of market appreciation partially offset by $1.5 billion of net outflows and a $0.1 billion reduction primarily related to mutual fund liquidations during the 12 months ended December 31, 2017. Fund Administration and Distribution Fees Fund administration and distribution fees totaled $65.8 million for the year ended December 31, 2017, an increase of $16.4 million, or 33%, when compared to the year ended December 31, 2016, due to an increase in open-end mutual fund AUM. Open-end mutual fund daily average AUM grew by $12.0 billion from $24.2 billion for the year ended December 31, 2016 to $36.2 billion for the year ended December 31, 2017 due primarily to the RS Acquisition (which was completed in July 2016 and included $13.2 billion of open-end mutual fund AUM at the date of acquisition). The increase in fees due to higher average AUM was partially offset by a reduction in the fee rate earned for administrative services. The administrative fee schedule is tiered such that the average fee rate earned declines as AUM increase. Personnel Compensation and Benefits The following table presents the components of GAAP compensation expense for the year ended December 31, 2017 and 2016: (1)Represents sales-based commissions paid to our distribution teams. Sales-based compensation varies based on gross client cash flows and revenue earned on sales. (2)Equity awards typically vest over several years based on service and the achievement of specific business and financial targets. The value of the equity awards are recognized as compensation expense over the vesting period. Personnel compensation and benefits was $144.1 million for the year ended December 31, 2017, an increase of $21.5 million, or 18%, from $122.6 million for the year ended December 31, 2016. Salaries and benefits was $49.7 million for the year ended December 31, 2017, an increase of $6.7 million, or 16%, from $43.0 million for the year ended December 31, 2016. This increase reflects the effect of increased headcount due to the RS Acquisition as well as new hires and annual salary increases. Incentive compensation was $66.0 million for the year ended December 31, 2017, an increase of $14.3 million, or 28%, from $51.7 million for the year ended December 31, 2016, due to higher pre-incentive compensation earnings and the effect of the RS Acquisition. Sales-based compensation was $15.0 million for the year ended December 31, 2017, an increase of $2.3 million, or 18%, from $12.7 million for the year ended December 31, 2016, as a result of higher gross flows and revenue. Equity award expense was $11.8 million for the year ended December 31, 2017, an increase of $3.0 million, or 34%, from $8.8 million for the year ended December 31, 2016, due to the equity awards to RS Investments employees in connection with the RS Acquisition and pre-existing awards that are still being expensed. Acquisition-related compensation was $1.6 million for the year ended December 31, 2017, a decrease of $4.8 million from $6.4 million for the year ended December 31, 2016, due to cash retention payments made in 2016 to former RS Investments employees in connection with the RS Acquisition and the impact of certain one-time compensation costs related to the integration of the RS Investments business onto our platform. Distribution and Other Asset-based Expenses Broker-dealer and platform distribution expenses along with fund expense reimbursements, sub-administration, sub-advisory and middle-office expenses are based on AUM. The following table presents the components of distribution and other asset-based expenses for the year ended December 31, 2017 and 2016: Distribution and other asset-based expenses are primarily based on percentages of AUM and increased by $25.9 million, or 33%, to $103.4 million for the year ended December 31, 2017, from $77.5 million for the year ended December 31, 2016, due to higher average open-end mutual fund AUM and an increase in the cost of third-party distribution. Asset-based expenses associated with fund reimbursements, sub-administration and middle-office outsourcing have increased year over year due to the increase in AUM as a result of the RS Acquisition and market appreciation. The increase in sub-advisory expenses is a result of the RS Acquisition, which included two sub-advisory relationships (Park Avenue and SailingStone). General and Administrative Expenses General and administrative expenses increased by $7.4 million, or 28%, to $34.0 million for the year ended December 31, 2017, from $26.6 million for the year ended December 31, 2016, driven by systems and data costs related to incremental Franchises and additional risk tools as well as database development and marketing costs for new products and ETFs. In addition, included in General and administrative expenses for the year ended December 31, 2017 was $2.1 million of costs related to debt modification as a result of the incremental term loan borrowing of $125 million in February 2017 and the repricing of the term loan in August 2017. Depreciation and Amortization Depreciation and amortization decreased by $0.5 million, or 2%, to $29.9 million for the year ended December 31, 2017, from $30.4 million for the year ended December 31, 2016, primarily due lower amortization of certain intangible assets acquired in connection with the management-led buyout with Crestview GP from KeyCorp that were fully amortized in 2017 partially offset by higher intangible asset amortization as a result of the RS Acquisition. Acquisition-Related Costs Acquisition-related costs decreased by $4.5 million to $2.1 million for the year ended December 31, 2017, from $6.6 million for the year ended December 30, 2016, due to the RS Acquisition costs incurred in the earlier period. Restructuring and Integration Costs Restructuring and integration costs decreased by $3.8 million to $6.2 million for the year ended December 31, 2017, from $10.0 million for the year ended December 31, 2016, due to costs related to the RS Acquisition which occurred in the third quarter of 2016. Included in the $6.2 million for the year ended December 31, 2017 were $3.0 million of loss on disposal of assets, $2.0 million of contract breakage, $0.6 million of severance and $0.6 million of other. Interest Expense and Other Financing Costs Interest expense increased by $14.2 million, or 41%, to $48.8 million for the year ended December 31, 2017, from $34.6 million for the year ended December 31, 2016. This increase was primarily due to incremental term loans incurred under the 2014 Credit Agreement in the amounts of $135.0 million and $125.0 million in July 2016 and February 2017, respectively. We used the proceeds of the incremental term loans to fund the RS Acquisition and associated transaction costs and to pay a dividend to our stockholders. On August 1, 2017, the 2014 Credit Agreement was amended to refinance all existing term loans outstanding, effective as of that date, reducing the spread above LIBOR from 7.50% to 5.25%. Our ongoing interest expense will further decrease as a result of the refinancing of the 2014 Credit Agreement that was completed concurrent with the IPO. The refinancing of the 2014 Credit Agreement reduced the interest rate on our credit agreement borrowings from LIBOR plus 5.25% to LIBOR plus 2.75%. See "-Liquidity and Capital Resources-Debt Refinancing." Income Tax (Expense)/Benefit The provision for income taxes for the year ended December 31, 2017 and 2016 comprises federal and state taxes and, in addition, for the year ended December 31, 2017, foreign income taxes. The difference between our effective tax rate and the statutory federal rate of 35% are state, local and foreign income taxes and non-deductible expenses. On December 22, 2017, the Tax Act was enacted. The Tax Act significantly revises the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. As a result of the reduction in the corporate income tax rate, we are required to remeasure our U.S. net deferred taxes at December 31, 2017. The impact of the remeasurement resulted in a one-time credit to income tax expense of $2.4 million for the three months and year ended December 31, 2017. Effective January 1, 2018, we estimate the impact of the Tax Act will lower our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 24% thus lowering our income tax expense beginning in calendar year 2018. The reduction in our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 24% will also reduce the tax benefit of goodwill and acquired intangible assets beginning in 2018. Our GAAP results of operations were as follows for the years ended December 31, 2016 and 2015. Investment Management Fees Investment management fees increased $46.9 million, or 23%, for the year ended December 31, 2016 compared to 2015 due to an increase in AUM and an increase in realized fee rate of approximately two basis points year over year. This increase was partially offset by a decrease in investment management fees of $8.7 million attributable to Diversified from 2015 to 2016. AUM increased by $21.9 billion from $33.1 billion at December 31, 2015 to $55.0 billion at December 31, 2016, of which $16.7 billion was from the RS Acquisition, $4.4 billion was due to market appreciation and $0.9 billion was from net inflows during the year. Fund Administration and Distribution Fees Fund administration and distribution fees totaled $49.4 million for the year ended December 31, 2016, an increase of $10.2 million, or 26%, when compared to the year ended December 31, 2015, due to an increase in open-end mutual fund AUM. Open-end mutual fund daily average AUM grew by $6.6 billion from $17.6 billion in 2015 to $24.2 billion in 2016 due to the RS Acquisition (which was completed in July 2016 and included $13.2 billion of open-end mutual fund AUM at the date of acquisition). The increase in fees due to higher average AUM was partially offset by a reduction in the fee rate earned for administrative services. The administrative fee schedule is tiered such that the average fee rate earned declines as AUM increase. Personnel Compensation and Benefits The following table presents the components of GAAP compensation expense for the years ended December 31, 2016 and 2015: (1)Represents sales-based commissions paid to our distribution teams. Sales-based compensation varies based on gross client cash flows and revenue earned on sales. (2)Equity awards typically vest over several years based on service and the achievement of specific financial and business targets. The value of the equity awards are recognized as compensation expense over the vesting period. Personnel compensation and benefits was $122.6 million for the year ended December 31, 2016, an increase of $28.8 million, or 31%, from $93.8 million for the year ended December 31, 2015. Salaries and benefits was $43.0 million for the year ended December 31, 2016, an increase of $7.1 million, or 20%, from $35.9 million for the year ended December 31, 2015. This increase reflects the effect of increased headcount due to the RS Acquisition as well as new hires and annual salary increases. Incentive compensation was $51.7 million for the year ended December 31, 2016, an increase of $9.1 million, or 21%, from $42.6 million for the year ended December 31, 2015, due to higher pre-incentive compensation earnings and the effect of the RS Acquisition. Sales-based compensation was $12.7 million for the year ended December 31, 2016, an increase of $4.7 million, or 59%, from $8.0 million for the year ended December 31, 2015, as a result of higher gross flows and revenue. Equity award expense was $8.8 million for the year ended December 31, 2016, an increase of $3.1 million, or 54%, from $5.7 million for the year ended December 31, 2015, due to the equity awards to RS Investments employees in connection with the RS Acquisition, pre-existing awards that are still being expensed and the achievement of certain performance-vesting metrics for other pre-existing awards. Acquisition-related compensation was $6.4 million for the year ended December 31, 2016, an increase of $4.8 million, or 300%, from $1.6 million for the year ended December 31, 2015, due to cash retention payments made in 2016 to former RS Investments employees in connection with the RS Acquisition and the impact of certain one-time compensation costs related to the integration of the RS Investments business onto our platform. Distribution and Other Asset-based Expenses Broker-dealer and platform distribution expenses along with fund expense reimbursements, sub-administration, sub-advisory and middle-office expenses are based on AUM. The following table presents the components of distribution and other asset-based expenses for the years ended December 31, 2016 and 2015: Distribution and other asset-based expenses are primarily based on percentages of AUM and have increased by $26.0 million, or 50%, to $77.5 million for the year ended December 31, 2016, from $51.5 million for the year ended December 31, 2015, due to higher average open-end mutual fund AUM and an increase in the cost of third-party distribution. Asset-based expenses associated with fund reimbursements, sub-advisory, sub-administration and middle-office outsourcing have increased year over year due to the increase in AUM as a result of the RS Acquisition, market appreciation and net inflows in 2016. General and Administrative Expenses General and administrative expenses increased by $3.6 million, or 16%, to $26.6 million for the year ended December 31, 2016, from $23.0 million for the year ended December 31, 2015, driven by systems and data costs related to incremental Franchises and additional risk tools as well as database development and marketing costs for new products and ETFs. Depreciation and Amortization Depreciation and amortization increased by $3.1 million, or 11%, to $30.4 million for the year ended December 31, 2016, from $27.3 million for the year ended December 31, 2015, primarily due to higher intangible asset amortization as a result of the RS Acquisition. Acquisition-Related Costs Acquisition-related costs increased by $3.4 million to $6.6 million for the year ended December 31, 2016, from $3.2 million for the year ended December 31, 2015, due to the RS Acquisition. Restructuring and Integration Costs Restructuring and integration costs increased by $1.4 million to $10.0 million for the year ended December 31, 2016, from $8.6 million for the year ended December 31, 2015 due to costs related to the RS Acquisition in 2016 being higher than similar costs incurred in 2015 related to the CEMP Acquisition as well as the remaining such costs from the Munder Acquisition and other business restructuring costs. Interest Expense and Other Financing Costs Interest expense increased by $8.6 million, or 33%, to $34.6 million for the year ended December 31, 2016, from $26.0 million for the year ended December 31, 2015. This increase was primarily due to incremental term loans incurred under the 2014 Credit Agreement in the amounts of $50.0 million and $135.0 million in May 2015 and July 2016, respectively. We used the proceeds of the incremental term loans to fund the RS Acquisition and associated transaction costs and to pay a dividend to our stockholders. Income Tax (Expense)/Benefit The effective tax rate for 2016 reflects the impact of the state taxes and permanent differences on a pre-tax loss in 2016 compared to pre-tax income in 2015. Effects of Inflation For the years ended December 31, 2017, 2016 and 2015, inflation did not have a material effect on our consolidated results of operations. Inflationary pressures can result in increases to our cost structure, especially to the extent that large expense components such as compensation are impacted. To the degree that these expense increases are not recoverable or cannot be counterbalanced through price increases due to the competitive environment, our profitability could be negatively impacted. In addition, the value of the fixed income assets that we manage may be negatively impacted when inflationary expectations result in a rising interest rate environment. Declines in the values of AUM could lead to reduced revenues as management fees are generally earned as a percentage of AUM. Supplemental Non-GAAP Financial Information Our management uses non-GAAP performance measures to evaluate the underlying operations of our business. Due to our acquisitive nature, there are a number of acquisition and restructuring related expenses included in GAAP measures that we believe distort the economic value of our organization and we believe that many investors use this information when assessing the financial performance of companies in the investment management industry. We have included these non-GAAP measures to provide investors with the same financial metrics used by management to assess the operating performance of our Company. The non-GAAP measures we report are Adjusted EBITDA and Adjusted Net Income. The following table sets forth a reconciliation from GAAP financial measures to non-GAAP measures for the periods indicated: (1)We add back interest paid on debt net of interest income; interest expense is included in "Interest expense and other financing costs" in our consolidated financial statements while interest income is shown in "Interest income and other income" in our consolidated financial statements. (2)We add back depreciation on property and equipment; included in "Depreciation and amortization" in our consolidated financial statements. (3)We add back other business taxes; other business taxes are included in "General and administrative" in our consolidated financial statements. (4)We add back amortization of acquisition-related intangibles; included in "Depreciation and amortization" in our consolidated financial statements. (5)We add back the expense associated with stock-based compensation associated with equity issued from pools that were created in connection with the management-led buyout with Crestview GP from KeyCorp, the Munder Acquisition and the RS Acquisition and as a result of IPO-related equity grants; included in "Personnel compensation and benefits" in our consolidated financial statements. (6)We add back direct incremental costs of acquisitions and the IPO, including expenses associated with third-party advisors, proxy solicitations of mutual fund shareholders for transaction consents, vendor contract early termination costs, impairment of receivables recorded in connection with an acquisition, and severance, retention and transaction incentive compensation. Severance, retention and transaction incentive compensation is included in "Personnel compensation and benefits" in our consolidated financial statements, impairment of receivables recorded in connection with an acquisition is included in "Interest income and other income/(expense)," costs associated with professional services incurred in connection with IPO readiness are included in "General and administrative"; all other incremental costs are included in "Restructuring and integration costs" or "Acquisition-related costs." (7)We add back debt issuance costs; included in "Interest expense and other financing costs" and "General and administrative" in our consolidated financial statements. See "-Liquidity and Capital Resources" for more information. (8)We add back pre-IPO governance expenses paid to Crestview and Reverence Capital, included in "General and administrative" in our consolidated financial statements. These payments terminated as of the completion of the IPO. (9)We adjust for earnings/losses on equity method investments, included in "Interest income and other income/(expenses)" in our consolidated financial statements. (10)Our compensation committee, together with our CEO, establishes a target percentage of our pre-bonus EBITDA to be allocated to employees as annual cash incentive compensation. If, as a result of a significant acquisition, we pay annual cash incentive compensation that is a greater percentage of pre-bonus EBITDA than our target percentage, we add back the amount of the annual incentive cash compensation in excess of the target percentage. For example, in 2016, as a result of the RS Acquisition, we paid incentive cash compensation at a greater percentage of pre-bonus EBITDA than our target percentage. We paid incentive cash compensation in 2016 at levels we considered appropriate taking into account the RS Acquisition (including the size of our Company post-acquisition) without the benefit of a full year of those earnings and before expense synergies were fully realized. We also paid incentive cash compensation on duplicative headcount while the integration of the RS Investments platform was being completed; included in "Personnel compensation and benefits" in our consolidated financial statements. (11)Reflects income taxes of 38% applied to the sum of line items i. to vii.; 38% represents statutory federal income tax rate of 35% plus an estimate for state, local and foreign income taxes. (12)On December 22, 2017, the Tax Act was enacted. The Tax Act significantly revises the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. As a result of the reduction in the corporate income tax rate, we are required to remeasure our U.S. net deferred taxes at December 31, 2017. The impact of the remeasurement was a one-time credit to income tax expense of $2.4 million for the three months and year ended December 31, 2017. (13)Represents the tax benefits associated with deductions allowed for intangibles and goodwill generated from prior acquisitions in which we received a step-up in basis for tax purposes. Acquired intangible assets and goodwill may be amortized for tax purposes, generally over a 15-year period. The tax benefit from amortization on these assets is included to show the full economic benefit of deductions for all acquired intangibles with a step-up in tax basis. Due to our acquisitive nature, tax deductions allowed on acquired intangible assets and goodwill provide us with a significant supplemental economic benefit. Effective January 1, 2018, we estimate the impact of the Tax Act will lower our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 24% thus lowering our income tax expense beginning in calendar year 2018. The reduction in our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 24% will also reduce the tax benefit of goodwill and acquired intangible assets beginning in 2018. Non-GAAP measures should be considered in addition to, and not as a substitute for, financial measures prepared in accordance with GAAP. Our non-GAAP measures may differ from similar measures at other companies, even if similar terms are used to identify these measures. Liquidity and Capital Resources Our primary uses of cash relate to repayment of our debt obligations and funding working capital needs and are expected to be met primarily through cash generated from our operations. The following table shows our liquidity position as of December 31, 2017 and 2016. We manage our cash balances in order to fund our day-to-day operations. Our accounts receivable consist primarily of investment management fees that have been earned but not yet received from clients. Included in other receivables are amounts due under a contract with a third party acquired in connection with the RS Acquisition, net income and other taxes receivable and amounts receivable from the funds. We perform a review of our receivables on a monthly basis to access collectability. The decrease in accounts and other receivables from December 31, 2016 to December 31, 2017 is due primarily to changes in other receivables, including a $14.3 million decrease in amounts due under the contract with a third party acquired in connection with the RS Acquisition (see Note 3 Acquisitions to the Consolidated Financial Statements included elsewhere in this report), $5.3 million decrease in net income taxes receivable and $6.3 million decrease in amounts receivable from the funds and other taxes receivable. The remaining $2.1 million decrease in accounts and other receivables from December 31, 2016 to December 31, 2017 relates to timing of collections of investment management fees invoiced to clients. We also maintained a $25.0 million revolving credit facility, as described below, which had $25.0 million undrawn as of December 31, 2017 and had $21.5 million undrawn as of December 31, 2016. 2014 Credit Agreement As of December 31, 2017, we had $499.7 million aggregate principal amount of outstanding term loans under our credit agreement, dated as of October 31, 2014 (as amended), or the 2014 Credit Agreement. Our 2014 Credit Agreement includes a revolving credit facility and provided for up to $25.0 million of revolving loans and a sublimit of up to $10.0 million of letters of credit. As of December 31, 2017, we had no amounts drawn on our revolving credit facility. Amounts outstanding under our 2014 Credit Agreement bore interest at a rate equal to, at our election, (i) a reserve-adjusted LIBOR rate (which, in the case of the term loans, shall not be less than 1.0% per annum and, in the case of our revolving credit facility, shall not be less than 0.0% per annum) plus an applicable margin of 6.0% per annum for the revolving credit facility and 5.25% for the term loans or (ii) an alternate base rate equal to the highest of (x) the prime rate announced by Morgan Stanley Senior Funding, Inc. from time to time, (y) the federal funds effective rate plus 0.50% and (z) the daily one-month reserve-adjusted LIBOR rate plus 1.0%, plus 5.0% per annum for the revolving credit facility and 4.25% for the term loans. Until the revolving credit facility terminates, we were required to pay each lender thereunder a commitment fee, which accrued at the rate of 0.50% per annum on the average daily unused amount of the revolving commitment of such lender. Under the terms of the 2014 Credit Agreement, we were required to pay an administration fee of $125,000 per year. We used the net proceeds from the IPO, together with proceeds of the Credit Agreement and cash on hand, to repay in full all indebtedness outstanding under our 2014 Credit Agreement. Debt Refinancing On February 12, 2018, concurrently with the closing of the IPO, we entered into a credit agreement, or the Credit Agreement, among the Company, as borrower, the lenders from time to time party thereto, Royal Bank of Canada, as administrative agent and collateral agent, and the other parties thereto, under which we received seven-year term loans in an aggregate principal amount of $360.0 million and established a five-year revolving credit facility (which was unfunded as of closing) with aggregate commitments of $50.0 million (with a $10.0 million sub-limit for the issuance of letters of credit). Subject to certain terms and conditions set forth in the Credit Agreement (including obtaining commitments from one or more new or existing lenders), we may incur additional loans or commitments under the Credit Agreement in an aggregate principal amount of up to $154.0 million (or, if greater, 100% of Consolidated Adjusted EBITDA (as defined in the Credit Agreement) for the most recently ended period of four fiscal quarters), plus certain additional amounts set forth in the Credit Agreement (including an unlimited amount of additional loans or commitments based on achievement of a specified first lien leverage ratio). Amounts outstanding under the Credit Agreement bear interest at an annual rate equal to, at our option, either LIBOR (adjusted for reserves) plus a margin of 2.75% or an alternate base rate plus a margin of 1.75%. We are also required to pay certain fees to the lenders, including, among others, a quarterly commitment fee on the average unused amount of the revolving credit facility. Term loans under the Credit Agreement will amortize at a rate of 1.00% per annum. In addition, the Credit Agreement requires that the term loans be mandatorily prepaid with (a) a percentage (ranging from 0% to 50%, depending on our first lien leverage ratio) of our annual excess cash flow on an annual basis (commencing with the fiscal year ending December 31, 2019), (b) all or a portion of the net cash proceeds of certain asset sales, casualty or condemnation events, subject to customary reinvestment rights, and (c) the proceeds of certain incurrences of indebtedness. At any time, subject to timely prior written notice, we may terminate the commitments under the revolving credit facility in full or in part or prepay term loans in whole or in part, subject to the payment of LIBOR breakage fees, if any, and, in the case of certain prepayments of term loans occurring within the six-month period following closing, a 1.00% premium. Our obligations under the Credit Agreement are guaranteed by all of our domestic subsidiaries (other than Victory Capital Advisers, Inc., our broker-dealer subsidiary), or the Guarantors, and secured by substantially all of the assets of the Company and the Guarantors, subject in each case to certain customary exceptions. The Credit Agreement contains customary affirmative and negative covenants, including covenants that affect, among other things, the ability of us and our subsidiaries to incur additional indebtedness, create liens, merge or dissolve, make investments, dispose of assets, engage in sale and leaseback transactions, make distributions and dividends and prepayments of junior indebtedness, engage in transactions with affiliates, enter into restrictive agreements, amend documentation governing junior indebtedness, modify our fiscal year and modify our organizational documents, subject to customary exceptions, thresholds, qualifications and "baskets." In addition, the Credit Agreement contains a financial performance covenant, requiring a maximum first lien leverage ratio, measured as of the last day of each fiscal quarter on which outstanding borrowings under the revolving credit facility exceed 35.0% of the commitments thereunder (excluding certain letters of credit), of no greater than 4.00 to 1.00. The repayment obligation under the Credit Agreement may be accelerated upon the occurrence of an event of default thereunder, including, among other things, failure to pay principal or interest on a timely basis, material inaccuracy of any representation or warranty, failure to comply with covenants, cross-default, change of control, certain insolvency or bankruptcy-related events and material judgments, subject, in each case, to any applicable grace and/or cure periods. Proceeds from both the term loans under the Credit Agreement and the IPO, as well as cash on hand, were used (i) to repay all indebtedness outstanding under our 2014 Credit Agreement, which was terminated as of closing, and (ii) for the payment of fees, commissions, premiums, expenses and other transaction costs (including original issue discount or upfront fees) payable in connection with the IPO, the Credit Agreement and the transactions related thereto. The proceeds of revolving loans incurred under the Credit Agreement may be used for general corporate purposes, including ongoing working capital requirements. Capital Requirements VCA is a registered broker-dealer subject to the Uniform Net Capital requirements under the Exchange Act, which requires maintenance of certain minimum net capital levels. In addition, we have certain non-U.S. subsidiaries that have minimum capital requirements. As a result, such subsidiaries of our Company may be restricted in their ability to transfer cash to their parents. VCA and our non-U.S. subsidiaries were in compliance with these requirements as of and for the years ended December 31, 2017, 2016 and (to the extent then-owned) 2015. Cash Flows for the Years Ended December 31, 2017, 2016 and 2015 Year Ended December 31, 2017 and 2016 Operating activities provided net cash of $96.2 million and $39.5 million for the years ended December 31, 2017 and 2016, respectively. The $56.7 million increase in net cash provided by operating activities was primarily due to the impact of the RS Acquisition on our earnings. Investing activities consist primarily of acquisitions and sales of property and equipment, as well as the purchase and sales of trading securities related to our deferred compensation plan. Investing activities used net cash of $8.5 million and $210.1 million for the years ended December 31, 2017 and 2016, respectively. The $201.6 million decrease in the net cash used in investing activities was primarily due to the RS Acquisition in August 2016. Financing activities consist primarily of dividend payments to our stockholders, proceeds received or paid from the issuance or repurchase of equity and debt-related activity. For the year ended December 31, 2017, financing activities included, but were not limited to, the incurrence of $125.0 million of incremental term loans under the 2014 Credit Agreement, the payment of a dividend to stockholders in the amount of $135.2 million and the repayment of long-term debt in the amount of $63.9 million. For the year ended December 31, 2016, financing activities included, but were not limited to, the incurrence of $135 million in incremental term loans under the 2014 Credit Agreement and the issuance of $88.3 million of equity, both in connection with the RS Acquisition, and the repayment of long-term debt in the amount of $21.0 million. Financing activities used net cash of $91.3 million for the year ended December 31, 2017. Financing activities generated net cash of $171.8 million for the year ended December 31, 2016. Year Ended December 31, 2016 and 2015 Operating activities provided net cash of $39.5 million and $40.7 million for the years ended December 31, 2016 and 2015, respectively. The $1.2 million decrease in net cash provided by operating activities was primarily due to the one-time, acquisition-related restructuring and integration-related costs incurred as a result of the RS Acquisition. Investing activities consist primarily of acquisitions of businesses and assets and acquisitions and sales of property and equipment. In 2016, investing activities included the RS Acquisition and in 2015 the CEMP Acquisition. Investing activities used net cash of $210.1 million and $20.1 million for the years ended December 31, 2016 and 2015, respectively. The $190.0 million increase in net cash used in investing activities was primarily due to the RS Acquisition. Financing activities consist primarily of dividend payments to our stockholders, proceeds received or paid from the issuance or repurchase of equity and debt-related activity. In 2016, financing activities included the incurrence of $135.0 million of incremental term loans under the 2014 Credit Agreement and the issuance of $88.3 million in equity to finance the RS Acquisition and in 2015 included the incurrence of $50.0 million of incremental term loans under the 2014 Credit Agreement to pay a $50.0 million dividend to our stockholders. Financing activities provided net cash of $171.8 million for the year ended December 31, 2016. Financing activities used net cash of $31.1 million for the year ended December 31, 2015. The $202.9 million increase in net cash from financing activities was related to the incurrence of $135.0 million in incremental indebtedness under the term loans under our 2014 Credit Agreement and the issuance of $88.3 million of equity related to the RS Acquisition in July 2016. Contractual Obligations The following summarizes our contractual obligations as of December 31, 2017: (1)The total principal payments on borrowings reflects the gross amount of principal outstanding on the term loans under the 2014 Credit Agreement as of December 31, 2017. Net proceeds received from the IPO and the Credit Agreement of $143.0 million and $355.9 million, respectively, were used concurrent with the closing of the IPO, together with $0.8 million of cash on hand, to repay the $499.7 million of outstanding term loans under the 2014 Credit Agreement. On February 21, 2018, the Company repaid $10.0 million of outstanding term loans under the Credit Agreement, and on March 18, 2018, the Company used the net proceeds from the underwriters' exercise of their option and cash on hand to repay an additional $27.0 million of the outstanding term loans under the Credit Agreement. After giving effect to such repayments, the current gross amount of term loans outstanding under the Credit Agreement is $323.0 million. (2)The total interest payable reflects the interest due on the principal outstanding on the term loans under the 2014 Credit Agreement as of December 31, 2017 using the 6.82% interest rate in effect on that date. The current interest rate on the term loans outstanding under the Credit Agreement decreased to 4.40% as of February 12, 2018, which is subject to adjustment as described herein. Off-Balance Sheet Arrangements In connection with dividends declared in May 2015, November 2015, February 2017 and December 2017, holders of restricted stock awards that were unvested at the time such dividends were declared are entitled to be paid the dividends as and when the restricted stock vests. Holders of stock options that were unvested at the time the November 2015 dividend was declared are entitled to receive a cash bonus equivalent of the November 2015 dividend as and when their stock options vest. These amounts are not recorded as a liability until and unless the awards vest in accordance with their respective agreements. As of December 31, 2017, the cash bonuses and distributions related to the May 2015, November 2015, February 2017 and December 2017 dividends on restricted shares and options that are expected to vest in the future totaled $2.0 million. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with GAAP. In preparing the financial statements, we are required to make estimates, judgments and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. We continually evaluate the accounting policies and estimates we use to prepare our consolidated financial statements. In general, our estimates are based on historical experience, information from third-party valuation professionals and various other assumptions that we believe to be reasonable under the facts and circumstances. Actual results may differ from our estimates and those differences may be material. Of the significant accounting policies described in Note 2 to the audited consolidated financial statements included in this report, we believe the following policies involve a higher degree of judgment and complexity. Indefinite-lived Intangible Assets The accounting for indefinite-lived intangible assets requires significant estimates and judgment in several areas: (1) valuation in connection with the initial purchase price allocation; (2) ongoing evaluation for impairment; and (3) reconsideration of an asset's useful life. The process of determining the fair value of identifiable intangible assets at the date of acquisition utilizes an income approach and requires significant estimates and judgment as to expectations for earnings on the related managed assets acquired, redemption rates, growth rates from sales efforts, the effects of market conditions and a discount rate. The process for estimating the fair value of acquired trade names considers comparable royalty rates and projected revenue streams. We typically utilize an independent valuation expert to assist with these valuations. Because the advisory and distribution contracts are with the funds, renewable annually and have a history of being renewed, industry practice under GAAP is to consider the contract lives to be indefinite and, as a result, not amortizable. Indefinite-lived intangible assets are reviewed for impairment annually as of October 1 using a qualitative approach which requires the weighing of positive and negative evidence collected through the consideration of various factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired. We consider macroeconomic and entity-specific factors, including changes to legal, regulatory or contractual provisions of the renewable advisory and distribution contracts, the effects of obsolescence, demand, competition and other economic factors that could impact the funds' projected performance and the existence or expectation of significant changes in the level and mix of managed assets. In addition, we consider whether events or circumstances indicate that a change in the useful life may have occurred. Indicators of a possible change in useful life monitored by us generally include changes in the use of the asset, a significant decline in the level of managed assets and significant reductions in underlying operating cash flows. If actual changes in the underlying managed assets or other conditions, such as redemption rates or changes to contractual provisions, indicate that it is more likely than not that the asset is impaired, or if the estimated useful life is reduced, we estimate the fair value of the intangible asset. The process of estimating the fair value of the intangible asset requires us to estimate the level and mix of managed assets, considering future redemption rates, growth rates, market appreciation/depreciation and a discount rate. If the carrying value of the intangible asset exceeds its fair value, we recognize an impairment charge equal to that excess. Definite-Lived Intangible Assets Definite-lived intangible assets are primarily comprised of customer relationships. These assets have definite lives given the underlying advisory contracts are between the Company and an institutional customer or the underlying advisory contract with the fund does not have a sufficient history of annual renewal to support an indefinite useful life. We monitor the useful lives of definite-lived intangible assets and revise the useful lives, if necessary, based on the circumstances. We review historical and projected attrition rates and other events that may influence our projections of the future economic benefit that we will derive from these relationships. Significant judgment is required to estimate the period during which these assets will contribute to our cash flows and the pattern over which these assets will be consumed. A change in the remaining useful life of any of these assets could have a significant impact on our amortization expense. All amortization expense is calculated on a straight-line basis. We periodically evaluate the remaining useful lives and carrying values of the definite-lived intangible assets to determine whether events and circumstances indicate that a change in the useful life or impairment in value may have occurred. Indicators of impairment monitored by us include a decline in the level of managed assets, changes to contractual provisions underlying certain intangible assets and reductions in underlying operating cash flows. If there is an indication of a change in the useful life or impairment in value of the definite-lived intangible assets, we compare the carrying value of the asset to the projected undiscounted cash flows expected to be generated from the underlying asset over its remaining useful life to determine whether impairment has occurred. If the carrying value of the asset exceeds the undiscounted cash flows, the asset is written down to its fair value determined by discounting the projected cash flows. Goodwill Goodwill represents the excess of the purchase price of acquisitions over the fair value of identified net assets and liabilities acquired. We have determined that we have only one reporting unit for purposes of assessing the carrying value of goodwill. Goodwill impairment testing is performed at the reporting unit level annually or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. We complete our annual goodwill impairment assessment as of October 1. For purposes of this assessment, we consider various qualitative factors, including but not limited to, AUM levels and flows, market performance of our products compared to peers, turnover of key personnel, projected operating results and the implied fair value of our business based on recent transactions. If we conclude based on the qualitative assessment that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, we compare the fair value of the reporting unit to its carrying value. If we determine that the fair value of the reporting unit is less than the carrying value, we measure the amount of impairment loss, if any, by comparing the implied fair value of goodwill to its recorded value. On October 1, 2017, we qualitatively determined that it was more likely than not that the fair value of our reporting unit was greater than its carrying value. Income Taxes Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. We measure our deferred tax assets and liabilities based on enacted tax rates and projected state apportionment percentages for the years in which the differences are expected to reverse. Our primary deferred tax assets relate to intangible asset amortization, share-based compensation, acquisition-related costs, restructuring costs, deferred compensation and operating loss carryforwards. We regularly assess the recoverability of our deferred tax assets, considering all available positive and negative evidence, including the results of recent operations and the timing, level and character of projected future taxable income. These estimates are projected through the life of the related deferred tax assets based on assumptions that we believe to be reasonable and consistent with demonstrated operating results. Based on this analysis and sensitivities of future operating results, we have concluded that it is more likely than not that the recorded deferred tax assets will be realized. Changes in future operating results not currently forecasted may have a significant impact on the realization of deferred tax assets. On December 22, 2017, the Tax Act was enacted. The Tax Act significantly revises the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. As a result of the reduction in the corporate income tax rate, we are required to remeasure our U.S. net deferred taxes at December 31, 2017. The impact of the remeasurement resulted in a one-time credit to income tax expense of $2.4 million for the three months and year ended December 31, 2017. Effective January 1, 2018, the impact of the Tax Act will lower our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 24% thus lowering our income tax expense beginning in calendar year 2018. The reduction in our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 24% will also reduce the tax benefit of goodwill and acquired intangible assets beginning in 2018. Share-Based Compensation We have share-based compensation arrangements covering directors, senior management, investment professionals and other employees. We calculate share-based compensation using the fair value of the awards on the grant date. Our share-based compensation arrangements include restricted stock and options which vest based on service and performance conditions. We recognize expense net of expected forfeitures on a straight-line basis over the requisite service period for service based awards and on an accelerated basis for performance based awards. We estimate the fair value of stock option awards using the Black-Scholes option pricing model. The Black-Scholes model requires us to make assumptions about the volatility of our stock and the expected life of our stock options. In measuring expected volatility, we consider the historical volatility of the common stock of several public peer companies. For restricted stock awards with service or performance conditions, we have historically determined the fair value of the awards using our share price on the date of grant. The most subjective assumption in the determination of the fair value of share-based awards is the estimated fair value of our stock on the date of grant. We have historically considered the implied fair value of the stock-based on periodic transactions with third parties, as well as an annual valuation of our Company performed by an independent third-party. Following the IPO, we have established a policy of considering the closing sale price of our Class A common stock as quoted on NASDAQ on the date of grant for purposes of determining fair value of such awards.

<s>[INST] document even though these statements may be affected by events or circumstances occurring after the forwardlooking statements or other statements were made. Therefore, no reader of this document should rely on these statements being current as of any time other than the date of this report. Overview We are an independent investment management firm operating a next generation, integrated multiboutique model with $61.8 billion in AUM as of December 31, 2017. Our differentiated model features a scalable operating platform that provides centralized distribution, marketing and operations infrastructure to our select group of Franchises. Our earnings are primarily driven by assetbased fees charged for services related to the investment strategies we deliver and consist of investment management, fund administration and distribution fees. We sell our products through our centralized distribution model with 96 professionals across both our institutional and retail distribution channels and marketing organization. We distribute our products through brokerdealers, retirement platforms and RIA networks. Our institutional sales team focuses on cultivating relationships with institutional consultants, who account for the majority of the institutional market, as well as mutual fund complexes seeking subadvisers. Our retail sales team offers intermediary and retirement platform clients mutual funds and ETFs as well as SMAs through wrap fee programs and access to our investment models through UMAs. We have grown our AUM from $17.9 billion following the managementled buyout with Crestview GP from KeyCorp in August 2013 to $61.8 billion at December 31, 2017. We attribute this growth to our success in sourcing and executing acquisitions, generating strong investment returns, and developing retail and institutional distribution channels with deep penetration. Company History On August 1, 2013, our management team and employees along with Crestview GP purchased all of the outstanding stock of VCM and VCA from KeyCorp. Following the acquisition, taking into account postclosing outflows, Victory had $17.9 billion in AUM, consisting of $13.7 billion in U.S. equities, $1.3 billion in international and global equities and $2.9 billion in fixed income. The investment teams consisted of the Sycamore, Expedition, NewBridge Asset Management, or NewBridge, and Diversified Franchises and included short government and investment grade convertible capabilities, which are currently part of the INCORE Capital Management, or INCORE, Franchise. On October 31, 2014, we acquired Munder Capital. Munder Capital was an institutional investment management firm providing domestic and international equity, as well as fixed income investment solutions. The Munder Acquisition increased our AUM by $18.1 billion. The Munder Capital AUM consisted of $14.4 billion in U.S. equities, $0.7 billion in international and global equities and $3.0 billion in fixed income. The Munder, Integrity and Trivalent Franchises joined us as a result of the Munder Acquisition. In addition, Munder Capital had a core fixed income team that we combined with our short government and investment grade convertible teams to form the current INCORE Franchise. As a result of integrating the Munder Capital business onto our operating platform, we achieved approximately $23 million in annualized expense synergies. On April 30, 2015, we acquired the business of CEMP. CEMP provided rulesbased investment products that combine fundamental criteria with a longterm volatilityweighted investment philosophy through a series of mutual funds and ETF offerings. With CEMP, we acquired $1.0 billion of rulesbased AUM. The CEMP Acquisition also marked our entry into the ETF marketplace. For each year during the fouryear period following the closing, the CEMP sellers are entitled to future payments in fixed amounts, with the fixed amounts increasing over the fouryear period, and variable amounts in respect of investment management revenue attributable to the CEMP business. The first earnout payments were made in 2016. See "Contractual Obligations" and Note 3 of our audited financial statements included elsewhere in this report. On July 29, 2016, we acquired RS Investments, an SECregistered investment adviser, and RS Investments' wholly owned subsidiaries. RS [/INST] Negative. </s>

Victory Capital Holdings, Inc.

2019-03-15

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the “Selected Financial Data” and our consolidated financial statements and related notes thereto included elsewhere in this report. In addition to historical information, this discussion contains forward-looking statements that involve risks, uncertainties and assumptions that could cause actual results to differ materially from management’s expectations. Factors that could cause such differences are discussed in the sections entitled “Forward-Looking Statements” and “Risk Factors.” We are not undertaking any obligation to update any forward-looking statements or other statements we may make in the following discussion or elsewhere in this document even though these statements may be affected by events or circumstances occurring after the forward-looking statements or other statements were made. Therefore, no reader of this document should rely on these statements being current as of any time other than the date of this report. Overview Our Business We are an investment management firm operating a next generation, integrated multi-boutique model with $52.8 billion in AUM as of December 31, 2018. Our differentiated model features a scalable operating platform that provides centralized distribution, marketing and operations infrastructure to our select group of Franchises and Solutions Platform. Our earnings are primarily driven by asset-based fees charged for services related to the investment strategies we deliver and consist of investment management, fund administration and distribution fees. Our Franchises are operationally integrated, but are separately branded and make investment decisions independently from one another within guidelines established by their respective investment mandates. Our integrated multi-boutique model creates a supportive environment in which our investment professionals, largely unencumbered by administrative and operational responsibilities, can focus on their pursuit of investment excellence. VCM employs all of our U.S. investment professionals across our Franchises, which are not separate legal entities. Our Solutions Platform consists of multi-Franchise and customized solutions strategies that are primarily rules-based. We offer our Solutions Platform through a variety of vehicles, including separate accounts, mutual funds and VictoryShares which is our ETF brand. Like our Franchises, our Solutions Platform is operationally integrated and supported by our centralized distribution, marketing and operational support functions. We sell our products through our centralized distribution model with 88 professionals across both our institutional and retail distribution channels and marketing organization. Our institutional sales team focuses on cultivating relationships with institutional consultants, who account for the majority of the institutional market, as well as asset allocators seeking sub-advisers. Our retail sales team offers intermediary and retirement platform clients, including broker-dealers, retirement platforms and RIA networks, mutual funds and ETFs as well as SMAs through wrap fee programs and access to our investment models through UMAs. We have grown our AUM from $17.9 billion following the management-led buyout with Crestview GP in August 2013 to $52.8 billion at December 31, 2018. We attribute this growth to our success in sourcing acquisitions and evolving them into organic growers, generating strong investment returns, and developing retail and institutional distribution channels with deep penetration. Agreement to Acquire Harvest Volatility Management and USAA Asset Management On September 21, 2018, we entered into an agreement to purchase 100% of the equity interests of Harvest Volatility Management (“Harvest”) for (i) $255 million in cash paid at the closing of the transaction ( the “Harvest Closing”) (ii) 1,565,370 shares of the Company’s Class B common stock, which equated to $15 million based on a volume-weighted average price per share of $9.5824 at September 21, 2018 to be paid at the Harvest Closing, (iii) $30.75 million in Class B common stock, issued in four equal installments at the end of each of the first four quarters following the Harvest Closing, and (iv) contingent earn-out payments based on the net revenue of the Harvest business in calendar years 2021, 2022 and 2023. Harvest is a leader in derivative asset management, specializing in yield enhancement overlay, risk reduction, alternative beta and absolute return strategies. Harvest offers a suite of value-added investment strategies for client portfolios that are designed to provide investors with risk-managed sources of income, absolute return and varying levels of market exposure. The acquisition will expand our Solutions Platform by adding a historically strong organic grower to our platform and will further diversify our AUM into strategies that are managed to be neutral to changing market cycles. On November 6, 2018, we entered into an agreement to acquire the USAA Acquired Companies and their Mutual Fund and ETF businesses and USAA 529 College Savings Plan for (i) $850 million in cash at the closing of the transaction and (ii) contingent payments based on annual revenue in each of the first four years following the closing. The USAA Acquired Companies have proven expertise in managing fixed income, global multi-asset and equity strategies through both internal investment teams and external subadvisors. The acquisition will diversify our AUM, expand our investment capabilities, increase our size and scale and introduce a new and unique direct-member distribution channel to our existing distribution platform. The Harvest and USAA Acquired Companies acquisitions are expected to close in the second quarter of 2019 and will be financed through a combination of debt, cash on the balance sheet and, in the case of Harvest, Victory equity. We have committed debt financing for both transactions with Barclays and RBC who have agreed to arrange and syndicate a new seven-year senior secured first lien term loan in an aggregate principal amount of up to $1.395 billion and a new five-year senior secured first lien revolving facility in an aggregate principal amount of up to $100 million. See Note 10 to the audited consolidated financial statements for more information on the debt financing. See Note 3 for more details on the Harvest and USAA Acquired Companies acquisitions. See “Risk Factors - Risks Relating to the USAA AMCO Acquisition and the Harvest Acquisition.” Highlights for 2018 2018 business and financial highlights included: · Our Franchises and Solutions Platform had strong investment performance. As of December 31, 2018, 23 of our mutual funds and ETFs have overall Morningstar ratings of four or five stars and 65% of our fund AUM was rated four or five stars overall by Morningstar. As of December 31, 2018, 57% of our strategies by AUM had investment returns in excess of their respective benchmarks over a one-year period, 68% over a three-year period, 74% over a five-year period and 88% over a ten-year period. On an equal-weighted basis, 59% of our strategies have outperformed their benchmarks over a one-year period, 59% over a three-year period, 63% over a five-year period and 75% over a ten-year period. · The industry recognized us for our achievements. For the fourth consecutive year, Victory has been ranked in the top 10 in their AUM category for Institutional Brand Awareness by eVestment. Victory ranked 6th among managers with $50-$100 billion in 2018, 4th among managers with $50-$100 billion in 2017 and 2016 and 1st among managers with $25-$50 billion in 2015. · Total revenue for the year ended December 31, 2018 was $413.4 million compared to $409.6 million for the year ended December 31, 2017. · Net income was $63.7 million for the year ended December 31, 2018 compared $25.8 million for the year ended December 31, 2017. · Adjusted EBITDA was $160.2 million or 38.7% for the year ended December 31, 2018 compared to $149.1 million or 36.4% for the year ended December 31, 2017. See “-Supplemental Non-GAAP Financial Information” for more information about how we calculate Adjusted EBITDA and a reconciliation of net income to Adjusted EBITDA. · Adjusted Net Income was $102.3 million for the year ended December 31, 2018 compared to $62.0 million for the year ended December 31, 2017. See “-Supplemental Non-GAAP Financial Information” for more information about how we calculate Adjusted Net Income and a reconciliation of net income to Adjusted Net Income. · On February 12, 2018, we issued 11,700,000 shares of Class A common stock in the IPO at a price of $13.00 per share for net proceeds of $143.0 million after deducting underwriting discounts. Net proceeds received from the IPO and the Credit Agreement of $143.0 million and $355.9 million, respectively, were used concurrent with the closing of the IPO, together with $0.8 million of cash on hand, to repay the $499.7 million of outstanding term loans under the 2014 Credit Agreement. On March 13, 2018, the Company issued an additional 1,110,860 shares of Class A common stock pursuant to the underwriters’ exercise of their option for net proceeds of $13.5 million after deducting underwriting discounts. The net proceeds from the underwriters’ exercise of their option and operating cash flow were used to pay down $80.0 million of the Existing Credit Agreement in 2018 to bring the balance to $280.0 million at December 31, 2018 resulting in a net debt to Adjusted EBITDA ratio of 1.5x. · We entered into agreements to purchase Harvest and the USAA Acquired Companies. We expect these acquisitions will diversify our AUM and investment capabilities, increase our size and scale, introduce a new and unique USAA direct-member channel to our existing distribution platform. Key Performance Indicators When we review our performance we focus on the indicators described below: (1) Total net flows including Diversified were ($2,427), ($1,471), $875 for the years ended December 31, 2018, 2017 and 2016. See “Business-Our Franchises-Munder Capital Management.” (2) Our management uses Adjusted EBITDA and Adjusted Net Income to measure the operating profitability of the business. These measures eliminate the impact of one-time acquisition, restructuring and integration costs and demonstrate the ongoing operating earnings metrics of the business. These measures are explained in more detail and reconciled to net income/(loss) calculated in accordance with GAAP in “-Supplemental Non-GAAP Financial Information.” (3) Adjusted EBITDA margin represents Adjusted EBITDA as a percentage of total revenue. (4) Represents the tax benefits associated with deductions allowed for intangibles and goodwill generated from prior acquisitions in which we received a step-up in basis for tax purposes. Acquired intangible assets and goodwill may be amortized for tax purposes, generally over a 15-year period. The tax benefit from amortization on these assets is included to show the full economic benefit of deductions for all acquired intangibles with a step-up in tax basis. Due to our acquisitive nature, tax deductions allowed on acquired intangible assets and goodwill provide us with a significant supplemental economic benefit. On December 22, 2017, the Tax Cuts and Jobs Act (“Tax Act”) was enacted. The Tax Act significantly revised the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. The reduction in the federal corporate income tax rate reduced the tax benefit of goodwill and acquired intangible assets beginning in 2018. Assets Under Management Our profitability is largely affected by the level and composition of our AUM (including asset class and distribution channel) and the effective fee rates on our products. The amount and composition of our AUM are, and will continue to be, influenced by a number of factors, including: · investment performance, including fluctuations in the financial markets and the quality of our investment decisions; · client flows into and out of our various strategies and investment vehicles; · industry trends toward products or strategies that we either do or do not offer; · our ability to attract and retain high quality investment, distribution, marketing and management personnel; · our decision to close strategies or limit growth of assets in a strategy when we believe it is in the best interest of our clients or conversely to re-open strategies in part or entirely; and · general investor sentiment and confidence. Our goal is to establish and maintain a client base that is diversified by Franchise and Solutions, asset class, distribution channel and vehicle. The chart below sets forth our AUM by Franchise and Solutions as of December 31, 2018: The following table presents our AUM by asset class as of the dates indicated: (1) Includes the impact of the RS Acquisition, which closed on July 29, 2016, and increased our AUM by $16.7 billion. (2) Includes the impact of the CEMP Acquisition, which closed on April 30, 2015, and increased our AUM by $1.0 billion. (3) Includes the impact of the Munder Acquisition, which closed on October 31, 2014, and increased our AUM by $18.1 billion. The following table summarizes our asset flows by asset class for the periods indicated: (1) Includes Diversified. See “Business-Our Franchises-Munder Capital Management.” (2) Reflects transfer of $5.0 million in assets from U.S. mid cap equity to Other effective January 1, 2016. (3) Includes the impact of the RS Acquisition, which closed on July 29, 2016, and increased our AUM by $16.7 billion. In connection with the retirement of our two CIOs at Diversified, we made the strategic decision to exit this Franchise and move the remaining AUM into our Munder Franchise, which was completed as of May 15, 2017. The following table presents the impact of Diversified on net client cash flows for the periods indicated. Given this decision, we believe this presentation is a better representation of our business on a going-forward basis. The following table presents our AUM by distribution channel as of the dates indicated: (1) The allocation of AUM by distribution channel involves the use of estimates and the exercise of judgment. The following table summarizes our asset flows by vehicle for the periods indicated: (1) Includes institutional and retail share classes and Variable Insurance Products or VIP funds. (2) Includes collective trust funds, wrap program separate accounts and unified managed accounts or UMAs. (3) Includes the impact of the RS Acquisition, which closed on July 29, 2016, and increased our AUM by $16.7 billion. At December 31, 2018, our total AUM was $52.8 billion, a decrease of $9.0 billion, or 15%, compared to $61.8 billion at December 31, 2017. The change in AUM during the year ended December 31, 2018 reflects net market depreciation of ($6.6) billion and net outflows of ($2.4) billion. The net outflows were primarily a result of ($2.7) billion net outflows of our U.S. mid cap equity strategies, ($0.8) billion of our fixed income strategies, ($0.6) billion of our U.S. large cap equity strategies, ($0.6) billion of our U.S. small cap equity strategies and ($0.5) billion in our commodity strategies, which were partially offset by $1.5 billion of net inflows in our global / non-U.S. equity strategies and $1.1 billion in our Solutions Platform. At December 31, 2017, our total AUM was $61.8 billion, an increase of $6.8 billion, or 12% compared to $55.0 billion at December 31, 2016. The change in AUM during the year ended December 31, 2017 reflects net market appreciation of $8.4 billion, net outflows of ($1.5) billion and a ($0.1) billion reduction primarily related to mutual fund liquidation. Excluding the impact of outflows from Diversified, net outflows would have been ($0.9) billion for the period. The net outflows were primarily a result of ($1.5) billion net outflows in our U.S. large cap equity strategies, ($1.1) billion in our U.S. small cap equity strategies, ($0.5) billion in our commodity strategies, ($0.4) billion in our global / non-U.S. equity strategies and ($0.4) billion in our fixed income strategies, which were partially offset by $1.3 billion of net inflows in our U.S. mid cap equity strategies and $1.1 billion in our Solutions Platform. At December 31, 2016, our total AUM was $55.0 billion, an increase of $21.9 billion, or 66%, compared to $33.1 billion at December 31, 2015. In addition to the RS Acquisition, which accounted for an increase in AUM of $16.7 billion as of the closing on July 29, 2016, the change in AUM during the year ended December 31, 2016 reflects net market appreciation of $4.4 billion and net inflows of $0.9 billion. Excluding the impact of outflows from Diversified, net inflows would have been $2.3 billion in 2016. The net inflows were primarily a result of $3.1 billion of net inflows in our U.S. mid cap equity strategies, $0.5 billion in our global / non-U.S. equity strategies and $0.2 billion in Solutions, which were largely offset by ($1.7) billion net outflows in our U.S. large cap equity strategies, ($0.8) billion in our fixed income strategies and ($0.3) billion in our commodity strategies. GAAP Results of Operations Our GAAP revenues principally consist of: i. Investment management fees, which are based on our overall weighted average fee rate charged to our clients and our level of AUM; and ii. Fund administration and distribution fees, which are asset-based fees earned from open-end mutual funds for administration and distribution services. Investment Management Fees Investment management fees are earned from managing clients’ assets. Our investment management fee revenue fluctuates based on a number of factors, including the total value of our AUM, the composition of AUM across investment strategies and vehicles, changes in the investment management fee rates on our products and the extent to which we enter into fee arrangements that differ from our standard fee schedule. Investment management fees are earned based on a percentage of AUM as delineated in the respective investment management agreements. Approximately 87% of our investment management fees are calculated based on daily average AUM with the remainder calculated based on monthly average AUM or point in time AUM. Fund Administration and Distribution Fees Fund administration fees are asset-based fees earned from open-end funds for administration services. Fund administration fees fluctuate based on the level of average open-end AUM and the fee rates charged for these services. Fund distribution fees are asset-based fees earned from open-end funds for distribution services. Fund distribution fees fluctuate based on the level of average open-end AUM and the composition of those assets across share classes that pay varying levels of fund distribution fees. Our GAAP expenses principally consist of: i. Personnel compensation and benefits; ii. Distribution and other asset-based expenses; iii. General and administrative expenses; iv. Depreciation and amortization charges; and v. Acquisition-related costs and restructuring / integration costs. Personnel Compensation and Benefits Personnel compensation and benefits is our most significant category of expense. Personnel compensation and benefits consists of (i) salaries, payroll related taxes and employee benefits, (ii) incentive compensation, (iii) sales-based compensation, (iv) compensation expense related to equity awards granted to employees and (v) acquisition-related compensation in the form of cash retention bonuses. Incentive compensation is the largest component of the total compensation of our employees. The aggregate amount of cash incentive compensation is funded by a pool that is based on a percentage of total Company earnings (before taking into account incentive compensation). This incentive pool is used to pay the investment teams a percentage of the revenue earned by their respective Franchise on a quarterly basis. This incentive pool is also used to pay incentive compensation to senior management and other non-investment employees on an annual basis. Incentive compensation paid to senior management and to other non-investment employees is discretionary and subjectively determined based on Company and individual performance and the total amount of the incentive compensation pool. Distribution and Other Asset-based Expenses Distribution and other asset-based expenses consists of (i) broker-dealer distribution fees and platform distribution fees, (ii) fund expense reimbursements to affiliates and (iii) sub-administration, sub-advisory and middle-office expenses. Broker-dealer distribution fees are paid by VCA as the broker-dealer for the Victory Funds to third-party distributors. The Victory Funds pay VCA for distribution services and VCA, in turn, pays third-party distributors. Platform distribution fees are paid by VCM as the investment adviser to the Victory Funds. Platform distribution fees are paid to financial advisors, retirement plan providers and intermediaries for servicing and administering accounts invested in shares of the Victory Funds. Distribution fees typically vary based on the level of AUM and the composition of those assets across share classes. Fund expense reimbursements result from VCM, as investment adviser for the Victory Funds and VictoryShares, agreeing to cap the annual operating expenses for certain share classes of the Victory Funds and VictoryShares. VCM has contractually agreed to reimburse the Victory Funds and VictoryShares for expenses in excess of these caps but may recoup these reimbursements for a period of time if the applicable Fund’s share class expenses and/or VictoryShares ETF expenses fall below the cap. Sub-administration, sub-advisory and middle-office expenses consist of fees paid to our sub-administrator of the Victory Funds and VictoryShares, fees paid to sub-advisers on certain Victory Funds and fees paid to vendors to which we outsource middle-office functions. · VCM acts as the administrator to the Victory Funds and VictoryShares. VCM has hired a sub-administrator, the fees for which are captured in sub-administration expense. As administrator, VCM supervises the operations of the Victory Funds and VictoryShares, including the services provided by the sub-administrator. The sub-administrator is paid through a contractual arrangement based on a percentage of the average fund AUM. · VCM, as the investment adviser for the Victory Funds, has hired unaffiliated sub-advisers to manage funds for which we do not have in-house capabilities. The fees paid to the sub-advisers are contractual based on a percentage of assets that they manage. · We have outsourced middle-office operations to achieve a scalable operational infrastructure that utilizes a variable-cost model. We have selected to partner with top-tier vendors who perform trade operations, portfolio accounting and performance measurement with oversight from our operations team. The fees paid to these vendors are variable and structured based on the number of accounts, assets and specific services performed. General and Administrative Expenses General and administrative expenses primarily consist of investment research and technology costs, professional and marketing fees, travel, rent and insurance expenses. Depreciation and Amortization Depreciation and amortization expense consists primarily of the depreciation of property and equipment as well as the amortization of acquired intangibles that have a definite life. These intangibles include customer relationships, investment advisory contracts, intellectual property and non-compete clauses acquired in connection with a business or asset acquisition. Both depreciation and amortization are recorded ratably over the assets’ useful lives. Acquisition-Related Costs Acquisition-related costs include legal fees, advisory services, mutual fund proxy voting costs and other one-time expenses related to acquisitions. Restructuring and Integration Costs Restructuring and integration costs include costs incurred in connection with business combinations, asset purchases and changes in business strategy. These include severance related expenses related to one-time benefit arrangements, contract termination and other costs to integrate investment platforms, products and personnel into existing systems, processes and service provider arrangements and restructure the business to capture operating expense synergies. Other non-operating items of income and expense consist of: i. Interest income and other income/(expense); ii. Interest expense and other financing costs; iii. Loss on debt extinguishment; and iv. Income tax (expense)/benefit. Interest Income and Other Income/(Expense) Interest income and other income/(expense) consists primarily of interest income, gains / losses on investments, dividend income on investments and income /expense associated with an other receivable recorded in connection with an acquisition. Interest Expense and Other Financing Costs Interest expense and other financing costs consists primarily of interest expense attributable to long-term debt. See “-Liquidity and Capital Resources” for more information. Loss on Debt Extinguishment Loss on debt extinguishment consists of the write-off of unamortized debt issuance costs and unamortized debt discount as a result of debt refinancing. Income Tax (Expense)/Benefit The provision for income taxes includes U.S. federal, state and local taxes, and following the RS Acquisition in 2016, foreign income taxes payable by certain of our subsidiaries. The effective tax rate is primarily driven by state and local taxes and permanent differences related to meals and entertainment. The portion of the effective income tax rate attributable to state and local income taxes varies from year to year depending on amounts of income apportioned to each jurisdiction, whether we file income tax returns on a unitary or separate return basis and with changes in tax laws. On December 22, 2017, the Tax Act was enacted. The Tax Act significantly revised the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. Our GAAP results of operations were as follows for the years ended December 31, 2018 and 2017. Investment Management Fees Investment management fees increased $8.9 million, or 3%, for the year ended December 31, 2018 compared to the year ended December 31, 2017 due to an increase in average AUM year over year, partially offset by a decrease in the realized fee rate due to asset mix shift. Average AUM increased by $3.6 billion to $61.4 billion for the year ended December 31, 2018 from $57.8 billion for the year ended December 31, 2017. The weighted average fee rate for the year ended December 31, 2018 was 67.3 basis points, a decrease of 3.5 basis points compared to the year ended December 31, 2017 due to asset mix shift. Fund Administration and Distribution Fees Fund administration and distribution fees totaled $60.7 million for the year ended December 31, 2018, a decrease of $5.1 million, or 8%, when compared to the year ended December 31, 2017, due to a decrease in fund distribution fees partially offset by an increase in fund administration fees. Fund distribution fees were $37.3 million for the year ended December 31, 2018, compared to $43.5 million for the year ended December 31, 2017. While mutual fund daily average AUM grew by $0.8 billion from $36.2 billion for the year ended December 31, 2017 to $37.0 billion for the year ended December 31, 2018, the mix of assets shifted to fewer 12b-1 paying share classes. Fund administration fees were $23.4 million for the year ended December 31, 2018, compared to $22.3 million for year ended December 31, 2017, due to higher mutual fund and ETF average daily assets. Personnel Compensation and Benefits The following table presents the components of GAAP compensation expense for the year ended December 31, 2018 and 2017: (1) Represents sales-based commissions paid to our distribution teams. Sales-based compensation varies based on gross and net client cash flows and revenue earned on sales. (2) Share-based compensation typically vests over several years based on service and the achievement of specific business and financial targets. The value of share-based compensation is recognized as compensation expense over the vesting period. Personnel compensation and benefits was $145.9 million for the year ended December 31, 2018, an increase of $1.8 million, or 1%, from $144.1 million for the year ended December 31, 2017. Salaries, payroll related taxes and employee benefits was $45.8 million for the year ended December 31, 2018, a decrease of $3.9 million, or 8%, from $49.7 million for the year ended December 31, 2017. This decrease was primarily due to a difference in the mark-to-market of the deferred compensation plan liability year over year. Incentive compensation was $71.3 million for the year ended December 31, 2018, an increase of $5.3 million, or 8%, from $66.0 million for the year ended December 31, 2017, due to higher pre-incentive compensation earnings. Sales-based compensation was $13.5 million for the year ended December 31, 2018, a decrease of $1.6 million, or 11%, from $15.1 million for the year ended December 31, 2017, as a result of lower gross flows. Share-based compensation was $15.2 million for the year ended December 31, 2018, an increase of $3.4 million, or 29%, from $11.8 million for the year ended December 31, 2017, due to the share-based compensation related to the IPO and pre-existing awards that are still being expensed. There was no acquisition-related cash retention compensation during the year ended December 31, 2018. Distribution and Other Asset-based Expenses Broker-dealer and platform distribution expenses along with fund expense reimbursements, sub-administration, sub-advisory and middle-office expenses are based on AUM. The following table presents the components of distribution and other asset-based expenses for the year ended December 31, 2018 and 2017: Distribution and other asset-based expenses are primarily based on percentages of AUM and decreased by $8.7 million, or 8%, to $94.7 million for the years ended December 31, 2018, from $103.4 million for the year ended December 31, 2017. Broker-dealer distribution fees and platform distribution fees decreased due to the mix of mutual fund assets and share classes. Asset-based expenses associated with sub-administration and fund expense reimbursements increased year over year due to the increase in fund AUM partially offset by operational efficiencies. The decrease in sub-advisory expense is a result of a decline in the assets included under our two sub-advisory relationships. Middle-office expense decreased year over year due to operational efficiencies partially offset by the increase in AUM. General and Administrative Expenses General and administrative expenses decreased by $4.0 million, or 12%, to $30.0 million for the year ended December 31, 2018, from $34.0 million for the year ended December 31, 2017, driven by operational efficiencies. Depreciation and Amortization Depreciation and amortization decreased by $6.6 million, or 22%, to $23.3 million for the year ended December 31, 2018, from $29.9 million for the year ended December 31, 2017, primarily due to lower amortization as certain intangible assets acquired in connection with the management-led buyout with Crestview GP reached the end of their useful lives. Acquisition-Related Costs Acquisition-related costs increased by $2.2 million, or 105%, to $4.3 million for the year ended December 31, 2018, from $2.1 million for the year ended December 31, 2017, primarily due to costs incurred related to the Harvest and USAA Acquired Companies transactions. Restructuring and Integration Costs Restructuring and integration costs decreased by $5.5 million, or 89%, to $0.7 million for the year ended December 31, 2018, from $6.2 million for the year ended December 31, 2017, primarily due to costs incurred in 2017 for contract breakage and asset write-offs associated with the integration of RS Investments. Loss on Debt Extinguishment Loss on debt extinguishment increased $5.8 million to $6.1 million for the year ended December 31, 2018, from $0.3 million for the year ended December 31, 2017, due to the write-off of unamortized debt issuance costs and unamortized debt discount as a result of the 2018 debt refinancing. Interest Expense and Other Financing Costs Interest expense and other financing costs decreased by $27.8 million, or 57%, to $20.7 million for the year ended December 31, 2018, from $48.5 million for the year ended December 31, 2017 as a result of refinancing activities and debt pre-payment. See Note 10 to the audited consolidated financial statements for further discussion. Income Tax Expense Income tax expense increased $8.6 million, or 68%, to $21.2 million for the year ended December 31, 2018, from $12.6 million for the year ended December 31, 2017 as a result of higher pre-tax income and a one-time credit to income tax expense in 2017 as a result of the remeasurement of our U.S. net deferred taxes required by the Tax Act partially offset by a reduction in our effective tax rate in 2018 due to the Tax Act. See Note 9 to the audited consolidated financial statements. Our GAAP results of operations were as follows for the years ended December 31, 2017 and 2016. Investment Management Fees Investment management fees increased $95.3 million, or 38%, for the year ended December 31, 2017 compared to the year ended December 31, 2016 due to an increase in average AUM year over year. Average AUM increased by $16.0 billion to $57.8 billion for the year ended December 31, 2017 from $41.8 billion for the year ended December 31, 2016. Fund Administration and Distribution Fees Fund administration and distribution fees totaled $65.8 million for the year ended December 31, 2017, an increase of $16.4 million, or 33%, when compared to the year ended December 31, 2016, due to an increase in open-end mutual fund AUM. Open-end mutual fund daily average AUM grew by $12.0 billion from $24.2 billion for the year ended December 31, 2016 to $36.2 billion for the year ended December 31, 2017 due primarily to the RS Acquisition (which was completed in July 2016 and included $13.2 billion of open-end mutual fund AUM at the date of acquisition). The increase in fees due to higher average AUM was partially offset by a reduction in the fee rate earned for administrative services. The administrative fee schedule is tiered such that the average fee rate earned declines as AUM increase. Personnel Compensation and Benefits The following table presents the components of GAAP compensation expense for the years ended December 31, 2017 and 2016: (1) Represents sales-based commissions paid to our distribution teams. Sales-based compensation varies based on gross client cash flows and revenue earned on sales. (2) Share-based compensation typically vests over several years based on service and the achievement of specific financial and business targets. The value of share-based compensation is recognized as compensation expense over the vesting period. Personnel compensation and benefits was $144.1 million for the year ended December 31, 2017, an increase of $21.5 million, or 18%, from $122.6 million for the year ended December 31, 2016. Salaries, payroll related taxes and employee benefits was $49.7 million for the year ended December 31, 2017, an increase of $6.7 million, or 16%, from $43.0 million for the year ended December 31, 2016. This increase reflects the effect of increased headcount due to the RS Acquisition as well as new hires and annual salary increases. Incentive compensation was $66.0 million for the year ended December 31, 2017, an increase of $14.3 million, or 28%, from $51.7 million for the year ended December 31, 2016, due to higher pre-incentive compensation earnings and the effect of the RS Acquisition. Sales-based compensation was $15.0 million for the year ended December 31, 2017, an increase of $2.3 million, or 18%, from $12.7 million for the year ended December 31, 2016, as a result of higher gross flows and revenue. Share-based compensation was $11.8 million for the year ended December 31, 2017, an increase of $3.0 million, or 34%, from $8.8 million for the year ended December 31, 2016, due to the share-based compensation awarded to RS Investments employees in connection with the RS Acquisition and pre-existing awards that are still being expensed. Acquisition and transaction-related compensation was $1.6 million for the year ended December 31, 2017, a decrease of $4.8 million from $6.4 million for the year ended December 31, 2016, due to cash retention payments made in 2016 to former RS Investments employees in connection with the RS Acquisition and the impact of certain one-time compensation costs related to the integration of the RS Investments business onto our platform. Distribution and Other Asset-based Expenses Broker-dealer and platform distribution expenses along with fund expense reimbursements, sub-administration, sub-advisory and middle-office expenses are based on AUM. The following table presents the components of distribution and other asset-based expenses for the year ended December 31, 2017 and 2016: Distribution and other asset-based expenses are primarily based on percentages of AUM and increased by $25.9 million, or 33%, to $103.4 million for the year ended December 31, 2017, from $77.5 million for the year ended December 31, 2016, due to higher average open-end mutual fund AUM and an increase in the cost of third-party distribution. Asset-based expenses associated with fund reimbursements, sub-administration and middle-office outsourcing have increased year over year due to the increase in AUM as a result of the RS Acquisition and market appreciation. The increase in sub-advisory expenses is a result of the RS Acquisition, which included two sub-advisory relationships (Park Avenue and SailingStone). General and Administrative Expenses General and administrative expenses increased by $7.4 million, or 28%, to $34.0 million for the year ended December 31, 2017, from $26.6 million for the year ended December 31, 2016, driven by systems and data costs related to incremental Franchises and additional risk tools as well as database development and marketing costs for new products and ETFs. In addition, included in general and administrative expenses for the year ended December 31, 2017 was $2.1 million of costs related to debt modification as a result of the incremental term loan borrowing of $125 million in February 2017 and the repricing of the term loan in August 2017. Depreciation and Amortization Depreciation and amortization decreased by $0.5 million, or 2%, to $29.9 million for the year ended December 31, 2017, from $30.4 million for the year ended December 31, 2016, primarily due lower amortization of certain intangible assets acquired in connection with the management-led buyout with Crestview GP from KeyCorp that were fully amortized in 2017 partially offset by higher intangible asset amortization as a result of the RS Acquisition. Acquisition-Related Costs Acquisition-related costs decreased by $4.5 million to $2.1 million for the year ended December 31, 2017, from $6.6 million for the year ended December 31, 2016, due to the RS Acquisition costs incurred in the earlier period. Restructuring and Integration Costs Restructuring and integration costs decreased by $3.8 million to $6.2 million for the year ended December 31, 2017, from $10.0 million for the year ended December 31, 2016, due to costs related to the RS Acquisition which occurred in the third quarter of 2016. Included in the $6.2 million for the year ended December 31, 2017 were $3.0 million of loss on disposal of assets, $2.0 million of contract breakage, $0.6 million of severance and $0.6 million of other. Interest Expense and Other Financing Costs Interest expense and other financing costs increased by $13.9 million, or 40%, to $48.5 million for the year ended December 31, 2017, from $34.6 million for the year ended December 31, 2016. This increase was primarily due to incremental term loans incurred under the 2014 Credit Agreement in the amounts of $135.0 million and $125.0 million in July 2016 and February 2017, respectively. We used the proceeds of the incremental term loans to fund the RS Acquisition and associated transaction costs and to pay a dividend to our shareholders. On August 1, 2017, the 2014 Credit Agreement was amended to refinance all existing term loans outstanding, effective as of that date, reducing the spread above LIBOR from 7.50% to 5.25%. Income Tax (Expense)/Benefit The provision for income taxes for the year ended December 31, 2017 and 2016 comprises federal and state taxes and, in addition, for the year ended December 31, 2017, foreign income taxes. The difference between our effective tax rate and the statutory federal rate of 35% are state, local and foreign income taxes and non-deductible expenses. On December 22, 2017, the Tax Act was enacted. The Tax Act significantly revised the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. As a result of the reduction in the corporate income tax rate, we were required to remeasure our U.S. net deferred taxes at December 31, 2017. The impact of the remeasurement resulted in a one-time credit to income tax expense of $2.4 million for the three months and year ended December 31, 2017. Effects of Inflation For the years ended December 31, 2018, 2017 and 2016, inflation did not have a material effect on our consolidated results of operations. Inflationary pressures can result in increases to our cost structure, especially to the extent that large expense components such as compensation are impacted. To the degree that these expense increases are not recoverable or cannot be counterbalanced through price increases due to the competitive environment, our profitability could be negatively impacted. In addition, the value of the fixed income assets that we manage may be negatively impacted when inflationary expectations result in a rising interest rate environment. Declines in the values of AUM could lead to reduced revenues as investment management fees are generally earned as a percentage of AUM. Supplemental Non-GAAP Financial Information Our management uses non-GAAP performance measures to evaluate the underlying operations of our business. Due to our acquisitive nature, there are a number of acquisition and restructuring related expenses included in GAAP measures that we believe distort the economic value of our organization and we believe that many investors use this information when assessing the financial performance of companies in the investment management industry. We have included these non-GAAP measures to provide investors with the same financial metrics used by management to assess the operating performance of our Company. The non-GAAP measures we report are Adjusted EBITDA and Adjusted Net Income. The following table sets forth a reconciliation from GAAP financial measures to non-GAAP measures for the periods indicated: (1) We add back interest paid on debt and other financing costs, net of interest income; interest expense is included in “Interest expense and other financing costs” in our consolidated financial statements while interest income is shown in “Interest income and other income” in our consolidated financial statements. (2) We add back depreciation on property and equipment; included in “Depreciation and amortization” in our consolidated financial statements. (3) We add back other business taxes; other business taxes are included in “General and administrative” in our consolidated financial statements. (4) We add back amortization of acquisition-related intangibles; included in “Depreciation and amortization” in our consolidated financial statements. (5) We add back the expense associated with share-based compensation associated with equity issued from pools that were created in connection with the management-led buyout with Crestview GP from KeyCorp, the Munder Acquisition and the RS Acquisition and as a result of IPO-related equity grants; included in “Personnel compensation and benefits” in our consolidated financial statements. (6) We add back direct incremental costs of acquisitions and the IPO, including expenses associated with third-party advisors, proxy solicitations of mutual fund shareholders for transaction consents, vendor contract early termination costs, loss on other receivable recorded in connection with an acquisition, and severance, retention and transaction incentive compensation. Severance, retention and transaction incentive compensation is included in “Personnel compensation and benefits” in our consolidated financial statements, loss on other receivable recorded in connection with an acquisition is included in “Interest income and other income/(expense),” costs associated with professional services incurred in connection with IPO readiness are included in “General and administrative”; all other incremental costs are included in “Restructuring and integration costs” or “Acquisition-related costs.” (7) We add back debt issuance costs; included in “Interest expense and other financing costs”, Loss on debt extinguishment” and “General and administrative” in our consolidated financial statements. See “-Liquidity and Capital Resources” for more information. (8) We add back pre-IPO governance expenses paid to Crestview and Reverence Capital, included in “General and administrative” in our consolidated financial statements. These payments terminated as of the completion of the IPO. (9) We adjust for earnings/losses on equity method investments, included in “Interest income and other income/(expenses)” in our consolidated financial statements. (10) Our compensation committee, together with our CEO, establishes a target percentage of our pre-bonus EBITDA to be allocated to employees as annual cash incentive compensation. If, as a result of a significant acquisition, we pay annual cash incentive compensation that is a greater percentage of pre-bonus EBITDA than our target percentage, we add back the amount of the annual incentive cash compensation in excess of the target percentage. In 2016, as a result of the RS Acquisition, we paid incentive cash compensation at a greater percentage of pre-bonus EBITDA than our target percentage. We paid incentive cash compensation in 2016 at levels we considered appropriate taking into account the RS Acquisition (including the size of our Company post-acquisition) without the benefit of a full year of those earnings and before expense synergies were fully realized. We also paid incentive cash compensation on duplicative headcount while the integration of the RS Investments platform was being completed; included in “Personnel compensation and benefits” in our consolidated financial statements. (11) For the year ended December 31, 2018, reflects income taxes of 25% applied to the sum of line items i. to vii.; 25% represents statutory federal income tax rate of 21% plus an estimate for state, local and foreign income taxes. For the years ended December 31, 2017 and December 31, 2016, reflects income taxes of 38% applied to the sum of line items i. to vii.; 38% represents statutory federal income tax rate of 35% plus an estimate for state, local and foreign income taxes. (12) On December 22, 2017, the Tax Act was enacted. The Tax Act significantly revised the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. As a result of the reduction in the corporate income tax rate, we were required to remeasure our U.S. net deferred taxes at December 31, 2017. The impact of the remeasurement was a one-time credit to income tax expense of $2.4 million for the year ended December 31, 2017. (13) Represents the tax benefits associated with deductions allowed for intangibles and goodwill generated from prior acquisitions in which we received a step-up in basis for tax purposes. Acquired intangible assets and goodwill may be amortized for tax purposes, generally over a 15-year period. The tax benefit from amortization on these assets is included to show the full economic benefit of deductions for all acquired intangibles with a step-up in tax basis. Due to our acquisitive nature, tax deductions allowed on acquired intangible assets and goodwill provide us with a significant supplemental economic benefit. Effective January 1, 2018, the impact of the Tax Act lowered our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 25% thus lowering our income tax expense beginning in calendar year 2018. The reduction in our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 25% also reduced the tax benefit of goodwill and acquired intangible assets beginning in 2018. Non-GAAP measures should be considered in addition to, and not as a substitute for, financial measures prepared in accordance with GAAP. Our non-GAAP measures may differ from similar measures at other companies, even if similar terms are used to identify these measures. Liquidity and Capital Resources Our primary uses of cash relate to repayment of our debt obligations, funding of acquisitions and working capital needs and are expected to be met primarily through cash generated from our operations. The following table shows our liquidity position as of December 31, 2018 and 2017. We manage our cash balances in order to fund our day-to-day operations and invest excess cash into money market funds and other short-term investments. Our accounts receivable consist primarily of investment management fees that have been earned but not yet received from clients. Included in other receivables are amounts due under a contract with a third party acquired in connection with the RS Acquisition, income and other taxes receivable and amounts receivable from the funds. We perform a review of our receivables on a monthly basis to access collectability. We maintained a $100.0 million revolving credit facility at December 31, 2018, which had $100.0 million undrawn as of December 31, 2018. See Note 10 to the audited consolidated financial statements for further discussion. Debt Refinancing On February 12, 2018, concurrently with the closing of the IPO, we entered into the Existing Credit Agreement under which we received seven-year term loans in an original aggregate principal amount of $360.0 million and established a five-year revolving credit facility (which was unfunded as of closing) with aggregate commitments of $50.0 million. On May 3, 2018, the Company signed an amendment to the Existing Credit Agreement increasing the revolving credit facility from $50.0 million to $100.0 million. See Note 10 to the audited consolidated financial statements for further discussion. The Company repaid $37.0 million, $23.0 million and $20.0 million of the outstanding term loans under the Existing Credit Agreement in the first quarter, second quarter and third quarter of 2018, respectively for a total of $80.0 million repaid during the year ended December 31, 2018. See Note 10 to the audited consolidated financial statements for further discussion. The Harvest Commitment Letter In connection with entering into the Harvest Purchase Agreement, on September 21, 2018, the Company entered into the Harvest Commitment Letter with Royal Bank of Canada (“RBC”) and Barclays Bank PLC (“Barclays”), pursuant to which RBC and Barclays have committed to provide, and have agreed to arrange and syndicate, an incremental senior secured term loan facility under the Existing Credit Agreement in an initial aggregate principal amount of up to $265 million (the “Harvest Facility”). The proceeds of the Harvest Facility, together with cash on the Company’s balance sheet at Harvest Closing, will be used by the Company to fund a portion of the Harvest Purchase Price and to pay fees and expenses incurred in connection with the Harvest Acquisition and the Harvest Facility, unless the Company finances the Harvest Acquisition with proceeds from the USAA AMCO Term Loan Facility described below. The availability of the Harvest Facility is subject to the satisfaction of certain customary conditions precedent. Neither the closing of the Harvest Facility, nor the receipt of any other financing, is a condition to the Harvest Closing. If the Company finances the Harvest Acquisition with proceeds from the USAA AMCO Term Loan Facility, it will not borrow under the Harvest Commitment Letter or enter into the Harvest Facility. USAA AMCO Credit Facilities Commitment Letter In connection with entering into the USAA Stock Purchase Agreement, on November 6, 2018 the Company entered into the USAA AMCO Credit Facilities Commitment Letter with Barclays and RBC, pursuant to which Barclays and RBC have committed to provide, and have agreed to arrange and syndicate, a new seven-year senior secured first lien term loan facility (the “USAA AMCO Term Loan Facility”) in an aggregate principal amount of up to $1.395 billion and a new five-year senior secured first lien revolving credit facility (together with the USAA AMCO Term Loan Facility, the “USAA AMCO Credit Facilities”) in an aggregate principal amount of up to $100 million. Proceeds from the USAA AMCO Term Loan Facility, together with cash on the Company’s balance sheet, will be used to refinance in full all debt outstanding under the Company’s Existing Credit Agreement, finance the USAA AMCO Acquisition and finance the above mentioned Harvest Acquisition, thus effectively replacing the Harvest Commitment Letter. Capital Requirements VCA is a registered broker-dealer subject to the Uniform Net Capital requirements under the Exchange Act, which requires maintenance of certain minimum net capital levels. In addition, we have certain non-U.S. subsidiaries that have minimum capital requirements. As a result, such subsidiaries of our Company may be restricted in their ability to transfer cash to their parents. VCA and our non-U.S. subsidiaries were in compliance with these requirements as of and for the years ended December 31, 2018, 2017 and 2016. Cash Flows for the Years Ended December 31, 2018, 2017 and 2016 Year Ended December 31, 2018 and 2017 Operating activities provided net cash of $134.3 million and $96.2 million for the years ended December 31, 2018 and 2017, respectively. The $38.1 million increase in net cash provided by operating activities was primarily due to growth in the business and lower interest expense as a result of refinancing activities and pre-payments. Investing activities consist primarily of purchases and sales of property and equipment, the purchases and sales of trading securities related to our deferred compensation plan and other investing activities related to our business operations. Investing activities used net cash of $11.5 million and $8.5 million for the years ended December 31, 2018 and 2017, respectively. The $3.0 million increase in the net cash used in investing activities was primarily due to additional equity investments made in Cerebellum Capital during the year ended December 31, 2018. Financing activities consist primarily of proceeds received or paid from the issuance or repurchase of equity, debt-related activity and dividend payments to our shareholders. For the year ended December 31, 2018, financing activities included, but were not limited to, the generation of net IPO proceeds of $156.5 million: $143.0 million received at the closing of the IPO and $13.5 million received at the subsequent closing of the underwriters’ exercise of their option, the incurrence of $360.0 million of term loans under the Existing Credit Agreement, the repayment of $499.7 million of term loans under the 2014 Credit Agreement and the repayment of long-term debt under the Existing Credit Agreement of $80.0 million. For the year ended December 31, 2017, financing activities included, but were not limited to, the incurrence of $125.0 million of incremental term loans under the 2014 Credit Agreement, the payment of a dividend to shareholders in the amount of $135.2 million and the repayment of long-term debt in the amount of $63.9 million. Financing activities used net cash of $84.2 million and $91.3 million for the year ended December 31, 2018 and 2017, respectively. Year Ended December 31, 2017 and 2016 Operating activities provided net cash of $96.2 million and $39.5 million for the years ended December 31, 2017 and 2016, respectively. The $56.7 million increase in net cash provided by operating activities was primarily due to the impact of the RS Acquisition on our earnings. Investing activities consist primarily of acquisitions and sales of property and equipment, as well as the purchase and sales of trading securities related to our deferred compensation plan. Investing activities used net cash of $8.5 million and $210.1 million for the years ended December 31, 2017 and 2016, respectively. The $201.6 million decrease in the net cash used in investing activities was primarily due to the RS Acquisition in August 2016. Financing activities consist primarily of dividend payments to our shareholders, proceeds received or paid from the issuance or repurchase of equity and debt-related activity. For the year ended December 31, 2017, financing activities included, but were not limited to, the incurrence of $125.0 million of incremental term loans under the 2014 Credit Agreement, the payment of a dividend to shareholders in the amount of $135.2 million and the repayment of long-term debt in the amount of $63.9 million. For the year ended December 31, 2016, financing activities included, but were not limited to, the incurrence of $135 million in incremental term loans under the 2014 Credit Agreement and the issuance of $88.3 million of equity, both in connection with the RS Acquisition, and the repayment of long-term debt in the amount of $21.0 million. Financing activities used net cash of $91.3 million for the year ended December 31, 2017. Financing activities generated net cash of $171.8 million for the year ended December 31, 2016. Contractual Obligations The following summarizes our contractual obligations as of December 31, 2018: (1) The total principal payments on borrowings reflects the gross amount of principal outstanding on the term loans under the Existing Credit Agreement as of December 31, 2018. The repayment of $80.0 million of the outstanding term loans under the Existing Credit Agreement in 2018 has satisfied the annual amortization of 1% per annum through 2024. (2) The total interest payable reflects the interest due on the principal amount of the term loans outstanding under the Existing Credit Agreement as of December 31, 2018 using the 5.55% interest rate in effect on that date. Off-Balance Sheet Arrangements In connection with dividends declared in February 2017 and December 2017, holders of restricted stock awards that were unvested at the time such dividends were declared are entitled to be paid the dividends as and when the restricted stock vests. These amounts are not recorded as a liability until and unless the awards vest in accordance with their respective agreements. As of December 31, 2018, the cash bonuses and distributions related to the February 2017 and December 2017 dividends on restricted shares and options that are expected to vest in the future totaled $1.8 million. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with GAAP. In preparing the financial statements, we are required to make estimates, judgments and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. We continually evaluate the accounting policies and estimates we use to prepare our consolidated financial statements. In general, our estimates are based on historical experience, information from third-party valuation professionals and various other assumptions that we believe to be reasonable under the facts and circumstances. Actual results may differ from our estimates and those differences may be material. Of the significant accounting policies described in Note 2 to the audited consolidated financial statements included in this report, we believe the following policies involve a higher degree of judgment and complexity. Indefinite-lived Intangible Assets The accounting for indefinite-lived intangible assets requires significant estimates and judgment in several areas: (1) valuation in connection with the initial purchase price allocation; (2) ongoing evaluation for impairment; and (3) reconsideration of an asset’s useful life. The process of determining the fair value of identifiable intangible assets at the date of acquisition utilizes an income approach and requires significant estimates and judgment as to expectations for earnings on the related managed assets acquired, redemption rates, growth rates from sales efforts, the effects of market conditions and a discount rate. The process for estimating the fair value of acquired trade names considers comparable royalty rates and projected revenue streams. We typically utilize an independent valuation expert to assist with these valuations. Because the advisory and distribution contracts are with the funds, renewable annually and have a history of being renewed, industry practice under GAAP is to consider the contract lives to be indefinite and, as a result, not amortizable. Indefinite-lived intangible assets are reviewed for impairment annually as of October 1 using a qualitative approach which requires the weighing of positive and negative evidence collected through the consideration of various factors to determine whether it is more likely than not that an indefinite-lived intangible asset is impaired. We consider macroeconomic and entity-specific factors, including changes to legal, regulatory or contractual provisions of the renewable advisory and distribution contracts, the effects of obsolescence, demand, competition and other economic factors that could impact the funds’ projected performance and the existence or expectation of significant changes in the level and mix of managed assets. In addition, we consider whether events or circumstances indicate that a change in the useful life may have occurred. Indicators of a possible change in useful life monitored by us generally include changes in the use of the asset, a significant decline in the level of managed assets and significant reductions in underlying operating cash flows. If actual changes in the underlying managed assets or other conditions, such as redemption rates or changes to contractual provisions, indicate that it is more likely than not that the asset is impaired, or if the estimated useful life is reduced, we estimate the fair value of the intangible asset. The process of estimating the fair value of the intangible asset requires us to estimate the level and mix of managed assets, considering future redemption rates, growth rates, market appreciation/depreciation and a discount rate. If the carrying value of the intangible asset exceeds its fair value, we recognize an impairment charge equal to that excess. Definite-Lived Intangible Assets Definite-lived intangible assets are primarily comprised of customer relationships. These assets have definite lives given the underlying advisory contracts are between the Company and an institutional customer or the underlying advisory contract with the fund does not have a sufficient history of annual renewal to support an indefinite useful life. We monitor the useful lives of definite-lived intangible assets and revise the useful lives, if necessary, based on the circumstances. We review historical and projected attrition rates and other events that may influence our projections of the future economic benefit that we will derive from these relationships. Significant judgment is required to estimate the period during which these assets will contribute to our cash flows and the pattern over which these assets will be consumed. A change in the remaining useful life of any of these assets could have a significant impact on our amortization expense. All amortization expense is calculated on a straight-line basis. We periodically evaluate the remaining useful lives and carrying values of the definite-lived intangible assets to determine whether events and circumstances indicate that a change in the useful life or impairment in value may have occurred. Indicators of impairment monitored by us include a decline in the level of managed assets, changes to contractual provisions underlying certain intangible assets and reductions in underlying operating cash flows. If there is an indication of a change in the useful life or impairment in value of the definite-lived intangible assets, we compare the carrying value of the asset to the projected undiscounted cash flows expected to be generated from the underlying asset over its remaining useful life to determine whether impairment has occurred. If the carrying value of the asset exceeds the undiscounted cash flows, the asset is written down to its fair value determined by discounting the projected cash flows. Goodwill Goodwill represents the excess of the purchase price of acquisitions over the fair value of identified net assets and liabilities acquired. We have determined that we have only one reporting unit for purposes of assessing the carrying value of goodwill. Goodwill impairment testing is performed at the reporting unit level annually or whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. We complete our annual goodwill impairment assessment as of October 1. For purposes of this assessment, we consider various qualitative factors, including but not limited to, AUM levels and flows, market performance of our products compared to peers, turnover of key personnel, projected operating results and the implied fair value of our business based on recent transactions. If we conclude based on the qualitative assessment that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, we compare the fair value of the reporting unit to its carrying value. If we determine that the fair value of the reporting unit is less than the carrying value, we measure the amount of impairment loss, if any, by comparing the implied fair value of goodwill to its recorded value. On October 1, 2018, we qualitatively determined that it was more likely than not that the fair value of our reporting unit was greater than its carrying value. Income Taxes Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. We measure our deferred tax assets and liabilities based on enacted tax rates and projected state apportionment percentages for the years in which the differences are expected to reverse. Our primary deferred tax assets relate to intangible asset amortization, share-based compensation, acquisition-related costs, restructuring costs, deferred compensation and operating loss carryforwards. We regularly assess the recoverability of our deferred tax assets, considering all available positive and negative evidence, including the results of recent operations and the timing, level and character of projected future taxable income. These estimates are projected through the life of the related deferred tax assets based on assumptions that we believe to be reasonable and consistent with demonstrated operating results. Based on this analysis and sensitivities of future operating results, we have concluded that it is more likely than not that the recorded deferred tax assets will be realized. Changes in future operating results not currently forecasted may have a significant impact on the realization of deferred tax assets. On December 22, 2017, the Tax Act was enacted. The Tax Act significantly revised the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. As a result of the reduction in the corporate income tax rate, we were required to remeasure our U.S. net deferred taxes at December 31, 2017. The impact of the remeasurement resulted in a one-time credit to income tax expense of $2.4 million for the three months and year ended December 31, 2017. Effective January 1, 2018, the impact of the Tax Act lowered our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 25% thus lowering our income tax expense beginning in calendar year 2018. The reduction in our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 25% also reduced the tax benefit of goodwill and acquired intangible assets beginning in 2018. Share-Based Compensation We have share-based compensation arrangements covering directors, senior management, investment professionals and other employees. We calculate share-based compensation using the fair value of the awards on the grant date. Our share-based compensation arrangements include restricted stock and options which vest based on service, performance and market conditions. We recognize expense on a straight-line basis over the requisite service period for service based awards and on an accelerated basis for awards that vest based on performance and market conditions. Share-based compensation expense is adjusted for actual forfeitures in the period the forfeiture occurs. We estimate the fair value of stock option awards using the Black-Scholes option pricing model. The Black-Scholes model requires us to make assumptions about the volatility of our stock and the expected life of our stock options. In measuring expected volatility, we consider the historical volatility of the common stock of several public peer companies adjusted for differing levels of leverage, and following the IPO, we also consider the volatility of the Company’s common stock for the post-IPO period. The fair value of restricted share awards with service based vesting conditions and performance based vesting conditions is based on the market price of our stock on the date of grant. The fair value of restricted share awards subject to market conditions is estimated based on a probability-weighted expected value analysis. The most subjective assumptions in the determination of the fair value of share-based awards and share-based compensation expense recognized is the estimated fair value of our stock on the date of grant and derived service period for non-service based awards. We have historically considered the implied fair value of our stock based on periodic transactions with third parties, as well as an annual valuation of our Company performed by an independent third-party. Following the IPO, we established a policy of considering the closing sale price of our Class A common stock as quoted on NASDAQ on the date of grant for purposes of determining fair value of such awards.

<s>[INST] Overview Our Business We are an investment management firm operating a next generation, integrated multiboutique model with $52.8 billion in AUM as of December 31, 2018. Our differentiated model features a scalable operating platform that provides centralized distribution, marketing and operations infrastructure to our select group of Franchises and Solutions Platform. Our earnings are primarily driven by assetbased fees charged for services related to the investment strategies we deliver and consist of investment management, fund administration and distribution fees. Our Franchises are operationally integrated, but are separately branded and make investment decisions independently from one another within guidelines established by their respective investment mandates. Our integrated multiboutique model creates a supportive environment in which our investment professionals, largely unencumbered by administrative and operational responsibilities, can focus on their pursuit of investment excellence. VCM employs all of our U.S. investment professionals across our Franchises, which are not separate legal entities. Our Solutions Platform consists of multiFranchise and customized solutions strategies that are primarily rulesbased. We offer our Solutions Platform through a variety of vehicles, including separate accounts, mutual funds and VictoryShares which is our ETF brand. Like our Franchises, our Solutions Platform is operationally integrated and supported by our centralized distribution, marketing and operational support functions. We sell our products through our centralized distribution model with 88 professionals across both our institutional and retail distribution channels and marketing organization. Our institutional sales team focuses on cultivating relationships with institutional consultants, who account for the majority of the institutional market, as well as asset allocators seeking subadvisers. Our retail sales team offers intermediary and retirement platform clients, including brokerdealers, retirement platforms and RIA networks, mutual funds and ETFs as well as SMAs through wrap fee programs and access to our investment models through UMAs. We have grown our AUM from $17.9 billion following the managementled buyout with Crestview GP in August 2013 to $52.8 billion at December 31, 2018. We attribute this growth to our success in sourcing acquisitions and evolving them into organic growers, generating strong investment returns, and developing retail and institutional distribution channels with deep penetration. Agreement to Acquire Harvest Volatility Management and USAA Asset Management On September 21, 2018, we entered into an agreement to purchase 100% of the equity interests of Harvest Volatility Management (“Harvest”) for (i) $255 million in cash paid at the closing of the transaction ( the “Harvest Closing”) (ii) 1,565,370 shares of the Company’s Class B common stock, which equated to $15 million based on a volumeweighted average price per share of $9.5824 at September 21, 2018 to be paid at the Harvest Closing, (iii) $30.75 million in Class B common stock, issued in four equal installments at the end of each of the first four quarters following the Harvest Closing, and (iv) contingent earnout payments based on the net revenue of the Harvest business in calendar years 2021, 2022 and 2023. Harvest is a leader in derivative asset management, specializing in yield enhancement overlay, risk reduction, alternative beta and absolute return strategies. Harvest offers a suite of valueadded investment strategies for client portfolios that are designed to provide investors with riskmanaged sources of income, absolute return and varying levels of market exposure. The acquisition will expand our Solutions Platform by adding a historically strong organic grower to our platform and will further diversify our AUM into strategies that are managed to be neutral to changing market cycles. On November 6, 2018, we entered into an agreement to acquire the USAA Acquired Companies and their Mutual Fund and ETF businesses and USAA 529 College Savings Plan for (i) $850 million in cash at the closing of the transaction and (ii) contingent payments based on annual revenue in each of the first four years following the closing. The USAA Acquired Companies have proven expertise [/INST] Positive. </s>

Victory Capital Holdings, Inc.

2020-03-13

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This Management’s Discussion and Analysis of Financial Condition and Results of Operations relates to, and should be read in conjunction with the “Selected Financial Data” and our consolidated financial statements and related notes thereto included elsewhere in this report. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions, which could cause actual results to differ materially from management’s expectations. Please refer to the sections of this report entitled “Forward-Looking Statements” and “Risk Factors.” Overview Our Business - We are a diversified global asset management firm with $151.8 billion in assets under management as of December 31, 2019. The Company operates a next-generation business model combining boutique investment qualities with the benefits of a fully integrated, centralized operating and distribution platform. We provide specialized investment strategies to institutions, intermediaries, retirement platforms and individual investors. With nine autonomous Investment Franchises and a Solutions Platform, Victory Capital offers a wide array of investment styles and investment vehicles including, actively managed mutual funds, separately managed accounts, rules-based and active ETFs, multi-asset class strategies, custom-designed solutions and a 529 College Savings Plan. Our earnings are primarily driven by asset-based fees charged for services related to the investment strategies we deliver and consist of investment management, fund administration and distribution fees. Franchises - Our Franchises are operationally integrated, but are separately branded and make investment decisions independently from one another within guidelines established by their respective investment mandates. Our integrated model creates a supportive environment in which our investment professionals, largely unencumbered by administrative and operational responsibilities, can focus on their pursuit of investment excellence. VCM employs all of our U.S. investment professionals across our Franchises, which are not separate legal entities. Solutions - Our Solutions Platform consists of multi-Franchise and customized solutions strategies that are primarily rules-based. We offer our Solutions Platform through a variety of vehicles, including separate accounts, mutual funds and VictoryShares which is our ETF brand. Like our Franchises, our Solutions Platform is operationally integrated and supported by our centralized distribution, marketing and operational support functions. Our approach furthers our commitment to rules-based investing and includes single and multi-factor strategies designed to provide a variety of outcomes, including maximum diversification, dividend income, downside mitigation, minimum volatility, thematic and targeted factor exposure. Professionals within our institutional, retail and direct member distribution channels and marketing organization sell our products through our centralized distribution model. Our institutional sales team focuses on cultivating relationships with institutional consultants, who account for the majority of the institutional market, as well as asset allocators seeking sub-advisers. Our retail sales team offers intermediary and retirement platform clients, including broker-dealers, retirement platforms and RIA networks, mutual funds and ETFs as well as SMAs through wrap fee programs and access to our investment models through UMAs. Our direct member channel serves the investment needs of clients including USAA members and military community. We have grown our AUM from $17.9 billion following the management-led buyout with Crestview GP in August 2013 to $151.8 billion at December 31, 2019. We attribute this growth to our success in sourcing acquisitions and evolving them into organic growers, generating strong investment returns, and developing institutional, retail, and direct client distribution channels with deep penetration. USAA AMCO Acquisition - Effective July 1, 2019, the Company completed the USAA AMCO Acquisition, a transformative acquisition that increased AUM by $81.1 billion and significantly impacted our financial results for the year ended December 31, 2019. The acquisition not only increased AUM and revenue, but also introduced additional personnel expenses and new and additional operating expenses such as third party distribution costs, expenses related to a transfer services agreement with USAA, 529 College Savings Plan, and direct member channel expenses that the Company did not incur prior to the acquisition. In conjunction with the USAA AMCO Acquisition, the Company entered into the 2019 Credit Agreement, dated July 1, 2019, and obtained a seven-year term loan in an aggregate principal amount of $1.1 billion. All indebtedness outstanding under the previous credit agreement was repaid and terminated as of July 1, 2019. The USAA AMCO Acquisition expands and diversifies our investment platform, particularly in the fixed income and solutions asset classes, and increases our size and scale. Additional products added to our investments platform include target date and target risk strategies, managed volatility mutual funds, active fixed income ETFs, sub-advised and multi-manager equity funds. We have also added to our lineup of asset allocation portfolios and smart beta equity ETFs. Through the acquisition, the Company has the rights to offer products and services using the USAA brand for a period of time and the opportunity to offer its products to USAA members through a direct member channel. In addition, we have entered into a referral agreement with USAA for members that are interested in investing in USAA Funds or USAA 529 College Savings Plan. Total consideration for the USAA AMCO Acquisition was $950.1 million, comprising of $851.3 million of cash paid at closing and $98.8 million as the estimated fair value of contingent consideration as of the acquisition date. A maximum of $150.0 million ($37.5 million per year) in contingent payments is payable to sellers based on the annual revenue of USAA Adviser attributable to all “non-managed money”-related AUM in each of the first four years following the closing date. The estimated fair value of contingent consideration arrangements as of December 31, 2019 were $118.7 million and consist of the USAA AMCO earn-out payment liability, which is included in consideration payable for acquisition of business in the Consolidated Balance Sheets. Refer to Note 4, Acquisitions, to the audited consolidated financial statements for further details on the USAA AMCO Acquisition. Business Highlights in 2019 Assets under management: • AUM at December 31, 2019 grew by $99.1 billion, or approximately 188%, to $151.8 billion from $52.8 billion at December 31, 2018, primarily driven by $81.1 billion of acquired assets. We generated $32.1 billion in gross flows and $1.9 billion in positive net inflows for the year ended December 31, 2019, compared to $14.1 billion in gross flows and $2.4 billion of negative net outflows for the same period in 2018. We experienced $16.1 billion in market appreciation for the year ended December 31, 2019 compared to $6.6 billion in market depreciation for the same period in 2018. • In 2019, our VictoryShares ETF platform exceeded the $5.0 billion AUM milestone. • We were ranked 7th in “Barron’s Top Fund Families” for the five-year period and 10th for the 10-year period ended December 31, 2019. We ranked 17th overall on a one-year basis for 2019. Investment performance: • Legacy Victory Capital: 25 of our Legacy Victory Capital mutual funds and ETFs had overall Morningstar ratings of four or five stars and 74% of our fund and ETF AUM were rated four or five stars overall by Morningstar. 77% of our strategies by AUM had investment returns in excess of their respective benchmarks over a one-year period, 79% over a three-year period, 73% over a five-year period and 92% over a ten-year period. On an equal-weighted basis, 48% of our strategies have outperformed their respective benchmarks over a one-year period, 63% over a three-year period, 62% over a five-year period and 82% over a ten-year period. • USAA Fixed Income: 11 of our USAA Fixed Income mutual funds and ETFs had overall Morningstar ratings of four or five stars and 96% of our fund and ETF AUM were rated four or five stars overall by Morningstar. 85% of our strategies by AUM had investment returns in excess of their respective benchmarks over a one-year period, 85% over a three-year period, 88% over a five-year period and 95% over a ten-year period. On an equal-weighted basis, 71% of our strategies have outperformed their respective benchmarks over a one-year period, 67% over a three-year period, 83% over a five-year period and 91% over a ten-year period. • Total Victory Capital: 44 of our Total Victory Capital mutual funds and ETFs had overall Morningstar ratings of four or five stars and 68% of our fund and ETF AUM were rated four or five stars overall by Morningstar. 67% of our strategies by AUM had investment returns in excess of their respective benchmarks over a one-year period, 64% over a three-year period, 60% over a five-year period and 71% over a ten-year period. On an equal-weighted basis, 43% of our strategies have outperformed their respective benchmarks over a one-year period, 51% over a three-year period, 53% over a five-year period and 66% over a ten-year period. Financial highlights: • Total revenue for the year ended December 31, 2019 was $612.4 million compared to $413.4 million for the year ended December 31, 2018. Net income was $92.5 million and $63.7 million, respectively, for the year ended December 31, 2019 and 2018. • Earnings per diluted share were $1.26 for the year ended December 31, 2019 compared to $0.90 for the same period in 2018. Adjusted net income with tax benefit per diluted share was $2.63 and $1.64, respectively, for the year ended December 31, 2019 and 2018. Refer to “Supplemental Non-GAAP Financial Information” for more information about how we calculate Adjusted Net Income and a reconciliation of net income to Adjusted Net Income. • Adjusted EBITDA was $268.8 million or 43.9% for the year ended December 31, 2019 compared to $160.2 million or 38.7% for the year ended December 31, 2018. Refer to “Supplemental Non-GAAP Financial Information” for more information about how we calculate Adjusted EBITDA and a reconciliation of net income to Adjusted EBITDA. • Adjusted Net Income was $172.8 million for the year ended December 31, 2019 compared to $102.3 million for the year ended December 31, 2018. Refer to “Supplemental Non-GAAP Financial Information” for more information about how we calculate Adjusted Net Income and a reconciliation of net income to Adjusted Net Income. • Subsequent to December 31, 2019, the Company repriced its term loan reducing the interest rate by 75 basis points for an estimated annual interest rate expense savings of approximately $7.0 million, or 13.5%. Key Performance Indicators The following table presents the key performance indicators we focus on when reviewing our results: (1) Total net flows including Diversified Equity Management (“Diversified”) were ($1,860), ($2,427) and ($1,471) for the years ended December 31, 2019, 2018, and 2017, respectively. Assets managed by Diversified were transferred to Munder on May 15, 2017. (2) Our management uses Adjusted EBITDA and Adjusted Net Income to measure the operating profitability of the business. These measures eliminate the impact of one-time acquisition, restructuring and integration costs and demonstrate the ongoing operating earnings metrics of the business. These measures are explained in more detail and reconciled to net income calculated in accordance with GAAP in “Supplemental Non-GAAP Financial Information.” (3) Adjusted EBITDA margin represents Adjusted EBITDA as a percentage of total revenue. (4) Represents the tax benefits associated with deductions allowed for intangible assets and goodwill generated from prior acquisitions in which we received a step-up in basis for tax purposes. Acquired intangible assets and goodwill may be amortized for tax purposes, generally over a 15-year period. The tax benefit from amortization on these assets is included to show the full economic benefit of deductions for all acquired intangibles with a step-up in tax basis. Due to our acquisitive nature, tax deductions allowed on acquired intangible assets and goodwill provide us with a significant supplemental economic benefit. On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was enacted. The Tax Act significantly revised the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. The reduction in the federal corporate income tax rate reduced the tax benefit of goodwill and acquired intangible assets beginning in 2018. Assets Under Management Our profitability is largely affected by the level and composition of our AUM (including asset class and distribution channel) and the effective fee rates on our products. The amount and composition of our AUM are, and will continue to be, influenced by a number of factors, including; (i) investment performance, including fluctuations in the financial markets and the quality of our investment decisions; (ii) client flows into and out of our various strategies and investment vehicles; (iii) industry trends toward products or strategies that we either do or do not offer; (iv) our ability to attract and retain high quality investment, distribution, marketing and management personnel; (v) our decision to close strategies or limit growth of assets in a strategy when we believe it is in the best interest of our clients or conversely to re-open strategies in part or entirely; and (vi) general investor sentiment and confidence. Our goal is to establish and maintain a client base that is diversified by Franchise and Solutions, asset class, distribution channel and vehicle. Valuation of Assets Under Management The fair value of assets under management of the Victory Funds, USAA Funds and VictoryShares is primarily determined using quoted market prices or independent third party pricing services or broker price quotes. In limited circumstances, a quotation or price evaluation is not readily available from a pricing service. In these cases, pricing is determined by management based on a prescribed valuation process that has been approved by the directors/trustees of the sponsored products. The same prescribed valuation process is used to price securities in separate accounts and other vehicles for which a quotation or price evaluation is not readily available from a pricing service. For the periods presented, a de minimis amount of the AUM was priced in this manner. AUM by Asset Class - the following table presents our AUM by asset class as of the dates indicated: (1) Includes the impact of the USAA AMCO Acquisition, which closed on July 1, 2019, increasing our AUM by $81.1 billion inclusive of managed portfolio assets invested through USAA’s brokerage business. We did not acquire the USAA brokerage business. As of December 31, 2019, these managed portfolio assets totaled $9.9 billion. (2) Includes the impact of the RS Acquisition, which closed on July 29, 2016, and increased our AUM by $16.7 billion. (3) Includes the impact of the CEMP Acquisition, which closed on April 30, 2015, and increased our AUM by $1.0 billion. Asset Flows by Asset Class - the following table summarizes our asset flows by asset class for the periods indicated: AUM by Distribution Channel - the following table presents our AUM by distribution channel as of the dates indicated: (1) The allocation of AUM by distribution channel involves the use of estimates and the exercise of judgment. Assets Flows by Vehicle - the following table summarizes our asset flows by vehicle for the periods indicated: (1) Includes institutional and retail share classes and Variable Insurance Products or VIP funds. (2) Excludes assets managed for other proprietary product (i.e. funds of funds) in order to adjust for double counting. (3) Includes collective trust funds, wrap program separate accounts and unified managed accounts or UMAs. December 31, 2019 AUM - Our total AUM at December 31, 2019 was $151.8 billion, an increase of $99.1 billion, or 187.8%, compared to $52.8 billion at December 31, 2018. The change in AUM during 2019 reflects $81.1 billion of acquired assets, $1.9 billion of positive net inflows, as well as $16.1 billion in positive market movement. Short-term money market assets accounted for $11.6 billion, or 7.6% of the total AUM at December 31, 2019. The net inflows were driven by $2.6 billion in our Solutions Platform and $2.3 billion in our fixed income strategies, partially offset by net outflows of $1.0 billion in our U.S. mid cap equity strategies, $0.9 billion in our U.S. large cap equity strategies, $0.9 billion in our U.S. small cap equity strategies, $0.2 billion in other and $0.1 billion in our global/non-U.S equity strategies. December 31, 2018 AUM - Our total AUM at December 31, 2018 was $52.8 billion, a decrease of $9.0 billion, or 14.6%, compared to $61.8 billion at December 31, 2017, reflected by $2.4 billion of negative net outflows and $6.6 billion in negative market movement. The net outflows were primarily a result of $2.7 billion in our U.S. mid cap equity strategies, $0.8 billion in our fixed income strategies, $0.6 billion in our U.S. large cap equity strategies, $0.6 billion in our U.S. small cap equity strategies and $0.4 billion in our other strategies, partially offset by net inflows of $1.5 billion in our global equity strategies and $1.1 billion in our Solutions Platform. December 31, 2017 AUM - Our total AUM at December 31, 2017 was $61.8 billion, an increase of $6.8 billion, or 12.3%, compared to $55.0 billion at December 31, 2016. The change in AUM reflects $1.5 billion of negative net outflows and $8.4 billion in positive market movement. The net outflows were primarily a result of $1.5 billion in our U.S. large cap equity strategies, $1.1 billion in our U.S. small cap equity strategies, $0.5 billion in our other strategies, $0.4 billion in our global equity strategies and $0.4 billion in our fixed income strategies, partially offset by net inflows of $1.3 billion in our U.S. mid cap equity strategies and $1.1 billion in our Solutions Platform. GAAP Results of Operations Our GAAP revenues principally consist of; (i) investment management fees, which are based on our overall weighted average fee rate charged to our clients and our level of AUM and (ii) fund administration and distribution fees, which are asset-based fees earned from open-end mutual funds for administration and distribution services. Fund administration and fund distribution fees also include fund transfer agent fees (related to the USAA Funds), which are based on a contractual rate applied to average AUM or the number of accounts in these funds. The Company has contractual arrangements with third parties to provide certain advisory, administration, transfer agent and distribution services. Management considers whether we are acting as the principal service provider or as an agent to determine whether revenue should be recorded based on the gross amount payable by the customer or net of payments to third-party service providers, respectively. Victory is considered a principal service provider if we control the service that is transferred to the customer. We are considered an agent when we arrange for the service to be provided by another party and do not control the service. Investment Management Fees - Investment management fees are earned from managing clients’ assets. Our investment management fee revenue fluctuates based on a number of factors, including the total value of our AUM, the composition of AUM across investment strategies and vehicles, changes in the investment management fee rates on our products and the extent to which we enter into fee arrangements that differ from our standard fee schedule. Investment management fees are earned based on a percentage of AUM as delineated in the respective investment management agreements. Our investment management fees are calculated based on daily average AUM, monthly average AUM or point in time AUM. Fund Administration and Distribution Fees - Fund administration fees are asset-based fees earned from open-end funds for administration services. Fund administration fees fluctuate based on the level of average open-end fund AUM and the fee rates charged for these services. Fund distribution fees are asset-based fees earned from open-end funds for distribution services. Fund distribution fees fluctuate based on the level of average open-end fund AUM and the composition of those assets across share classes that pay varying levels of fund distribution fees. The Company has contractual arrangements with a third party to provide certain sub-administration services. We are the primary obligor under the contracts with the Victory Funds, USAA Funds and VictoryShares and have the ability to select the service provider and establish pricing. As a result, fund administration fees and sub-administration expenses are recorded on a gross basis. VCA has contractual arrangements with third parties to provide certain distribution services. VCA is the primary obligor under the contracts with the Victory Funds and USAA Funds and has the ability to select the service provider and establish pricing. Substantially all of VCA’s revenue is recorded gross of payments made to third parties. Fund transfer agent fees are earned for providing mutual fund shareholder services. Transfer agent fees fluctuate based on the level of average AUM and the number of accounts in the USAA Funds. The Company has contractual arrangements with a third party to provide certain sub-transfer agent services. We are the primary obligor under the transfer agency contracts with the USAA Funds and have the ability to select the service provider and establish pricing. As a result, fund transfer agent fees and sub-transfer agent expenses are recorded on a gross basis. GAAP Expenses Our GAAP expenses principally consist of; (i) personnel compensation and benefits; (ii) distribution and other asset-based expenses; (iii) general and administrative expenses; (iv) depreciation and amortization charges; and (v) acquisition-related expenses comprising of changes in the fair value of contingent acquisition payments and restructuring and acquisition costs. Personnel Compensation and Benefits - Personnel compensation and benefits is our most significant category of expense. Personnel compensation and benefits consists of (i) salaries, payroll related taxes and employee benefits, (ii) incentive compensation, (iii) sales-based compensation, (iv) compensation expense related to equity awards granted to employees and directors and (v) acquisition-related compensation in the form of cash retention bonuses. Incentive compensation is the largest component of the total compensation of our employees. The aggregate amount of cash incentive compensation is funded by a pool that is based on a percentage of total Company earnings (before taking into account incentive compensation). This incentive pool is used to pay the investment teams a percentage of the revenue earned by their respective Franchise on a quarterly basis. This incentive pool is also used to pay incentive compensation to senior management and other non-investment employees on an annual basis. Incentive compensation paid to senior management and to other non-investment employees is discretionary and subjectively determined based on Company and individual performance and the total amount of the incentive compensation pool. Distribution and Other Asset-based Expenses - Distribution and other asset-based expenses consists of (i) broker-dealer distribution fees and platform distribution fees, (ii) fund expense reimbursements to affiliates and (iii) sub-administration, sub-transfer agent, sub-advisory expenses and middle-office expenses. Broker-dealer distribution fees are paid by VCA as the broker-dealer for the Victory Funds and USAA Funds to third-party distributors. The Victory Funds and USAA Funds pay VCA for distribution services and VCA, in turn, pays third-party distributors. Platform distribution fees are paid by VCM as the investment adviser to the Victory Funds and USAA Funds. Platform distribution fees are paid to financial advisors, retirement plan providers and intermediaries for servicing and administering accounts invested in shares of the Victory Funds and USAA Funds. Distribution fees typically vary based on the level of AUM and the composition of those assets across share classes. Fund expense reimbursements (contra revenue) result from VCM, as investment adviser for the Victory Funds, VictoryShares and USAA Funds, agreeing to cap the annual operating expenses for certain share classes of the Victory Funds, USAA Funds and VictoryShares. VCM has contractually agreed to reimburse the Victory Funds, USAA Funds and VictoryShares for expenses in excess of these caps but may recoup these reimbursements for a period of time if the applicable Fund’s share class expenses and/or VictoryShares ETF expenses fall below the cap. Sub-administration, sub-transfer agent, sub-advisory and middle-office expenses consist of fees paid to our sub-administrators of the Victory Funds, VictoryShares and USAA Funds, fees paid to our sub-transfer agent for the USAA Funds, fees paid to sub-advisers on certain Victory Funds and USAA Funds and fees paid to vendors to which we outsource middle-office functions. • VCM acts as the administrator to the Victory Funds, VictoryShares and USAA Funds. VCM has hired a sub-administrator, the fees for which are captured in sub-administration expense. As administrator, VCM supervises the operations of the Victory Funds, VictoryShares and USAA Funds, including the services provided by the sub-administrators. The sub-administrators are paid through a contractual arrangement based on a percentage of the average fund AUM. • VCTA acts as the transfer agent to the USAA Funds. VCTA has hired a sub-transfer agent, the fees for which are captured in sub-administration expense. As transfer agent, VCTA oversees the services provided by the sub-transfer agent. The sub-transfer agent is paid through a contractual arrangement based on a percentage of average fund AUM. • VCM, as the investment adviser for the Victory Funds and USAA Funds, has hired unaffiliated sub-advisers to manage funds for which we do not have in-house capabilities. The fees paid to the sub-advisers are contractual based on a percentage of assets that they manage. • We have outsourced middle-office operations to achieve a scalable operational infrastructure that utilizes a variable-cost model. We have selected to partner with top-tier vendors who perform trade operations, portfolio accounting and performance measurement with oversight from our operations team. The fees paid to these vendors are variable and structured based on the number of accounts, assets and specific services performed. General and Administrative Expenses - General and administrative expenses primarily consist of investment research and technology costs, professional and marketing fees, travel, rent and insurance expenses. Depreciation and Amortization - Depreciation and amortization expense consists primarily of the depreciation of property and equipment as well as the amortization of acquired intangibles that have a definite life. These intangibles include customer relationships, investment advisory contracts, intellectual property and non-compete clauses acquired in connection with a business or asset acquisition. Both depreciation and amortization are recorded ratably over the assets’ useful lives. Acquisition-Related Costs - Acquisition-related costs include legal fees, advisory services, mutual fund proxy voting costs and other one-time expenses related to acquisitions. Restructuring and Integration Costs - Restructuring and integration costs include costs incurred in connection with business combinations, including the increase in the fair value of contingent acquisition payments, asset purchases and changes in business strategy. These include severance expenses related to one-time benefit arrangements, contract termination and other costs to integrate investment platforms, products and personnel into existing systems, processes and service provider arrangements and restructuring the business to capture operating expense synergies. Other non-operating items of income and expense consist of; (i) interest income and other income (expense); (ii) interest expense and other financing costs; (iii) loss on debt extinguishment; and (iv) income tax (expense) benefit. Interest Income and Other Income (Expense) - Interest income and other income (expense) consists primarily of interest income, gains (losses) on investments and dividend income on investments. Interest Expense and Other Financing Costs - Interest expense and other financing costs consists primarily of interest expense attributable to long-term debt. Refer to “Liquidity and Capital Resources” for more information. Loss on Debt Extinguishment - Loss on debt extinguishment consists of the write-off of unamortized debt issuance costs and unamortized debt discount as a result of debt refinancing and the acceleration of the paydown of debt principal. Income Tax Expense - The provision for income taxes includes U.S. federal, state and local taxes, and foreign income taxes payable by certain of our subsidiaries. The effective tax rate is primarily driven by state and local taxes and permanent differences related to meals and entertainment. The portion of the effective income tax rate attributable to state and local income taxes varies from year to year depending on amounts of income apportioned to each jurisdiction, whether we file income tax returns on a unitary or separate return basis and with changes in tax laws. On December 22, 2017, the Tax Act was enacted and significantly revised the U.S. corporate income tax law by, among other things, decreasing the federal corporate income tax rate from 35% to 21% effective January 1, 2018. The following table presents our GAAP results of operations for the years ended December 31, 2019, 2018 and 2017. Investment Management Fees 2019 compared to 2018 - Investment management fees increased $114.1 million, or 32.4%, to $466.8 million in 2019 from $352.7 million in 2018 due to an increase in average AUM year over year, partially offset by a decrease in the realized fee rate due to a shift in asset mix. Average AUM was $102.7 billion in 2019 compared to $61.4 billion in 2018, mostly attributable to the acquired assets in the USAA AMCO Acquisition. The Company adopted Accounting Standards Update (“ASU”) 2014-09 on January 1, 2019. Mutual fund and ETF waivers and expense reimbursements are recorded as a reduction to investment management fees under the new standard ($18.7 million in 2019). The comparative periods have not been restated and continue to be reported under the legacy guidance, as permitted by the Financial Accounting Standards Board (the “FASB”). 2018 compared to 2017 - Investment management fees increased $8.9 million, or 2.5%, to $352.7 million in 2018 from $343.8 million in 2017 due to the same factors related to average AUM and shift in asset mix as discussed above in the “2019 compared to 2018” section. Average AUM was $61.4 billion in 2018 compared to $57.8 billion in 2017. Fund Administration and Distribution Fees 2019 compared to 2018 - Fund administration and distribution fees totaled $145.6 million in 2019, an increase of $84.8 million, or 139.7%, from $60.7 million in 2018. Fund administration fees increased by $48.7 million, or 210.2%, due to an increase in average AUM year over year, mostly attributable to the USAA AMCO Acquisition and the addition of $42.8 million in transfer agent fees with the USAA Funds, partially offset by a reduction in fund distribution fees due to a shift in the mix of assets to lower 12b-1 paying share classes. Transfer agent fees represent a new revenue stream for VCTA in accordance with a contract with the USAA Funds. 2018 compared to 2017 - Fund administration and distribution fees totaled $60.7 million in 2018, a decrease of $5.1 million, or 7.7%, from $65.8 million in 2017, due to a decrease in fund distribution fees partially offset by an increase in fund administration fees. The decrease in fund distribution fees was due to a shift in the mix of assets to lower 12b-1 paying share classes, partially offset by an increase in average AUM in 2018. The increase in fund administration fees was due to higher mutual fund and ETF average daily assets. Personnel Compensation and Benefits The following table presents the components of GAAP compensation expense for the year ended December 31, 2019, 2018 and 2017: (1) Represents sales-based commissions paid to our distribution teams. Sales-based compensation varies based on gross and net client cash flows and revenue earned on sales. (2) Share-based compensation typically vests over several years based on service and the achievement of specific business and financial targets. The value of share-based compensation is recognized as compensation expense over the vesting period. 2019 compared to 2018 - Personnel compensation and benefits were $179.8 million in 2019, an increase of $33.9 million, or 23.3%, from $145.9 million in 2018 primarily attributable to an increase in headcount due to the USAA AMCO Acquisition, as well as a year over year increase in deferred compensation plan liabilities from favorable market action. The increase in incentive compensation was due to higher pre-incentive compensation earnings while performance award vestings in 2019 contributed to the increase in share-based compensation. The Company incurred $1.6 million in acquisition and transaction-related compensation expense in 2019 with no such expense incurred during the previous year. 2018 compared to 2017 - Personnel compensation and benefits increased by $1.8 million, 1.2%, to $145.9 million in 2018 from $144.1 million in 2017. The slight increase was due to an increase in incentive compensation, partially offset by a year over year decrease in deferred compensation plan liabilities from unfavorable market action. Share-based compensation increased in 2018 due to the IPO and pre-existing awards, while sales-based compensation decreased as a result of lower gross flows. Distribution and Other Asset-based Expenses The following table presents the components of distribution and other asset-based expenses for the year ended December 31, 2019, 2018 and 2017: 2019 compared to 2018 - Distribution and other asset-based expenses are primarily based on AUM. Distribution and other asset-based expenses were $146.6 million in 2019, an increase of $51.9 million, or 54.9%, from $94.7 million in 2018, primarily due to the USAA AMCO Acquisition. The acquisition introduced new operating expenses that the Company did not incur prior to the acquisition, such as platform distribution costs paid to third parties and USAA, sub-transfer agent service costs and 529 College Savings Plan expenses. Fund expense reimbursements declined by $12.9 million due to the change in the classification of such reimbursements with the adoption of ASU 2014-09 on January 1, 2019. Mutual fund and ETF waivers and expense reimbursements are recorded as a reduction to investment management fees under ASU 2014-09, whereas under legacy revenue recognition guidance these were recorded as a distribution and other asset-based expense. The comparative periods have not been restated and continue to be reported under the legacy guidance, as permitted by the FASB. Broker-dealer distribution fees decreased due to the shift in the mix of assets to lower and non 12b-1 paying share classes. 2018 compared to 2017 - Distribution and other asset-based expenses decreased by $8.8 million, or 8.5%, to $94.7 million in 2018, from $103.4 million in 2017. Broker-dealer distribution fees and platform distribution fees decreased due to the mix of mutual fund assets and share classes. General and Administrative Expenses 2019 compared to 2018 - General and administrative expenses were $46.6 million in 2019 compared to $30.0 million in 2018. The increase of $16.6 million, or 55.2%, was primarily due to the addition of transition service agreement costs related to the USAA AMCO Acquisition, as well as one-time debt repricing expenses related to the 2019 Credit Agreement. 2018 compared to 2017 - General and administrative expenses decreased by $4.0 million, or 11.7%, to $30.0 million in 2018, from $34.0 million in 2017, driven by operational efficiencies. Depreciation and Amortization 2019 compared to 2018 - Depreciation and amortization increased by $0.6 million, or 2.6%, to $23.9 million in 2019, from $23.3 million in 2018, due to the addition of definite-lived intangible assets acquired in connection with the USAA AMCO Acquisition, partially offset by definite-lived assets acquired in connection with the CEMP Acquisition and the management-led buyout with Crestview GP becoming fully amortized in 2018. 2018 compared to 2017 - Depreciation and amortization decreased to $23.3 million in 2018, from $29.9 million in 2017, primarily due to certain definite-lived intangible assets acquired in connection with the management-led buyout with Crestview GP becoming fully amortized in 2018. Acquisition-Related Costs 2019 compared to 2018 - Acquisition-related costs were $22.3 million and $4.3 million, respectively, in 2019 and 2018, with the increase primarily due to the USAA AMCO Acquisition which closed on July 1, 2019. The acquisition-related expenses include various transaction costs such as legal and filing fees and other professional fees. On April 22, 2019, the Company and Harvest Volatility Management, LLC (“Harvest”) entered into an agreement to mutually terminate the purchase agreement entered into on September 21, 2018. Neither the Company nor Harvest was responsible for any termination fee to the other party as a result of the termination. 2018 compared to 2017 - Acquisition-related costs increased by $2.2 million, or 107.5%, to $4.3 million in 2018, from $2.1 million in 2017, primarily due to costs incurred related to the USAA AMCO Acquisition and Harvest. Restructuring and Integration Costs 2019 compared to 2018 - Restructuring and integration costs were $8.7 million and $0.7 million, respectively, in 2019 and 2018, with the increase due to severance costs and integration and conversion costs related to the USAA AMCO Acquisition. 2018 compared to 2017 - Restructuring and integration costs decreased by $5.5 million, or 88.0%, to $0.7 million in 2018, from $6.2 million in 2017, primarily due to costs incurred in 2017 for contract breakage and asset write-offs associated with the integration of RS Investment Management Co. LLC (“RS Investments”). Interest Income and Other Income (Expense) 2019 compared to 2018 - Interest income and other income (expense) was income of $6.8 million in 2019, compared to expense of $2.9 million in 2018. The increase was collectively due to a (i) gain on sale of an equity method investment in Cerebellum of $2.9 million, (ii) higher yields on our cash invested in money market accounts and (iii) net unrealized gains on deferred compensation plan investments. 2018 compared to 2017 - Interest income and other income (expense) was expense of $2.9 million in both 2018 and 2017, and mainly consisted of net unrealized losses on deferred compensation plan investments. Interest Expense and Other Financing Costs 2019 compared to 2018 - Interest expense and other financing costs increased by $20.2 million, or 97.6%, to $40.9 million in 2019, from $20.7 million in 2018 due to the Company entering into the 2019 Credit Agreement, dated July 1, 2019, in conjunction with the USAA AMCO Acquisition. All indebtedness outstanding under the previous credit agreement was repaid and terminated as of July 1, 2019. Refer to Note 11, Debt, to the audited financial statements for further details on the 2019 Credit Agreement. 2018 compared to 2017 - Interest expense and other financing costs decreased by $20.8 million, or 57.3%, to $20.7 million in 2018, from $48.5 million in 2017 as a result of refinancing activities and the paydown of debt principal. Loss on Debt Extinguishment 2019 compared to 2018 - Loss on debt extinguishment was $9.9 million in 2019. The Company wrote-off unamortized debt issuance costs and unamortized debt discount due to (i) the termination of the previous credit agreement, dated February 2018 ($5.5 million) and (ii) accelerating the paydown of debt principal under the 2019 Credit Agreement ($4.4 million). The Company also paid down $148.0 million of debt in 2019 under the 2019 Credit Agreement. Refer to Note 11, Debt, to the audited financial statements for further details on the 2019 Credit Agreement. The Company incurred a $6.1 million loss on debt extinguishment in 2018 due to the termination of a previous credit agreement, dated October 2014. 2018 compared to 2017 - Loss on debt extinguishment was $6.1 million in 2018 as discussed above in the “2019 compared to 2018” section. The Company incurred a $0.3 million loss on debt extinguishment in 2017 due to the repricing of a previous term loan. Income Tax Expense 2019 compared to 2018 - Our effective tax rate was 23.4% and 25.0% in 2019 and 2018, respectively. The decrease in the effective tax rate was primarily due to higher excess tax benefits on share-based compensation net of expense related to recognizing a liability for unrecorded tax benefits. Refer to Note 10, Income Taxes, to the audited financial statements for further details on income taxes. 2018 compared to 2017 - Our effective tax rate was 25.0% and 32.8% in 2018 and 2017, respectively, with the year over year decrease due to a reduction in our effective tax rate in 2018 related to the Tax Act. Effects of Inflation Inflation did not have a material effect on our consolidated results of operations. Inflationary pressures can result in increases to our cost structure, especially to the extent that large expense components such as compensation are impacted. To the degree that these expense increases are not recoverable or cannot be counterbalanced through price increases due to the competitive environment, our profitability could be negatively impacted. In addition, the value of the fixed income assets that we manage may be negatively impacted when inflationary expectations result in a rising interest rate environment. Declines in the values of AUM could lead to reduced revenues as investment management fees are generally earned as a percentage of AUM. Supplemental Non-GAAP Financial Information We report our financial results in accordance with GAAP. Our management uses non-GAAP performance measures to evaluate the underlying operations of our business. Non-GAAP financial measures are used to supplement GAAP results to provide a more complete understanding of the factors and trends affecting our business than GAAP results alone. Due to our acquisitive nature, there are a number of acquisition and restructuring related expenses included in GAAP measures that we believe distort the economic value of our organization and we believe that many investors use this information when assessing the financial performance of companies in the investment management industry. We have included these non-GAAP measures to provide investors with the same financial metrics used by management to assess the operating performance of our Company. Non-GAAP measures should be considered in addition to, and not as a substitute for, financial measures prepared in accordance with GAAP. Our non-GAAP measures may differ from similar measures at other companies, even if similar terms are used to identify these measures. Specifically, we make use of the non-GAAP financial measures “Adjusted EBITDA” and “Adjusted Net Income.” The impact of the Tax Act lowered our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 25% thus lowering our income tax expense beginning in calendar year 2018. The reduction in our combined statutory federal income tax rate plus an estimate for state, local and foreign income taxes from approximately 38% to 25% also reduced the tax benefit of goodwill and acquired intangible assets beginning in 2018. The following table sets forth a reconciliation from GAAP financial measures to non-GAAP measures for the periods indicated: Adjustments made to GAAP Net Income to calculate Adjusted EBITDA and Adjusted Net Income, as applicable, are: (1) Adding back interest paid on debt and other financing costs, net of interest income. (2) Adding back depreciation on property and equipment. (3) Adding back other business taxes. (4) Adding back amortization expense on acquisition-related intangible assets. (5) Adding back share-based compensation associated with equity awards issued from pools created in connection with the management-led buyout and various acquisitions and as a result of equity grants related to the initial public offering of our Class A common stock (the “IPO”). (6) Adding back direct incremental costs of acquisitions and the IPO, including restructuring costs. (7) Adding back debt issuance cost expense. (8) Adding back pre-IPO governance expenses paid to the Company’s private equity partners that terminated as of the completion of the IPO (9) Adjusting for (earnings) losses on equity method investments. (10) Subtracting an estimate of income tax expense applied to the sum of the adjustments above. (11) Remeasurement of our U.S. net deferred taxes resulting in a one-time income tax expense of $2.4 million in 2017 due to the Tax Act enacted on December 22, 2017. (12) Represents the tax benefits associated with deductions allowed for intangibles and goodwill generated from acquisitions in which we received a step-up in basis for tax purposes. Acquired intangible assets and goodwill may be amortized for tax purposes, generally over a 15-year period. The tax benefit from amortization on these assets is included to show the full economic benefit of deductions for all acquired intangibles with a step-up in tax basis. Due to our acquisitive nature, tax deductions allowed on acquired intangible assets and goodwill provide us with a significant supplemental economic benefit. The following table presents the components of acquisition, restructuring and exit costs for the periods indicated: Liquidity and Capital Resources Sources and Uses of Cash - We generate strong cash flows from operations that allow us to meet our cash requirements. Our primary uses of cash include (i) repayment of our debt obligations, (ii) funding of acquisitions, (iii) payment of contingent consideration for previous acquisitions, and (iv) working capital needs. Cash flows from operations also allow us to meet certain other cash requirements such as quarterly cash dividends and the repurchase of our Class A common stock. We believe we have sufficient liquidity and capital resources to continue to paydown our debt obligations as well as to continue focusing on acquisition candidates that increase our size, scale, asset class and client diversification. The following table presents our liquidity position as of December 31, 2019 and 2018: (1) We manage our cash balances in order to fund our day-to-day operations and invest excess cash into money market funds and other short-term investments. (2) Our accounts receivables consist primarily of investment management, fund administrative and distribution fees that have been earned but not yet received from clients. We perform a review of our receivables on a monthly basis to access collectability. (3) Revolving credit facility of $100.0 million at December 31, 2019 and 2018, which had $100.0 million undrawn as of both periods. (4) Accounts and other payables consist primarily of various payables related to operations, transaction costs and interest payable on the term loan, as well as accrued compensation and benefits. Transaction costs consist of non-recurring transaction costs of $8.5 million and restructuring and integration costs of $3.0 million. Excludes long-term debt, net due to the Company satisfying the required principal amortization of 1.00% per annum through the term loan, June 2026. As previously noted, the USAA AMCO Acquisition introduced additional personnel expenses and new and additional operating expenses such as expenses related to a transfer services agreement with USAA, 529 College Savings Plan, and direct member channel expenses that the Company did not incur prior to the acquisition. 2019 Credit Agreement - In conjunction with the USAA AMCO Acquisition, the Company entered into the 2019 Credit Agreement, dated July 1, 2019, and obtained a seven-year term loan in an aggregate principal amount of $1.1 billion. All indebtedness outstanding under the previous credit agreement was repaid and terminated as of July 1, 2019. In 2019, the Company repaid $148.0 million of the outstanding term loans under the 2019 Credit Agreement, and subsequent to December 31, 2019, the Company has repaid an additional $38.0 million. As of December 31, 2019, we were in compliance with our financial performance covenant. Refer to Note 4, Acquisitions, to the audited consolidated financial statements for further details on the USAA AMCO Acquisition, as well as Note 11, Debt, for further information on the 2019 Credit Agreement. The First Amendment - Subsequent to December 31, 2019, the Company entered into the First Amendment dated as of July 1, 2019 with other loan parties thereto, Barclays Bank PLC, as administrative agent, and the Royal Bank of Canada as fronting bank, and the lenders party thereto which amends the 2019 Credit Agreement. Pursuant to the The First Amendment, effective January 17, 2020, the Company refinanced the Existing Term Loans with the Repriced Term Loans in an aggregate principal amount of $952.0 million. The Repriced Term Loans provide for substantially the same terms as the Existing Term Loans, including the same maturity date of June 2026, except that the Repriced Term Loans provide for a reduced applicable margin on the LIBOR of 75 basis points. The applicable margin on LIBOR under the Repriced Term Loans is 2.50%, compared to 3.25% under the Existing Term Loans. Capital Requirements - VCA is a registered broker-dealer subject to the Uniform Net Capital requirements under the Exchange Act, which requires maintenance of certain minimum net capital levels. In addition, we have certain non-U.S. subsidiaries that have minimum capital requirements. As a result, such subsidiaries of our Company may be restricted in their ability to transfer cash to their parents. VCA and our non-U.S. subsidiaries were in compliance with these requirements as of and for the years ended December 31, 2019, 2018 and 2017. Cash Flows - the following table is derived from our Consolidated Statements of Cash Flows for the year ended December 31, 2019, 2018 and 2017. Operating Activities 2019 compared to 2018 - Cash provided by operating activities was $227.4 million in 2019, compared to $134.3 million in 2018. The $93.0 million net increase in cash provided by operating activities was primarily due to a $48.2 million net increase in working capital as a result of timing of accrued expenses and compensation and a $28.8 million increase in net income, as well as adjustments for certain non-cash items which contributed $16.1 million to the increase in cash provided by operating activities. The USAA AMCO Acquisition increased revenue and introduced new operating expenses that the Company did not incur prior to the acquisition, such as distribution costs paid to third parties and USAA, sub-transfer agent service costs, 529 College Savings Plan expenses, and direct member channel expenses. 2018 compared to 2017 - Cash provided by operating activities was $134.3 million in 2018, compared to $96.2 million in 2017. The $38.2 million net increase in cash provided by operating activities was mostly attributable to a $37.9 million increase in net income due to growth in the business and lower interest expense as a result of refinancing activities and pre-payments. Investing Activities 2019 compared to 2018 - Cash used in investing activities increased by $838.3 million to $849.8 million in 2019, from $11.5 million in 2018. The increase was primarily due to $851.3 million paid in cash at the July 1, 2019 closing of the USAA AMCO Acquisition, partially offset by $10.6 million in proceeds from the Company selling 100% of its equity investment in Cerebellum. 2018 compared to 2017 - Cash used in investing activities was $11.5 million in 2018, compared to $8.5 million in 2017. The $3.0 million net increase in cash used in investing activities was primarily due to additional equity investments made in Cerebellum in 2018. Financing Activities 2019 compared to 2018 - Cash provided by financing activities was $608.0 million in 2019 and consisted of $1,069.0 million of net proceeds from the 2019 Credit Agreement, partially offset by the repayment and termination of the previous credit agreement (dated February 2018) of $280.0 million and repayment of long-term debt under the 2019 Credit Agreement in the third and fourth quarter of 2019 of $148.0 million. The repurchase of our Class A common stock and payment of dividends contributed $15.5 million and $7.4 million, respectively, in cash used in financing activities during 2019. Cash used in financing activities was $84.2 million in 2018 and consisted of the repayment of $499.7 million of term loans under a previous credit agreement (dated October 2014) and the repayment of long-term debt under a previous credit agreement (dated February 2018) of $80.0 million, partially offset by $360.0 million of net proceeds from a previous credit agreement (dated February 2018) and the generation of $156.5 million of net IPO proceeds. 2018 compared to 2017 - Cash used in financing activities was $84.2 million in 2018 as discussed above in the “2019 compared to 2018” section. Cash used in financing activities was $91.2 million in 2017 and consisted of the payment of a dividend to shareholders of $135.2 million, the repayment of long-term debt under a previous credit agreement (dated October 2014) of $63.9 million, partially offset by $125.0 million of net proceeds from a previous credit agreement (dated October 2014). Contractual Obligations The following summarizes our contractual obligations as of December 31, 2019: (1) The total principal payments on borrowings reflects the gross amount of principal outstanding on the term loans under the 2019 Credit Agreement as of December 31, 2019. The Company has satisfied the required principal amortization of 1.00% per annum through the term of the loan, June 2026. Subsequent to December 31, 2019, the Company has repaid an additional $38.0 million of principal outstanding on the term loans under the 2019 Credit Agreement. (2) The total interest payable reflects the interest obligation over the life of the loans calculated based on the principal amount of the term loans outstanding under the 2019 Credit Agreement as of December 31, 2019 using the 5.34863% interest rate in effect on that date. The Company entered into the First Amendment to the Credit Agreement on January 17, 2020. Pursuant to the First Amendment, the Company refinanced the Existing Term Loans with Repriced Term Loans in an aggregate principal amount of $952.0 million. The Repriced Term Loans provide for a reduced applicable margin on LIBOR of 75 basis points (2.50% compared to 3.25%), for an estimated annual interest rate expense savings of approximately $7.0 million, or 13.5%. (3) Represents the fair value of the contingent consideration that is estimated to be paid over the next four years resulting from the USAA AMCO Acquisition. A maximum of $150.0 million ($37.5 million per year) in contingent payments is potentially payable to the sellers. (4) Operating leases include the minimum rent commitments under non-cancelable operating leases, net of cash expected to be received under the sub-lease. Off-Balance Sheet Arrangements In connection with dividends declared in February 2017 and December 2017, holders of restricted stock awards that were unvested at the time such dividends were declared are entitled to be paid the dividends as and when the restricted stock vests. Holders of stock options that were unvested at the time the December 2017 dividend was declared are entitled to receive a cash bonus equivalent of the December 2017 dividend as and when their stock options vest. These amounts are not recorded as a liability until and unless the awards vest in accordance with their respective agreements. The Company announced the initiation of quarterly cash dividends in August 2019 and paid a quarterly dividend in September and December 2019. Holders of restricted stock awards that are unvested at the time the quarterly dividends are declared are entitled to be paid these dividends as and when the restricted stock vests. As of December 31, 2019, the cash bonuses and distributions related to dividends on restricted shares and options that are expected to vest in the future totaled $1.3 million. Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in accordance with GAAP is based on the selection and application of accounting policies that require us to make significant estimates and assumptions that in certain circumstances affect amounts reported in the audited consolidated financial statements. In preparing these financial statements, our estimates and judgements are based on historical experience, information from third-party valuation professionals and various other assumptions, giving due consideration to materiality. We consider the accounting policies discussed below to be critical to the understanding of our consolidated financial statements. Actual results could differ from our estimates and assumptions, and any such difference could be material to our consolidated financial statements. Significant accounting policies are described more fully in Note 2, Significant Accounting Policies, to the audited consolidated financial statements. Business Combinations - We recognize and measure identifiable assets acquired and liabilities assumed in business combinations as of the acquisition date at fair value. The process of determining the fair value of identifiable intangible assets at the date of acquisition utilizes an income approach and requires significant estimates and judgment as to expectations for earnings on the related managed assets acquired, redemption rates, growth rates from sales efforts, the effects of market conditions and a discount rate. The process for estimating the fair value of acquired trade names considers comparable royalty rates and projected revenue streams. We typically utilize an independent valuation expert to assist with these valuations. We recognize and measure contingent consideration liabilities at fair value as of the acquisition date using an option pricing model and Monte Carlo simulation. These valuations require significant estimates and judgments related to projected revenue growth rates, adjustments for market-based risk, volatility and discount rates. The fair value of contingent consideration liabilities is remeasured at each reporting period, typically using the same methodology used to determine the acquisition date fair value. Any change in the fair value estimate subsequent to the acquisition date is recorded in the earnings of that period. Goodwill and Indefinite-lived Intangible Assets - The accounting for goodwill and indefinite-lived intangible assets requires significant estimates and judgment in the ongoing evaluation for impairment, and for indefinite-lived intangible assets, reconsideration of an asset’s useful life. Changes in these assumptions or estimates could materially affect the determination of the fair value of goodwill and indefinite-lived intangible assets. Goodwill and indefinite-lived intangible assets are reviewed for impairment annually as of October 1 using a qualitative approach which requires the weighing of positive and negative evidence collected through the consideration of various factors to determine whether it is more likely than not that the asset is impaired. For goodwill, we consider the Company’s performance relative to historical or projected future operating results, significant changes in the Company's use of the acquired assets in a business combination or strategy for the Company's overall business, market cap and significant industry or economic trends. If, after considering various factors, management determines that it is more likely than not that goodwill is impaired, a two-step process to test for and measure impairment is performed which begins with a quantitative assessment to estimate the fair value of the Company. The assumptions used to estimate fair value for goodwill include management's estimates of future growth rates, operating cash flows, discount rates and terminal value. Because the advisory, distribution and transfer agent contracts are with the funds, renewable annually and have a history of being renewed, industry practice under GAAP is to consider the contract lives to be indefinite and, as a result, not amortizable. For these fund contracts as well as the trade name indefinite-lived intangible assets, we consider (i) macroeconomic and entity-specific factors, including changes to legal, regulatory or contractual provisions of the renewable advisory and distribution contracts, (ii) the effects of obsolescence, demand, competition and other economic factors that could impact the funds’ projected performance and (iii) the existence or expectation of significant changes in the level and mix of managed assets. In addition, for indefinite-lived intangible assets, we consider whether events or circumstances continue to support an indefinite useful life. Indicators monitored by us that may indicate an indefinite useful life is no longer supported generally include (i) changes in the use of the asset, (ii) a significant decline in the level of managed assets and (iii) significant reductions in underlying operating cash flows. Indefinite-lived intangible assets are combined into a single unit of accounting for purposes of testing impairment if they operate as a single asset and represent as a group the highest and best use of the assets. If actual changes in the underlying managed assets or other conditions, such as redemption rates or changes to contractual provisions, indicate that it is more likely than not that the asset is impaired, or if the estimated useful life is reduced, we perform a quantitative approach to estimate the fair value of the intangible asset. The process of estimating the fair value of the intangible asset requires us to estimate the level and mix of managed assets, considering future redemption rates, growth rates, market appreciation/depreciation and a discount rate. If the carrying value of the intangible asset exceeds its fair value, we recognize an impairment charge equal to that excess.

<s>[INST] This Management’s Discussion and Analysis of Financial Condition and Results of Operations relates to, and should be read in conjunction with the “Selected Financial Data” and our consolidated financial statements and related notes thereto included elsewhere in this report. In addition to historical information, this discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions, which could cause actual results to differ materially from management’s expectations. Please refer to the sections of this report entitled “ForwardLooking Statements” and “Risk Factors.” Overview Our Business We are a diversified global asset management firm with $151.8 billion in assets under management as of December 31, 2019. The Company operates a nextgeneration business model combining boutique investment qualities with the benefits of a fully integrated, centralized operating and distribution platform. We provide specialized investment strategies to institutions, intermediaries, retirement platforms and individual investors. With nine autonomous Investment Franchises and a Solutions Platform, Victory Capital offers a wide array of investment styles and investment vehicles including, actively managed mutual funds, separately managed accounts, rulesbased and active ETFs, multiasset class strategies, customdesigned solutions and a 529 College Savings Plan. Our earnings are primarily driven by assetbased fees charged for services related to the investment strategies we deliver and consist of investment management, fund administration and distribution fees. Franchises Our Franchises are operationally integrated, but are separately branded and make investment decisions independently from one another within guidelines established by their respective investment mandates. Our integrated model creates a supportive environment in which our investment professionals, largely unencumbered by administrative and operational responsibilities, can focus on their pursuit of investment excellence. VCM employs all of our U.S. investment professionals across our Franchises, which are not separate legal entities. Solutions Our Solutions Platform consists of multiFranchise and customized solutions strategies that are primarily rulesbased. We offer our Solutions Platform through a variety of vehicles, including separate accounts, mutual funds and VictoryShares which is our ETF brand. Like our Franchises, our Solutions Platform is operationally integrated and supported by our centralized distribution, marketing and operational support functions. Our approach furthers our commitment to rulesbased investing and includes single and multifactor strategies designed to provide a variety of outcomes, including maximum diversification, dividend income, downside mitigation, minimum volatility, thematic and targeted factor exposure. Professionals within our institutional, retail and direct member distribution channels and marketing organization sell our products through our centralized distribution model. Our institutional sales team focuses on cultivating relationships with institutional consultants, who account for the majority of the institutional market, as well as asset allocators seeking subadvisers. Our retail sales team offers intermediary and retirement platform clients, including brokerdealers, retirement platforms and RIA networks, mutual funds and ETFs as well as SMAs through wrap fee programs and access to our investment models through UMAs. Our direct member channel serves the investment needs of clients including USAA members and military community. We have grown our AUM from $17.9 billion following the managementled buyout with Crestview GP in August 2013 to $151.8 billion at December 31, 2019. We attribute this growth to our success in sourcing acquisitions and evolving them into organic growers, generating strong investment returns, and developing institutional, retail, and direct client distribution channels with deep penetration. USAA AMCO Acquisition Effective July 1, 2019, the Company completed the USAA AMCO Acquisition, a transformative acquisition that increased AUM by $81.1 billion and significantly impacted our financial results for the year ended December 31, 2019. The acquisition not only increased AUM and revenue, but also introduced additional personnel expenses and new and additional operating expenses such as third party distribution costs, expenses related to a transfer services agreement with USAA, 529 College Savings Plan, and direct member channel expenses that the Company did not incur prior to the acquisition. In conjunction with the USAA AMCO Acquisition, the Company entered into the 2019 Credit Agre [/INST] Positive. </s>

Simply Good Foods Co

2017-11-09

2017-08-26

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes included in Item 8 of this Annual Report on Form 10-K. In addition to historical information, the following discussion contains forward-looking statements, such as statements regarding the Company’s expectation for future performance, liquidity and capital resources that involve risks, uncertainties and assumptions that could cause actual results to differ materially from the Company's expectations. The Company's actual results may differ materially from those contained in or implied by any forward-looking statements. Factors that could cause such differences include those identified below and those described in “Cautionary Note Regarding Forward-Looking Statements,” and in Item 1A “Risk Factors” of this Annual Report on Form 10-K. The Company assumes no obligation to update any of these forward-looking statements. Effective August 29, 2015, Atkins changed its fiscal year end from the last Saturday in December to the last Saturday in August. Atkins’ fiscal year 2016 ended August 27, 2016 and was a 52-week period. Atkins fiscal period 2015 ended August 29, 2015 and was a 35-week period. Fiscal years 2014 and 2013 were each 52-week periods and ended December 27, 2014 and December 28, 2013, respectively. Atkins’ fiscal quarters are comprised of 13 weeks each, except for 53-week fiscal periods for the which the fourth quarter will be comprised of 14 weeks, and end on the 13th Saturday of each quarter (14th Saturday of the fourth quarter, when applicable). Excluding the impacts of the Business Combination, fiscal year 2017 will be a 52-week period and will end August 26, 2017. Atkins’ fiscal quarters for fiscal 2017 ended on November 26, 2016, February 25, 2017, May 27, 2017 and August 26, 2017. As a result of the Business Combination, information is presented for the successor period from July 7, 2017 through August 26, 2017, the predecessor period from August 28, 2016 through July 6, 2017, the 52-week period ended August 27, 2016, the 35-week period ended August 29, 2015 and the 52-week periods ended December 27, 2014 and December 28, 2013 are derived from Atkins’ audited consolidated financial statements and the notes thereto. The information for the 53-week period ended August 29, 2015 and the 35-week period ended August 30, 2014 are derived from unaudited consolidated financial statements. Because the 53-week period ended August 29, 2015 included an additional week of operation, the Company's net sales, expenses and other results of operations may be higher for that period. Overview Simply Good Foods is a developer, marketer and seller of branded nutritional foods and snacking products. Our highly-focused product portfolio consists primarily of nutrition bars, RTD shakes, snacks and confectionery products marketed under the Atkins®, SimplyProtein®, Atkins Harvest Trail, and Atkins Endulge® brand names. Over the past 45 years, Atkins has become an iconic American brand that for many consumers stands for “low carb,” “low sugar” and “protein rich” nutrition. In our core snacking business, we strive to offer a complete line of nutrition bars, RTD shakes and confections that satisfy hunger while providing consumers with a convenient, “better-for-you” snacking alternative. In addition to snacking products, we have entered into a license arrangement for frozen meals sold in the United States by Bellisio Foods, Inc. We are a leading brand in nutritional snacking with a broad and growing consumer base. Our sales, marketing and R&D capabilities enable us to distribute products to a national customer base across the mass merchandiser, grocery and drug channels. We believe that our broad brand recognition, depth of management talent and strong cash generation position us to continue to innovate in the Atkins brand and acquire other brands, and thereby become an industry leading snacking platform. To that end, in December 2016, we completed the acquisition of Wellness Foods, Inc., a Canada-based developer, marketer and seller of the SimplyProtein® brand that is focused on protein-rich and low-sugar products, which management believes has significant opportunity for expansion in the U.S. Seasonality We have experienced in the past, and expect to continue to experience, seasonal fluctuations in our retail sales as a result of consumer spending patterns. Historically, the months of January to May result in the greatest retail sales due to renewed consumer focus on healthy living following New Year’s Day, as well as significant customer merchandising around that time. We believe these consumer spending patterns are driven primarily by the predisposition of consumers to adjust their approach to nutrition at certain times of the year as well as the timing of our advertising linked with key customer promotion windows. Matters Affecting Comparability Our results of operations for the periods presented in this section were affected by the following: Acquisition of Atkins The Simply Good Foods Company ("Simply Good Foods”), was formed on March 30, 2017 to consummate a business combination with NCP-ATK Holdings, Inc. (“Atkins”) and Conyers Park Acquisition Corp ("Conyers Park"). Conyers Park, a special purpose acquisition company ("SPAC"), was formed on April 20, 2016 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. On April 10, 2017, Conyers Park and Atkins entered into a definitive agreement (the "Merger Agreement"). Under the terms of the agreement, Conyers Park and Atkins combined under a new holding company, Simply Good Foods, which is listed on the NASDAQ Capital Market under the symbol “SMPL” as of closing of the Business Combination. On July 7, 2017, Simply Good Foods completed the business combination (the "Business Combination") with Conyers Park and Atkins. As a result Simply Good Foods owns all of the equity in Atkins. As a result of the Business Combination, Simply Good Foods is the acquirer for accounting purposes and the successor while Atkins is the acquiree and accounting predecessor. Our financial statement presentation includes the financial statements of Atkins as “Predecessor” for periods prior to the Closing Date and of Simply Good Foods for periods after the Closing Date, including the consolidation of Atkins. For convenience, we have also included under “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations” supplemental pro forma combined information for 2017 and pro forma information for 2016 that gives effect to the Business Combination as if such transaction had been consummated on August 30, 2015. References in this Annual Report to information provided on a pro forma combined basis refer to such supplemental pro forma financial information. Licensing of the Frozen Meals On September 1, 2016, the agreement with Bellisio Foods to license Atkins’ frozen meals resulting in royalty income became effective. This income is reported within net sales in 2017 whereas the frozen sales and related profitability was included in net sales through operating income in all prior periods. For a further discussion of this agreement, see Note 17. Significant Agreement to the consolidated financial statements. Change in Fiscal Year Effective August 29, 2015, Atkins changed its fiscal year end from the last Saturday in December to the last Saturday in August. The intent of the change was to better align the reporting of Atkins’ financial results with the consumer spending patterns on our business and the seasonality of the business. This change has also allowed us to better synchronize our management processes and business cycles with our customers. Our Reportable Segment Our business is organized around one reportable segment based on our go-to-market strategies, the objectives of the business and how our chief decision maker, our CEO, monitors operating performance and allocates resources. Recent Developments Emerging Growth Status Simply Good Foods qualifies as an “emerging growth company” pursuant to the provisions of the JOBS Act, enacted on April 5, 2012. Section 102 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. However, Simply Good Foods is choosing to “opt out” of such extended transition period, and as a result, Simply Good Foods will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Simply Good Foods’ decision to opt out of the extended transition period is irrevocable. Subject to certain conditions set forth in the JOBS Act, Simply Good Foods is not required to, among other things, (1) provide an auditor’s attestation report on our systems of internal controls over financial reporting pursuant to Section 404, (2) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (3) comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (4) disclose certain executive compensation-related items such as the correlation between executive compensation and performance and comparisons of the Chief Executive Officer’s compensation to median employee compensation. These exemptions will apply until Simply Good Foods no longer meets the requirements of being an emerging growth company. Simply Good Foods will remain an emerging growth company until the earlier of (a) the last day of the fiscal year (i) following the fifth anniversary of the completion of Conyers Park’s initial public offering, which was July 20, 2016, (ii) in which Simply Good Foods has total annual gross revenue of at least $1.0 billion or (iii) in which Simply Good Foods is deemed to be a large accelerated filer, which means the market value of our common stock that is held by non-affiliates exceeds $700 million as of the last business day of our prior second fiscal quarter, and (b) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior 3-year period. Results of Operations In assessing the performance of our business, we consider a number of key performance indicators used by management and typically used by our competitors, including the non-GAAP measures of EBITDA and Adjusted EBITDA. Because not all companies use identical calculations, this presentation of EBITDA and Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. See "Reconciliation of Adjusted EBITDA" below for a reconciliation of EBITA and Adjusted EBITDA to net income. Comparison of Results for the Successor Period from July 7, 2017 through August 26, 2017 and the Predecessor Period from August 28, 2016 through July 6, 2017. The following table presents, for the periods indicated, selected information from our consolidated financial results, including information presented as a percentage of net sales (in thousands): Net sales. Net sales for the successor period from July 7, 2017 through August 26, 2017 were $56.3 million compared to $339.8 million for the predecessor period from August 28, 2016 through July 6, 2017. There was no impact to net sales as a result of the Business Combination. Cost of goods sold. Cost of goods sold for the successor period from July 7, 2017 through August 26, 2017 were $35.9 million compared to $180.0 million for the predecessor period from August 28, 2016 through July 6, 2017. As a result of the Business Combination, there was a one-time inventory fair value step-up of $6.0 million that was charged to cost of goods sold in the successor period from July 7, 2017 through August 26, 2017. Gross profit. Gross profit for the successor period from July 7, 2017 through August 26, 2017, including the effect of the one-time inventory fair value step-up, were $20.4 million, or 36.2% of net sales, compared to the predecessor period from August 28, 2016 through July 6, 2017, gross profit was $159.8 million, or 47.0% of net sales. Operating expenses. Operating expenses for the successor period from July 7, 2017 through August 26, 2017 were $18.5 million or 32.9% of net sales compared to $136.1 million or 40.1% of net sales the predecessor period from August 28, 2016 through July 6, 2017. Interest expense. Interest expense for the successor period from July 7, 2017 through August 26, 2017 was $1.7 million or 3.0% or net sales compared to $22.7 million or 6.7% of net sales for the predecessor period from August 28, 2016 through July 6, 2017. The lower interest expense in the successor period from July 7, 2017 through August 26, 2017 is the result of the reduced principal balance of the debt as well as a reduction in the rate of interest being incurred on the debt. Income tax expense. Income tax expense for the successor period from July 7, 2017 through August 26, 2017 was $0.3 million compared to $4.6 million for the predecessor period from August 28, 2016 through July 6, 2017. Higher taxes in the predecessor period relate to the impacts of the nondeductible business combination transaction costs. Adjusted EBITDA. Adjusted EBITDA decreased $55.2 million or 86.5% for the successor period from July 7, 2017 through August 26, 2017 compared to the predecessor period from August 28, 2016 through July 6, 2017. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see "Reconciliation of Adjusted EBITDA". Supplemental Pro Forma Combined 52-Week Period Ended August 26, 2017 For comparative purposes, we are presenting a supplemental unaudited pro forma combined statement of operations for the 52-week period ended August 26, 2017, and we discuss such pro forma combined results compared to the Predecessor’s full year 2016 results below. The unaudited pro forma combined statements of operations for the fiscal year ended August 26, 2017 presents our consolidated results of operations giving pro forma effect to the Business Combination as if it had occurred as of August 28, 2016. The pro forma combined adjustments are based on available information and upon assumptions that our management believes are reasonable in order to reflect, on a pro forma combined basis, the impact of these transactions on the historical financial information of our Predecessor and Successor entities, as applicable. The Business Combination is accounted for using the acquisition method of accounting in accordance with the FASB Accounting Standards Codification (“ASC”) 805, Business Combinations (“ASC 805”). ASC 805 requires, among other things, that assets acquired and liabilities assumed be recognized at their fair values, as determined in accordance with ASC 820, Fair Value Measurements, as of the Business Combination date. Under the acquisition method of accounting, the assets acquired and liabilities assumed will be recorded at the effective time of the Business Combination at their respective fair values. ASC 805 establishes a measurement period to provide the Company with a reasonable amount of time to obtain the information necessary to identify and measure various items in a business combination and cannot extend beyond one year from the acquisition date. The initial estimated fair values of the acquired assets and assumed liabilities as of the Closing Date, which are based on the consideration paid and our estimates and assumptions, are reflected herein. As explained in more detail in Note 3. Business Combinations in the Consolidated Financial Statements, the total purchase price to acquire Atkins has been allocated to the assets acquired and assumed liabilities, based upon preliminary estimated fair values at the Closing Date. We utilized third-party valuation specialists to assist our management in determining the fair values of the acquired assets and liabilities assumed. We have not finalized our assessment of the purchase consideration and estimated fair value of assets acquired and liabilities assumed as of August 26, 2017. The unaudited pro forma combined financial information contains a variety of adjustments, assumptions and estimates, is subject to numerous other uncertainties and the assumptions and adjustments as described in the accompanying notes hereto and should not be relied upon as being indicative of our results of operations had the Business Combination occurred on August 28, 2016. The unaudited pro forma combined financial information also does not project our results of operations for any future period or date. The unaudited pro forma combined financial information for the 52-weeks ended August 26, 2017 includes results of the Successor and Predecessor entities. The pro forma combined adjustments give effect to the items identified in the pro forma combined table below in connection with the Business Combination. Pro Forma Combined Statement of Operations For the pro forma combined 52-week period ended August 26, 2017 (In thousands) i. The amounts presented represent the Successor’s and Predecessor’s historical GAAP results of operations. ii. The adjustment represents a non-cash, one time inventory fair value adjustment recorded in conjunction with the Business Combination and was recognized in the successor period, and is not indicative of future cost of goods sold. iii. The adjustment represents the incremental stock based compensation expense incurred under the Simply Good Foods Omnibus Incentive Plan. iv. The adjustment reflects the difference in the intangible asset amortization expense associated with the allocation of purchase price to intangible assets due to the Business Combination. The amortization expense decreased as more indefinite lived intangible assets were identified for the successor entity than the predecessor entity. The amount of amortizable intangible assets identified in the Business Combination decreased from $125.8 million to $88.0 million. Refer to Note 5 of the consolidated financial statements for additional details. v. Business combination transaction expenses primarily consist of fees related to the Business Combination and the Company’s acquisition activities. Refer to Note 3 of the consolidated financial statements for additional details. vi. Predecessor warrants were accounted for as warrant liabilities, which were exercised and settled with the Business Combination. vii. Represents the adjustment necessary to arrive at the expected interest expense associated with the new term loan and revolving debt facilities of Simply Good Foods. The predecessor entity had $337.2 million outstanding as of August 27, 2016 while the successor entity had $200.0 million outstanding. The long term debt of the predecessor entity accrued interest at 6.25% on the first lien and 9.75% on the second lien while the successor debt accrues interest at 3 month LIBOR plus 4%. The significant reduction in outstanding principal, and lower interest rates, drive significant expense savings. Refer to Note 7 of the consolidated financial statements for additional details on long-term debt. viii. Represents the adjustment necessary to arrive at an effective income tax rate of 39.6%. ix. Adjusted EBITDA is a non-GAAP financial measure. For a reconciliation to its most directly comparable GAAP measure, see "Reconciliation of Adjusted EBITDA" within this section. Supplemental Pro Forma 52-Week Period Ended August 27, 2016 The following unaudited pro forma financial information has been prepared from the perspective of Atkins and its fiscal year end of August 27, 2016. The unaudited pro forma income statement for the 52-weeks ended August 27, 2016 presents the historical consolidated statement of operations of Atkins for the 52-weeks ended August 27, 2016, giving effect to the Business Combination as if it had occurred on August 30, 2015. The unaudited pro forma financial statements give effect to the Business Combination in accordance with the acquisition method of accounting for business combinations. The historical financial information has been adjusted to give pro forma effect to events that are related and/or directly attributable to the Business Combination, are factually supportable and are expected to have a continuing impact on the results of the combined company. The adjustments presented on the unaudited pro forma financial statements have been identified and presented to provide relevant information necessary for an accurate understanding of the combined company upon consummation of the Business Combination. The unaudited pro forma financial statements also reflect the impact of the Atkins license arrangement for frozen meals sold in the U.S. by Bellisio. This agreement was effective September 1, 2016 and is a seven-year license with Bellisio to license its frozen meals business. Bellisio manufactures, distributes, markets, promotes and sells Atkins frozen food products under the Atkins licensed mark. The effects of the license agreement are presented in the “Frozen License Adjustments” and “Atkins' Pro Forma” columns in the unaudited historical consolidated statement of operations for the 52-weeks ended August 27, 2016. The unaudited pro forma financial information is for illustrative purposes only. The financial results may have been different if the Business Combination actually been completed sooner. You should not rely on the unaudited pro forma financial information as being indicative of the historical results that would have been achieved if the Business Combination been completed as of August 30, 2015. Pro Forma Statement of Operations For the pro forma 52-week period ended August 27, 2016 (In thousands) i. The amounts in this column represents the Predecessor’s historical GAAP results after removing the results of operations of the Frozen operations. ii. The adjustment represents the incremental stock based compensation expense under the new Simply Good Foods omnibus incentive plan. iii. The adjustment reflects the difference in the intangible asset amortization expense associated with the allocation of purchase price to intangible assets due to the Business Combination. The amortization expense decreased as more indefinite lived intangible assets were identified for the successor entity than the predecessor entity. The amount of amortizable intangible assets identified in the Business Combination decreased from $125.8 million to $88.0 million. Refer to Note 5 of the consolidated financial statements for additional details. iv. The Simply Good Foods warrants are not warrant liabilities and are accounted for as equity warrants. The adjustment represents the corresponding decrement to expense. v. The adjustment represents the expected interest expense associated with the new term loan and revolving debt facilities of Simply Good Foods. The predecessor entity had $337.2 million outstanding as of August 27, 2016 while the successor entity had $200.0 million outstanding. The long term debt of the predecessor entity accrued interest at 6.25% on the first lien and 9.75% on the second lien while the successor debt accrues interest at 3 month LIBOR and 4%. The significant reduction in outstanding principal, and lower interest rates, drive significant expense savings. Refer to Note 7 of the consolidated financial statements for additional details on long-term debt. vi. Represents the effective income tax rate of 39.6% vii. Approximately $2.1 million of Pro Forma Frozen Licensing Selling costs were previously classified as Pro Forma Frozen Licensing Distribution expenses. Comparison of Results for the Supplemental Pro Forma Combined 52-Week Period Ended August 26, 2017 and the Supplemental Pro Forma 52-Week Period Ended August 27, 2016 For comparative purposes, we are presenting a supplemental unaudited pro forma combined statement of operations for the 52-week period ended August 26, 2017, and we discuss such pro forma combined results compared to the supplemental unaudited pro forma statement of operations for the 52-week period ended August 27, 2016. The following table presents, for the periods indicated, selected information from our supplemented unaudited pro forma consolidated financial results, including information presented as a percentage of net sales (in thousands): Net sales. Net sales increased $27.1 million, or 7.4%, for the pro forma combined 52-weeks ended August 26, 2017 compared to the pro forma 52-weeks ended August 27, 2016. The increase in net sales was driven primarily by growth of $20.0 million in Atkins core business and the December 2016 addition of Wellness Foods of $7.1 million. The growth in the core business net sales was primarily driven by increased demand, growing volume $17.4 million, and improved returns of $2.6 million. The improvement to returns was principally due to the 2016 recall expense which decreased 2016 Net Sales. The recall was subsequently reimbursed in 2017. Cost of goods sold. Cost of goods sold increased $10.5 million, or 5.2%, for the pro forma combined 52-weeks ended August 26, 2017 compared to the pro forma 52-weeks ended August 27, 2016. The increase was primarily due to volume growth of $6.9 million and the Wellness Foods acquisition of $3.6 million. Gross profit. Gross profit increased $16.7 million, or 9.8%, for the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 52-week period ended August 27, 2016. Gross margin of 47.0% for the pro forma combined 52-weeks ended August 26, 2017 improved 110 bps from 45.9% for the pro forma 52-weeks ended August 27, 2016 due to the favorable recall expense, cost saving initiatives and favorable mix. Operating expenses. Operating expenses increased $5.8 million, or 4.8%, for the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 52-week period ended August 27, 2016 due to the following: • Selling. Selling expenses increased $0.2 million, or 1.0%, for the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 52-week period ended August 27, 2016. • Marketing. Marketing expenses increased $1.9 million, or 5.3%, for the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 52-week period ended August 27, 2016 to support the growth of the snacking business. • Distribution. Distribution expenses increased $2.3 million, or 14.8%, for the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 52-week period ended August 27, 2016. The increase in distribution expenses was primarily driven by a one-time surcharge in 2017 of $0.8 million. • General and administrative. General and administrative expenses increased $2.3 million for the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 52-week period ended August 27, 2016. The increase related to the acquisition of Wellness Foods and incremental costs associated with public company operations. • Depreciation and amortization. Depreciation and amortization expenses were flat for the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 52-week period ended August 27, 2016. • Other expense. Other expenses decreased $0.9 million for the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 52-week period ended August 27, 2016. Loss (gain) on foreign currency transactions Loss on foreign currency transactions increased $1.3 million for the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 53-week period ended August 27, 2016. Income tax expense (benefit). Income tax expense increased $4.9 million, from the pro forma combined 52-week period ended August 26, 2017 compared to the pro forma 52-week period ended August 27, 2016. The difference is due higher income before operations in 2017 compared to 2016. Adjusted EBITDA. Pro forma adjusted EBITDA increased $8.3 million, or 12.9%, for the pro forma combined 52-week period ended August 26, 2017 (unaudited) compared to the pro forma 52-week period ended August 27, 2016 (unaudited). The increase was driven by the increase in gross profit. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see "Reconciliation of Adjusted EBITDA". Comparison of Results for the 52-Week Period Ended August 27, 2016 and the 53-Week Period Ended August 29, 2015 The following table sets forth information comparing the components of net income for the 52-week period ended August 27, 2016 (audited) and the 53-week period ended August 29, 2015 (unaudited). Effective August 29, 2015, Atkins changed its fiscal year end from the last Saturday in December to the last Saturday in August. The intent of the change was to better align the reporting of Atkins’ financial results with the consumer spending patterns on its business and the seasonality of the business. This change has also allowed Atkins to better synchronize its management processes and business cycles with its consumers. For comparative purposes, we are presenting a supplemental unaudited statement of operations for the 53-week period ended August 29, 2015. Net sales. Net sales increased $8.7 million, or 2%, for the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The increase in net sales was driven primarily by growth in Atkins’ U.S. snacking products, which were up $12.5 million, partially offset by declines in frozen meals of $2.2 million and an unfavorable currency impact of $2.1 million. The increase in U.S. snacking products of $12.5 million was due to a volume increase of $7.7 million driven by an increase in demand and positive price/mix of $7.7 million, partially offset by an increase in returns of $2.9 million. The pricing and mix increase can be primarily attributed to the annualized impact of Atkins’ price increase on U.S. snacking products in December 2014 of approximately $2.5 million as well as improved product mix largely due to the addition of the Atkins Lift line to the portfolio at a higher price point. The increase in returns was principally due to the one-time impact of an ingredient recall on some of Atkins’ products in June of 2016. Atkins recognized a loss for this of approximately $2 million, and successfully pursued collection of this from its supplier in 2017. Cost of goods sold. Cost of goods sold increased $2.4 million, or 1%, from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The increase in cost of goods sold was driven primarily by the net sales increase noted above totaling approximately $5 million partially offset by cost savings and improved product mix of approximately $3 million. Gross profit. Gross profit increased $6.3 million, or 4%, from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The increase in gross profit was driven primarily by the net sales increase noted above (approximately $4 million), the annualized impact of Atkins’ price increase from snacking products in December 2014 of approximately $2.5 million as well as favorable cost savings and product mix of approximately $3 million partially offset by the increase in returns and allowances of $3 million, principally due to the one-time cost of the recall, and product mix. Operating expenses. Operating expenses increased $4.1 million, or 3%, from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited) due to the following: • Selling, marketing and distribution. Selling, marketing and distribution expenses increased $1.0 million, or 1%, from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The increase in selling, marketing and distribution expenses was driven primarily by costs growing proportionally with the increased net sales. • General and administrative. General and administrative expenses increased $2.6 million, or 6%, from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The increase in general and administrative expenses was driven primarily by increases in employee related costs of $1.3 million and in facility costs of $0.4 million as well as some one-time legal settlements of $0.6 million in 2016. • Depreciation and amortization. Depreciation and amortization expenses decreased $0.8 million, or 7%, from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The decrease in depreciation and amortization expenses was driven primarily by the decrease in amortization of intangible assets. • Other expense. Other expenses increased $1.3 million from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The increase in other expenses was due to the one-time costs of restructuring activities largely due to the employee costs eliminated as part of the licensing of Atkins’ frozen meal products. Interest expense. Interest expense decreased $0.6 million, or 2.0%, from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The decrease in interest expense was driven primarily by reduced levels of debt. Other income (expense). Other expense increased $0.5 million from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited) due to an increase in warrant liabilities of $1.8 million partially offset by more favorable currency transaction expense of $1.3 million. Income tax expense (benefit). Income tax expense increased $1.3 million, for the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The increase in the income tax expense was primarily driven by the increase in pretax income of $2.3 million in the 52-week period ended August 27, 2016, combined with a one-time tax benefit of $0.9 million and remaining net benefit of $0.4 million for all other items affecting income tax, both of which reduced tax expense in the 53-week period ended August 29, 2015. The one-time tax benefit relates to a reduction in the federal income tax rate used to record income taxes from 35% to 34% during 53-week period ended August 29, 2015. Net income. Net income increased $1.0 million, or 11%, from the 52-week period ended August 27, 2016 (audited) compared to the 53-week period ended August 29, 2015 (unaudited). The increase in net income was driven primarily by improved income from operations largely due to improved gross profit partially offset by higher operating expenses and increased income taxes. Adjusted EBITDA. Adjusted EBITDA increased $4.9 million, or 8%, from the 52-week period ended August 27, 2016 (unaudited) compared to the 53-week period ended August 29, 2015 (unaudited). The increase was driven primarily by improved income from operations largely due to improved gross profit partially offset by higher operating expenses. Additionally, Adjusted EBITDA is improved by the exclusion of the loss from the ingredient recall and frozen meals restructuring charges that are one-time items in EBITDA. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see "Reconciliation of Adjusted EBITDA". Comparison of Results for the 35-Week Period Ended August 29, 2015 and December 27, 2014 The following table sets forth information comparing the components of net income for the 35-week periods ended August 29, 2015 (audited) and December 27, 2014 (unaudited). Effective August 29, 2015, Atkins changed its fiscal year end from the last Saturday in December to the last Saturday in August. The intent of the change was to better align the reporting of Atkins’ financial results with the consumer spending patterns on its business and the seasonality of the business. This change has also allowed Atkins to better synchronize its management processes and business cycles with its consumers. For comparative purposes, we are presenting a supplemental unaudited statement of operations for the 35-week period ended December 27, 2014. Net sales. Net sales decreased $7.5 million, or 3%, for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited). The decrease in net sales was driven primarily by decreases to the U.S. snacking business of $7.9 million and an unfavorable currency impact of $3.5 million partially offset by an increase in frozen meals of $2.0 million and an increase in our international business in constant dollars of $1.9 million. The decrease in the U.S. snacking business was due to a volume decrease of $12.7 million partially offset by positive pricing and mix changes of $4.8 million. The volume decline was largely driven by a decline in retail inventory levels primarily due to our warehouse shutdown the last week in August 2015 to conduct a physical inventory in connection with the shift in year end from December to August in the 35-week period ended August 29, 2015. This resulted in a delay in timing of shipment to customers and reduced retail inventory levels. The pricing and mix increase can be primarily attributed to the price increase from snacking products in December of 2014. Cost of goods sold. Cost of goods sold decreased $3.7 million, or 2%, for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited). The decrease in cost of goods sold was driven primarily by the net sales decrease noted above. Gross profit. Gross profit decreased $3.8 million, or 4%, for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited). The decrease in gross profit was driven primarily by the net sales decrease noted above (approximately $2.5 million) and negative product price/mix of approximately $0.5 million. Operating expenses. Operating expenses increased $0.5 million, or 1%, for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited) due to the following: • Selling, marketing and distribution. Selling, marketing and distribution expenses decreased $1.4 million, or 2%, for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited) as costs decreased proportionally with the reduced net sales. • General and administrative. General and administrative expenses increased $2.0 million, or 8%, for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited). The increase in general and administrative expenses was driven primarily by increases in employee related costs due to a one-time bonus payout for all employees in August 2015 as well as a smaller bonus payout in 2014. • Depreciation and Amortization. Depreciation and amortization expenses decreased $0.2 million, or 3%, for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended August 30, 2014 (unaudited). Interest expense. Interest expense was relatively unchanged from the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited) as debt levels were relatively constant. Other income (expense). Other income increased $1.7 million for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited) due to a decrease in warrant liabilities of $2.6 million partially offset by unfavorable currency transaction expense of $0.8 million. Income tax expense (benefit). Income tax benefit increased $1.8 million, for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited). The increase in the income tax benefit was primarily driven by the increase in pretax loss of $2.6 million, the increase in non-temporary differences $0.9 million and a one-time tax benefit of $0.9 million. The one-time tax benefit relates to a reduction in the federal income tax rate used to record income taxes from 35% to 34% during the 35-week period ended August 29, 2015. These tax credits are offset by the change in tax expenses of valuation allowance of $0.3 million, state income tax adjustment of $0.2 million and all other changes affecting income tax of $0.4 million. Net income (loss). Net loss increased $0.8 million, or 18%, for the 35-week period ended August 29, 2015 (audited) compared to the 35-week period ended December 27, 2014 (unaudited). The decrease in profitability was driven primarily by the decline in gross profit and increase in operating expenses partially offset by a decrease in other expense and an increase in income tax benefits. Adjusted EBITDA. Adjusted EBITDA decreased $6.1 million, or 27%, for the 35-week period ended August 29, 2015 (unaudited) compared to the 35-week period ended December 27, 2014 (unaudited). The decrease in Adjusted EBITDA was driven primarily by the decline in gross profit and increase in operating expenses. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see "Reconciliation of Adjusted EBITDA". Comparison of Results for the 52-Week Period Ended December 27, 2014 and December 28, 2013 The following table sets forth information comparing the components of net income for the 52-week period ended December 27, 2014 (audited) and December 28, 2013 (audited). Net sales. Net sales increased $36 million, or 9%, for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). The increase in net sales was driven primarily by growth in the U.S. snacking business of $21.2 million, an increase in the frozen meals business of $12.3 million and growth in international of $2.4 million. The impact of currency between periods was negligible. The growth in the U.S. snacking business represents volume growth of approximately $25.6 million, partially offset by pricing and mix changes of approximately $4.4 million. Volume growth was largely due to an increase in consumer demand, while the pricing and mix decrease can be primarily attributed to the expansion of products into certain lower price point products. The frozen meals increase can be attributed to the significant increase in consumers and retail distribution in the second year of launch. Cost of goods sold. Cost of goods sold increased $28.7 million, or 13%, for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). The increase in cost of goods sold was driven primarily by the net sales increase noted above (approximately $20 million) and negative product mix due to the increase in higher-cost frozen meals as a percentage of the portfolio. Gross profit. Gross profit increased $7.2 million, or 4%, for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). The increase in gross profit was driven primarily by the net sales increase noted above (approximately $9 million) partially offset by negative product mix principally due to the increase in lower margin frozen meals. Operating expenses. Operating expenses increased $1.0 million, or 1%, for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited) due to the following: • Selling, marketing and distribution. Selling, marketing and distribution expenses increased $0.6 million, or 1%, for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). The increase in selling, marketing and distribution expense was driven primarily by increased selling and marketing costs principally behind the frozen meals expansion. As a percentage of net sales, the decline was driven by efficiency gains in distribution costs and sales commissions. • General and administrative. General and administrative expenses increased $1.0 million, or 2%, for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). The increase is driven by an increase in employee and facility costs of $1.3 million largely due to the expansion into frozen meals. In addition, the 52-week period ended December 27, 2014 (audited) includes approximately $1.5 million in one-time costs for an external study to assess strategic options that was offset by approximately $2.7 million in one-time costs to refinance Atkins’ debt that was incurred in the 52-week period ended December 28, 2013 (audited). • Depreciation and amortization. Depreciation and amortization expenses decreased $0.1 million, or 1%, for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). • Other expense. Other expenses decreased $0.4 million for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). Interest expense. Interest expense decreased $7.6 million, or 21%, for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). The decrease in interest expense was driven primarily by the write off of all remaining deferred financing fees in 2013 in connection with the refinancing. Other income (expense). Other expense decreased $0.7 million for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited) due to a decrease in warrant liabilities of $3.4 million partially offset by unfavorable currency transaction expense of $2.4 million. Income tax expense (benefit). Income tax expense increased $3.8 million for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). The increase in income tax expense was primarily driven by the increase in pretax income $14.5 million and an increase in state income tax $0.4 million; offset by tax credits on non-temporary differences of $1.2 million and a valuation allowance of $0.5 million. Net income. Net income increased $10.7 million for the 52-week period ended December 27, 2014 (audited) compared to the 52-week period ended December 28, 2013 (audited). The increase in net income was largely due to the increased gross profit and lower interest expense as a result of the debt refinancing partially offset by increased operating expenses and higher taxes. Adjusted EBITDA. Adjusted EBITDA increased $5.3 million, or 8%, for the 52-week period ended December 27, 2014 (unaudited) compared to the 52-week period ended December 28, 2013 (unaudited). The increase was driven by the increase in gross profit partially offset by increased operating expenses to support the new frozen meals. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see "Reconciliation of Adjusted EBITDA". Reconciliation of Adjusted EBITDA Adjusted EBITDA. Adjusted EBITDA is a non-GAAP financial measure commonly used in our industry and should not be construed as an alternative to net income as an indicator of operating performance or as an alternative to cash flow provided by operating activities as a measure of liquidity (each as determined in accordance with GAAP). Simply Good Foods defines Adjusted EBITDA (earnings before interest, tax, depreciation, and amortization) as net income (loss) before interest expense, income tax expense, depreciation and amortization with further adjustments to exclude the following items: stock-based compensation and warrant expense, transaction costs and IPO readiness, restructuring costs, management fees, transactional exchange impact and other one-time expenses. The Company believes that the inclusion of these supplementary adjustments in presenting Adjusted EBITDA are appropriate to provide additional information to investors and reflects more accurately operating results of the on-going operations. Adjusted EBITDA may not be comparable to other similarly titled captions of other companies due to differences in calculation. The unaudited tables below provides a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, which is net income (loss), for the periods ending August 26, 2017 (Successor), July 6, 2017 (Predecessor), pro forma combined period ending August 26, 2017, pro forma predecessor period ending August 27, 2016, and fiscal years ending August 27, 2016, August 29, 2015, December 27, 2014, and December 28, 2013. _____________________ (1) Other items consist principally of exchange impact of foreign currency transactions as well as minor impacts of channel inventory returns Liquidity and Capital Resources Overview We have historically funded our operations with cash flow from operations and, when needed, with borrowings under our credit facility. Our principal uses for liquidity have been debt service and working capital. We believe our sources of liquidity and capital will be sufficient to finance our continued operations, growth strategy and additional expenses we expect to incur as a public company for at least the next twelve months. Following the consummation of the Business Combination, we are obligated to make payments under the Tax Receivable Agreement (the “TRA”). Although the actual timing and amount of any payments that may be made under the TRA will vary, the payments that we will be required to make could be significant. Any payments made by us under the TRA will generally reduce the amount of overall cash flow that might have otherwise been available to us and, to the extent that we are unable to make payments under the TRA for any reason, the unpaid amounts generally will be deferred and will accrue interest until paid by us. See Note 9. Income Taxes of the consolidated financial statements for additional information on the TRA. Debt and credit facilities On July 7, 2017, the Company entered into a Credit Agreement with Barclays Bank PLC and other parties. The Credit Agreement provides for a term facility of $200.0 million (“Term Facility”) with a seven year maturity, and a revolving loan of up to $75.0 million (the “Revolving Credit Facility”) with a five year maturity, in each case under the new first lien senior secured loan facilities (the “New Credit Facilities”). Substantially concurrently with the consummation of the Business Combination, the full $200.0 million of the first lien term loan (the “Term Loan”) were drawn, and no revolving loans were drawn. The interest rate per annum is based on either (i) a base rate equaling the higher of (a) the “prime rate”, (b) the federal funds effective rate plus 0.50% and (c) the Eurocurrency rate applicable for an interest period of one month plus 1.00% plus (x) 3.00% margin for Term Loan or (y) 2.00% margin for Revolving Credit Facility, or (ii) London Interbank Offered Rate (“LIBOR”) adjusted for statutory reserve requirements, plus (x) 4.00% margin for Term Loan and is subject to a floor of 1.00% or (y) 3.00% margin for Revolving Credit Facility. The applicable margin for Revolving Credit Facility will be adjusted after the completion of the Company’s first full fiscal quarter after the closing of the Business Combination based upon the Company’s consolidated first lien net leverage ratio. As security for the payment or performance of its debt, the Company has pledged certain equity interests in its subsidiaries. The New Credit Facilities are subject to mandatory prepayments based on contractual terms. With respect to the Term Loan, prior to the six-month anniversary of the Closing Date as of July 7, 2017, a 1.00% prepayment premium is payable by the Company in connection with certain repricing events. The Company may also voluntarily prepay outstanding loans at any time. The credit facilities governing our debt arrangements contain certain financial and other covenants. The revolving credit facility has a maximum total net leverage ratio equal to or less than 6.25:1.00 (with a reduction to 6.00:1.00 on and after the third anniversary of the closing date of the credit facilities) contingent on credit extensions in excess of 30% of the total amount of commitments available under the revolving credit facility, and limitations on our ability to, among other things, incur and/or undertake asset sales and other dispositions, liens, indebtedness, certain acquisitions, and investments, consolidations, mergers, reorganizations and other fundamental changes payment of dividends and other distributions to equity and warrant holders and prepayments of material subordinated debt, in each case, subject to customary exceptions materially consistent with credit facilities of such type and size. Any failure to comply with the restrictions of the credit facilities may result in an event of default. The credit facilities governing our debt arrangements bear interest at variable rates. If market interest rates increase, variable rate debt will create higher debt service requirements, which could adversely affect our cash flow. As the Company has not drawn on the revolving credit facility as of August 26, 2017, no debt covenants were applicable as of the period then ended. Cash Flows Operating activities. Our net cash used in operating activities was $27.4 million for the successor period ending August 26, 2017, a decrease of $49.3 million, compared to net cash provided by operating activities of $21.9 million for the predecessor period ending July 6, 2017. This decrease of $49.3 million was due primarily to the payment of transaction related expenses in the successor period offset by higher net income of approximately $2.9 million. The Company has $56.5 million in cash and cash equivalents as of August 26, 2017 which is sufficient to satisfy current liabilities, current maturities of long term debt, and the interest payments associated with them. Investing activities. Our net cash used in investing activities was $197.3 million for the successor period ended August 26, 2017, which was an increase in cash used of $176.8 million compared to net cash used in investing activities of $20.5 million for the predecessor period. The large increase was due to the net exchange of cash in the Business Combination in the successor period of $196.8 million compared to the purchase of Wellness Foods for approximately $20.0 million (net of cash acquired) in December 2016 (Predecessor period). Financing activities. Our net cash provided by financing activities was $280.8 million for the successor period ended August 26, 2017, an increase of cash provided of $334.3 million, compared to net cash used in financing activities of $53.5 million for the predecessor period. This increase in cash provided was due to the proceeds from the issuance of long term debt of $191.9 million and proceeds from the issuance of equity of $97.0 million in the successor period related to the Business Combination. Off-Balance Sheet Arrangements As of August 26, 2017, Atkins had no material off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on its financial condition, changes in financial condition, income or expenses, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations The following table summarizes Simply Good Foods' expected material contractual payment obligations as of August 26, 2017. _______________ (1) As of August 26, 2017, the Company is obligated under multiple non-cancelable operating leases, which continue through 2021. Rent expenses, inclusive of real estate taxes, utilities and maintenance incurred under operating leases, are included in general and administrative expenses in the Company's consolidated statements of operations, were $0.3 million for successor period from July 7, 2017 through August 26, 2017 and $1.7 million for predecessor period from August 28, 2016 through July 6, 2017. Critical Accounting Policies, Judgments and Estimates General The consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the U.S. While the majority of the Company’s revenues, expenses, assets and liabilities are not based on estimates, there are certain accounting principles that require management to make estimates regarding matters that are uncertain and susceptible to change. Critical accounting policies are defined as those policies that are reflective of significant judgments, estimates and uncertainties, which would potentially result in materially different results under different assumptions and conditions. Management regularly reviews the estimates and assumptions used in the preparation of the Company’s financial statements for reasonableness and adequacy. The following critical accounting discussion pertains to accounting policies the Company believes are most critical to the portrayal of its historical financial condition and results of operations and that require significant, difficult, subjective or complex judgments. Other companies in similar businesses may use different estimation policies and methodologies, which may impact the comparability of the Company's financial condition, results of operations and cash flows to those of other companies. Our significant accounting policies are discussed in Note 2. Summary of Significant Accounting Policies of our Consolidated Financial Statements in this filing; however, we believe the following accounting policies are critical in the preparation of our consolidated financial statements because of the judgment necessary to account for these matters and the significant estimates involved, which are susceptible to change. Use of Estimates The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements. Estimates also affect the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates. Cash and Cash Equivalents Cash and cash equivalents consist of cash on hand, deposits available on demand, and other short-term, highly liquid investments with original maturities of three months or less. Because of the short maturity of these investments, the carrying amounts approximate their fair value. Concentration of Credit Risk We maintain cash balances in six financial institutions. The Company holds material cash balances in the U.S. which are insured by the Federal Deposit Insurance Corporation up to $250,000 per institution. From time to time, the Company’s balances may exceed these limits. As of August 26, 2017 and August 27, 2016, uninsured cash balances were approximately $56.1 million and $78.2 million, respectively. As a result of the acquisition of Wellness Foods, discussed in Note 3. Business Combinations, the Company has banking relationships in Canada subject to the Canadian Deposit Insurance Corporation which insures up to CAD $100,000 per institution. As of August 26, 2017, the Company had uninsured CAD $3.1 million related to Wellness Foods banking relationships. The Company believes it is not exposed to any significant credit risk on cash. Revenue Recognition The Company recognizes revenue from the sale of product when (i) persuasive evidence of an arrangement exists, (ii) the price is fixed or determinable, (iii) title and risk of loss pass to the customer at the time of delivery and (iv) there is reasonable assurance of collection of the sales proceeds. The Company records estimated reductions to revenue for customer programs, slotting fees and incentive offerings, including special pricing agreements, price protection, promotions and other volume-based incentives at the time the incentive is offered or at the time of revenue recognition for the underlying transaction that results in progress by the customer toward earning the incentive. Some of these incentives are recorded by estimating costs based on historical experience and expected levels of performance of the trade promotion. Business Combinations As discussed in detail in Note 3. Business Combinations of our Consolidated Financial Statements in this filing, on July 7, 2017, Simply Good Foods acquired the Atkins business from Roark. Roark retained a minority interest in Simply Good Foods after the transaction. The Business Combination was funded through a combination of cash, stock, and debt financing. The Business Combination is accounted for using the acquisition method of accounting in accordance with the FASB Accounting Standards Codification (“ASC”) 805, Business Combinations (“ASC 805”). ASC 805 requires, among other things, that assets acquired and liabilities assumed be recognized at their fair values, as determined in accordance with ASC 820, Fair Value Measurements, as of the Business Combination date. Under the acquisition method of accounting, the assets acquired and liabilities assumed will be recorded at the effective time of the Business Combination at their respective fair values and added to those of Conyers Park. ASC 805 establishes a measurement period to provide the Company with a reasonable amount of time to obtain the information necessary to identify and measure various items in a business combination and cannot extend beyond one year from the acquisition date. Tax Receivable Arrangement As discussed in Note 3 and Note 9, simultaneously with the closing of the Business Combination, Simply Good Foods entered into the Tax Receivable Agreement (the "TRA"). The TRA is contingent consideration and included as part of the consideration transferred in the Business Combination. The Tax Receivable Agreement obligation is recorded at its acquisition-date fair value and classified as a liability. The Tax Receivable Agreement will generally provide for the payment by Simply Good Foods to the Selling Equity holders for certain federal, state, local and non-U.S. tax benefits deemed realized in post-closing taxable periods by Simply Good Foods, Conyers Park, Atkins and Atkins eligible subsidiaries from the use of up to $100 million of the following tax attributes: (i) net operating losses available to be carried forward as of the closing of the Business Combination; (ii) certain deductions generated by the consummation of the transactions contemplated by the Merger Agreement; and (iii) remaining depreciable tax basis from the 2003 acquisition of Atkins Nutritionals, Inc. As of August 26, 2017, the estimated fair value of these contingent payments is $25.7 million which has been recorded as a liability and represents 100% of the value of the recorded tax attributes. Subsequent changes in fair value of the contingent liability will be recognized in earnings. Goodwill and Indefinite-Lived Intangible Assets Goodwill and intangible assets result primarily from the Business Combination acquisitions, including the 2011 acquisition of the Company by Roark. Intangible assets primarily include brands and trademarks with indefinite lives and customer-related relationships with finite lives. Upon acquisition, the purchase price is first allocated to identifiable assets and liabilities, including customer-related intangible assets and trademarks, with any remaining purchase price recorded as goodwill. Finite-lived intangible assets are amortized utilizing the straight-line method over their estimated useful lives. The Company reviews for impairment indicators of finite-lived intangibles and other long-lived assets as described in the "Property and Equipment" significant accounting policy. For goodwill and other intangible assets that have indefinite lives, those assets are not amortized. Rather, impairment tests are conducted on an annual basis or more frequently if indicators of impairment are present. Goodwill is allocated to the reporting unit in which the business that created the goodwill resides. A reporting unit is an operating segment, or a business unit one level below that operating segment, for which discrete financial information is prepared and regularly reviewed by segment management. The Company has determined that it has one reporting unit for purposes of allocating goodwill. A qualitative assessment of goodwill and indefinite-lived intangibles was performed in 2014, 2015, 2016 and 2017. Qualitative assessment includes consideration for the economic, industry and market conditions in addition to the overall financial performance of the Company and these assets. Based on the results of assessment, it was determined that it is more likely than not the reporting unit had a fair value in excess of carrying value. Accordingly, no further impairment testing was completed and no impairment charges related to goodwill or indefinite-lived intangibles were recognized during the fiscal periods ended August 26, 2017, August 27, 2016, August 29, 2015 or December 27, 2014. Income Taxes Income taxes include federal, state and foreign taxes currently payable and deferred taxes arising from temporary differences between income for financial reporting and income tax purposes. Deferred tax assets and liabilities are determined based on the differences between the financial statement balances and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the year that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to amounts expected to be realized. Share-Based Compensation Share-based compensation is rewarded to employees, directors, and consultants of the Company. Share-based compensation expense is recognized for equity awards over the vesting period based on their grant-date fair value. The fair value of option awards is estimated at the date of grant using the Black-Scholes valuation model. The exercise price of each stock option equals or exceeds the estimated fair value of the Company’s stock price on the date of grant. Options can generally be exercised over a maximum term of ten years. Compensation expense is recognized only for equity awards expected to vest, and the Company accounts for forfeitures as they are incurred. Share based compensation expense is included within the same financial statement caption where the recipient’s other compensation is reported. Accounts Receivable and Trade Promotions The Company estimates the allowance for doubtful accounts based upon a review of outstanding receivables, historical collection information and fiscal strength of the customer. Normally, accounts receivable are due within 30 days after the date of the invoice. Receivables more than 90 days old are considered past due. Accounts receivable are written off when they are determined to be uncollectible. The Company’s policy for estimating allowances for doubtful accounts with respect to receivables is to record an allowance based on a historical evaluation of write-offs, aging of balances, and other quantitative and qualitative analysis. At August 26, 2017 and August 27, 2016, the allowance for doubtful accounts was $0.4 million and $0.3 million, respectively. The Company estimates allowances to reflect commitments made to customers for customer-executed promotional activities and other incentive offerings, including special pricing agreements, price protection, promotions, and volume-based incentives, as well as damaged and aged customer inventory. These allowances are based on historical evaluations, both qualitative and quantitative, as well as the Company’s best estimate of current activity. The allowances for customer programs and other incentive offerings are recorded at the time the incentive is offered or at the time of revenue recognition for the underlying transaction that results in progress by the customer toward earning the incentive. The Company’s allowances for these commitments are recorded as a reduction to both accounts receivables and net sales. At August 26, 2017 and August 27, 2016, the allowance for these commitments was $7.8 million and $9.6 million, respectively. Inventories Inventories, which consist of nutrition bars, shakes, frozen meals and packaging material, are valued at the lower of cost or market, with cost determined using standard costs which approximate costs determined on the first-in, first-out method, and with market defined as the lower of replacement cost or realizable value. Inventories consist materially of finished goods. Obsolete inventory is reserved at 50% for inventory four to six months from expiration, and 100% for items within three months of expiration. Reserves are also taken for certain products or packaging materials when it is determined their cost may not be recoverable. At August 26, 2017 and August 27, 2016, the provision for obsolete inventory was $1.0 million and $1.0 million, respectively. As a result of the Business Combination, Simply Good Foods recorded a one-time inventory fair value step-up of $6.0 million, as determined in accordance with FASB Accounting Standards Codification (ASC) 820, Fair Value Measurements (ASC 820). Refer to Note 3. Business Combinations for additional information regarding the transaction. The one-time inventory fair value step-up impacts cost of goods sold of the successor period. Property and Equipment Property and equipment are stated at cost or the allocated fair value in purchase accounting, net of accumulated depreciation. The costs of additions and betterments that substantially extend the useful life of an asset are capitalized and the expenditures for ordinary repairs and maintenance are expensed in the period incurred. When items of property and equipment are sold or retired, the related costs and accumulated depreciation are removed from the accounts, and any gain or loss is included in other income. The Company capitalizes costs of materials and consultants involved in developing its website and mobile applications for smart phones (collectively, “website development costs”). Costs incurred during the preliminary project and post-implementation stages are charged to expense. Website development costs are amortized on a straight-line basis over an estimated useful life of three years. Amortization of capitalized website development costs expensed were $0.1 million for the successor period from July 7, 2017 through August 26, 2017 and $0.5 million for the predecessor period from August 28, 2016 through July 6, 2017, and $0.6 million, $0.3 million, and $0.8 million during the fiscal years ended August 27, 2016, August 29, 2015, and December 27, 2014, respectively. There were no disposals of fully amortized website development costs during the successor period from July 7, 2017 through August 26, 2017 or the predecessor period from August 28, 2016 through July 6, 2017, or for the fiscal periods ending August 27, 2016, and August 29, 2015. For the fiscal year ended December 27, 2014, the total disposals of fully amortized website development costs was $1.9 million. Leasehold improvements are amortized over the shorter of the remaining term of the lease or the useful life of the improvement utilizing the straight-line method. The Company determines whether there has been an impairment of long-lived assets, excluding goodwill and indefinite lived intangible assets, whenever events or changes in business circumstances indicate that the carrying value of any long-lived assets may not be fully recoverable. There were no indicators of impairment in the successor period from July 7, 2017 through August 26, 2017 or the predecessor period from August 28, 2016 through July 6, 2017, or the fiscal years ending August 27, 2016, August 29, 2015, and December 27, 2014. Deferred Financing Costs and Debt Discounts Costs incurred in obtaining long-term financing paid to parties other than creditors are considered a debt discount and are amortized over the terms of the long-term financing agreements using the effective-interest method. Amounts paid to creditors are recorded as a reduction in the proceeds received by the creditor and are considered a discount on the issuance of debt. Research and Development Activities The Company’s research and development activities primarily consist of generating and testing new product concepts, new flavors, and packaging and are primarily internal. The Company expenses research and development costs as incurred as they primarily relate to compensation, facility costs and purchased research and development services, materials and supplies. Research and development costs are included in general and administrative expenses in the Company’s Consolidated Statements of Operations and Comprehensive Income (Loss). The Company’s total research and development expenses were $0.4 million for the successor period from July 7, 2017 through August 26, 2017 and $1.9 million for the predecessor period from August 28, 2016 through July 6, 2017, and $2.1 million, $1.4 million, and $2.1 million for the 52-week period ended August 27, 2016, the 35-week period ended August 29, 2015, and the 52-week period ended December 27, 2014, respectively. Foreign Currency Translation For all foreign operations, the functional currency is the local currency. Assets and liabilities of these operations are translated into U.S. dollars using the exchange rate in effect at the end of each reporting period. Income statement accounts are translated at the average rate of exchange prevailing during each reporting period. Translation adjustments arising from the translation of these amounts are recorded as a component of Other Comprehensive Income (Loss). Unrealized foreign currency gains and losses arising from the remeasurement of intercompany positions within the Company’s international subsidiaries are recorded as a component of other income (expense). Advertising Costs Production costs related to television commercials are expensed when first aired. All other advertising costs are expensed when incurred through selling and marketing. Total advertising costs were $3.8 million for the successor period from July 7, 2017 through August 26, 2017 and $26.6 million for the predecessor period from August 28, 2016 through July 6, 2017 and $27.8 million, $23.0 million, and $27.7 million for the 52-week period ended August 27, 2016, the 35-week period ended August 29, 2015, and the 52-week period ended December 27, 2014, respectively. Production costs related to television commercials not yet aired are included in prepaid expenses in the accompanying Consolidated Balance Sheets. Production costs related to television commercials not yet aired were $1.2 million and nil at August 26, 2017 and August 27, 2016, respectively. Shipping and Handling Costs Costs associated with products shipped to customers are recognized in distribution in the accompanying Consolidated Statements of Operations and Comprehensive Income (Loss). The Company’s cost of sales does not include shipping and handling amounts related to the delivery to the buyer. Costs of $2.8 million for the successor period from July 7, 2017 through August 26, 2017 and $15.0 million for the predecessor period from August 28, 2016 through July 6, 2017 were recorded and $18.5 million, $11.4 million, and $19.5 million associated with products shipped to customers in the 52-week period ended August 27, 2016, the 35-week period ended August 29, 2015, and the 52-week period ended December 27, 2014, respectively. New Accounting Pronouncements Refer to Note 2. Summary of Significant Accounting Policies of our Consolidated Financial Statements in this filing for further information regarding recently issued accounting standards. JOBS Act Simply Good Foods qualifies as an “emerging growth company” pursuant to the provisions of the JOBS Act, enacted on April 5, 2012. Section 102 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. However, Simply Good Foods is choosing to “opt out” of such extended transition period, and as a result, Simply Good Foods will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Simply Good Foods’ decision to opt out of the extended transition period is irrevocable. Subject to certain conditions set forth in the JOBS Act, Simply Good Foods is not required to, among other things, (1) provide an auditor’s attestation report on our systems of internal controls over financial reporting pursuant to Section 404, (2) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (3) comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (4) disclose certain executive compensation-related items such as the correlation between executive compensation and performance and comparisons of the Chief Executive Officer’s compensation to median employee compensation. These exemptions will apply until Simply Good Foods no longer meets the requirements of being an emerging growth company. Simply Good Foods will remain an emerging growth company until the earlier of (a) the last day of the fiscal year (i) following the fifth anniversary of the completion of Conyers Park’s initial public offering, which was July 20, 2016, (ii) in which Simply Good Foods has total annual gross revenue of at least $1.0 billion or (iii) in which Simply Good Foods is deemed to be a large accelerated filer, which means the market value of its common stock that is held by non-affiliates exceeds $700 million as of the last business day of its prior second fiscal quarter, and (b) the date on which we have issued more than $1.0 billion in non-convertible debt during the prior 3-year period.

<s>[INST] Effective August 29, 2015, Atkins changed its fiscal year end from the last Saturday in December to the last Saturday in August. Atkins’ fiscal year 2016 ended August 27, 2016 and was a 52week period. Atkins fiscal period 2015 ended August 29, 2015 and was a 35week period. Fiscal years 2014 and 2013 were each 52week periods and ended December 27, 2014 and December 28, 2013, respectively. Atkins’ fiscal quarters are comprised of 13 weeks each, except for 53week fiscal periods for the which the fourth quarter will be comprised of 14 weeks, and end on the 13th Saturday of each quarter (14th Saturday of the fourth quarter, when applicable). Excluding the impacts of the Business Combination, fiscal year 2017 will be a 52week period and will end August 26, 2017. Atkins’ fiscal quarters for fiscal 2017 ended on November 26, 2016, February 25, 2017, May 27, 2017 and August 26, 2017. As a result of the Business Combination, information is presented for the successor period from July 7, 2017 through August 26, 2017, the predecessor period from August 28, 2016 through July 6, 2017, the 52week period ended August 27, 2016, the 35week period ended August 29, 2015 and the 52week periods ended December 27, 2014 and December 28, 2013 are derived from Atkins’ audited consolidated financial statements and the notes thereto. The information for the 53week period ended August 29, 2015 and the 35week period ended August 30, 2014 are derived from unaudited consolidated financial statements. Because the 53week period ended August 29, 2015 included an additional week of operation, the Company's net sales, expenses and other results of operations may be higher for that period. Overview Simply Good Foods is a developer, marketer and seller of branded nutritional foods and snacking products. Our highlyfocused product portfolio consists primarily of nutrition bars, RTD shakes, snacks and confectionery products marketed under the Atkins®, SimplyProtein®, Atkins Harvest Trail, and Atkins Endulge® brand names. Over the past 45 years, Atkins has become an iconic American brand that for many consumers stands for “low carb,” “low sugar” and “protein rich” nutrition. In our core snacking business, we strive to offer a complete line of nutrition bars, RTD shakes and confections that satisfy hunger while providing consumers with a convenient, “betterforyou” snacking alternative. In addition to snacking products, we have entered into a license arrangement for frozen meals sold in the United States by Bellisio Foods, Inc. We are a leading brand in nutritional snacking with a broad and growing consumer base. Our sales, marketing and R&D capabilities enable us to distribute products to a national customer base across the mass merchandiser, grocery and drug channels. We believe that our broad brand recognition, depth of management talent and strong cash generation position us to continue to innovate in the Atkins brand and acquire other brands, and thereby become an industry leading snacking platform. To that end, in December 2016, we completed the acquisition of Wellness Foods, Inc., a Canadabased developer, marketer and seller of the SimplyProtein® brand that is focused on proteinrich and lowsugar products, which management believes has significant opportunity for expansion in the U.S. Seasonality We have experienced in the past, and expect to continue to experience, seasonal fluctuations in our retail sales as a result of consumer spending patterns. Historically, the months of January to May result [/INST] Positive. </s>

Simply Good Foods Co

2018-10-24

2018-08-25

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes included in Item 8 of this Annual Report on Form 10-K. In addition to historical information, the following discussion contains forward-looking statements, such as statements regarding the Company’s expectation for future performance, liquidity and capital resources that involve risks, uncertainties and assumptions that could cause actual results to differ materially from the Company's expectations. The Company's actual results may differ materially from those contained in or implied by any forward-looking statements. Factors that could cause such differences include those identified below and those described in “Cautionary Note Regarding Forward-Looking Statements,” and in Item 1A “Risk Factors” of this Annual Report on Form 10-K. The Company assumes no obligation to update any of these forward-looking statements. Atkins fiscal year ends the last Saturday in August. Atkins’ fiscal years 2018, 2017 and 2016 ended August 25, 2018, August 26, 2017 and August 27, 2016, respectively, and were each fifty-two week periods. Atkins’ fiscal quarters are comprised of 13 weeks each, except for fifty-three week fiscal periods for the which the fourth quarter will be comprised of fourteen weeks, and end on the thirteenth Saturday of each quarter (fourteenth Saturday of the fourth quarter, when applicable). Atkins’ fiscal quarters for fiscal 2018 ended on November 24, 2017, February 24, 2018, May 26, 2018 and August 25, 2018. As a result of the Business Combination, information is presented for the successor period for the fifty-two week period ended August 25, 2018, the successor period from July 7, 2017 through August 26, 2017, the predecessor period from August 28, 2016 through July 6, 2017 and the fifty-two week period ended August 27, 2016 are derived from Atkins’ audited consolidated financial statements and the notes thereto. Overview Simply Good Foods is a developer, marketer and seller of branded nutritional foods and snacking products. Our highly-focused product portfolio consists primarily of nutrition bars, RTD shakes, snacks and confectionery products marketed under the Atkins®, SimplyProtein®, Atkins Harvest Trail and Atkins Endulge® brand names. Over the past 45 years, Atkins has become an iconic American brand that for many consumers stands for “low carb,” “low sugar” and “protein rich” nutrition. The Atkins philosophy focuses on a healthy nutritional approach with reduced levels of refined carbohydrates and refined sugars and encourages the consumption of lean protein, fiber, fruits, vegetables, and good fats. In our core Atkins snacking business, we strive to offer a complete line of nutrition bars, ready-to-drink shakes and confections that satisfy hunger while providing consumers with a convenient, “better-for-you” snacking alternative. Our sales, marketing and R&D capabilities enable us to distribute products into a national customer base across the mass merchandiser, grocery and drug channels. We believe that Atkins’ broad brand recognition, depth of management talent and strong cash generation position us to continue to innovate in the Atkins brand and acquire other brands, and thereby become an industry leading snacking platform. To that end, in December 2016, Atkins completed the acquisition of Wellness Foods, Inc. (“Wellness Foods”), a Canada-based developer, marketer and seller of the SimplyProtein® brand that is focused on protein-rich and low-sugar products, which our management believes has significant opportunity for expansion in the U.S. In addition to snacking products, Atkins entered into a license arrangement in 2014 for frozen meals sold in the U.S. by Bellisio Foods, Inc. Matters Affecting Comparability The Simply Good Foods Company (“Simply Good Foods”) was formed on March 30, 2017 to consummate a business combination with NCP-ATK Holdings, Inc. (“Atkins”) and Conyers Park Acquisition Corp (“Conyers Park”). Conyers Park, a special purpose acquisition company (“SPAC”), was formed on April 20, 2016 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. On April 10, 2017, Conyers Park and Atkins entered into a definitive merger agreement (the “Merger Agreement”). Under the terms of the agreement, Conyers Park and Atkins combined under a new holding company, Simply Good Foods, which was listed on the NASDAQ Capital Market under the symbol “SMPL” as of closing of the Business Combination. On July 7, 2017 (the “Closing Date”) Simply Good Foods completed the business combination with Conyers Park and Atkins (the “Business Combination”). As a result, Simply Good Foods owns all of the equity in Atkins. As a result of the Business Combination, Simply Good Foods is the acquirer for accounting purposes and the successor while Atkins is the acquiree and accounting predecessor. Our financial statement presentation includes the financial statements of Atkins as “Predecessor” for periods prior to the Closing Date and of Simply Good Foods for periods after the Closing Date, including the consolidation of Atkins. Following the consummation of the Business Combination, we are obligated to make payments under the Tax Receivable Agreement (the “TRA”). See Note 9, Income Taxes of the Consolidated Financial Statements included in this Report, for a detailed discussion of the TRA. For convenience, we have also included pro forma combined information for the comparable periods of fiscal 2017 as if the Business Combination had been completed at the beginning of the 2017 fiscal year. References in this Annual Report to information provided on a pro forma basis refer to such pro forma combined financial information. Our Reportable Segment Our business is organized around one reportable segment based on our go-to-market strategies, the objectives of the business and how our chief decision maker, our Chief Executive Officer, monitors operating performance and allocates resources. Key Financial Definitions Net sales. Net sales consists primarily of product sales less cost of promotional activities, slotting fees and other sales credits and adjustments, including product returns. The Company also includes licensing revenue from the frozen meals business in net sales. Cost of goods sold. Cost of goods sold consists primarily of the costs we pay to our contract manufacturing partners to produce the products sold. These costs include the purchase of raw ingredients, packaging and a tolling charge for the contract manufacturer. Cost of goods sold includes products provided at no charge as part of promotions and the non-food materials provided with customer orders. Operating expenses. Operating expenses consist primarily of selling, marketing, distribution, general and administrative, depreciation and amortization, and other expenses. The following is a brief description of the components of operating expenses: • Distribution. Distribution is principally freight associated with shipping and handling of products to the customer. • Selling. Selling expenses are comprised of broker commissions and customer marketing. • Marketing. Marketing expenses are comprised of media and other marketing costs. • General and administrative. General and administrative expenses are comprised of expenses associated with corporate and administrative functions that support our business, including fees for employee salaries, professional services, insurance and other general corporate expenses. • Depreciation and amortization. Depreciation and amortization costs consist of costs associated with the depreciation of fixed assets and capitalized leasehold improvements and amortization of intangible assets. • Business transaction costs. Business transaction costs are comprised of legal, due diligence and accounting firm expenses associated with the process of actively pursuing a potential business combination. • Gain in fair value change of contingent consideration - TRA liability. Gain in fair value change of contingent consideration - TRA liability charges relate to fair value adjustments of the TRA liability. • Other expense. Other expense is principally costs of restructuring consisting of severance and related expenses. Results of Operations In assessing the performance of our business, we consider a number of key performance indicators used by management and typically used by our competitors, including the non-GAAP measures of EBITDA and Adjusted EBITDA. Because not all companies use identical calculations, this presentation of EBITDA and Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. See “Reconciliation of Adjusted EBITDA” below for a reconciliation of EBITDA and Adjusted EBITDA to net income for each applicable period. Comparison of Results for the Successor Fifty-Two Weeks Ended August 25, 2018, the Successor Period from July 7, 2017 through August 26, 2017 and the Predecessor Period from August 28, 2016 through July 6, 2017 The following table presents, for the periods indicated, selected information from our consolidated financial results, including information presented as a percentage of net sales: Comparison of Results for the Successor Fifty-Two Weeks Ended August 25, 2018 and the Successor Period from July 7, 2017 through August 26, 2017 Net sales. Net sales for the successor fifty-two week period ended August 25, 2018 were $431.4 million compared to $56.3 million for the Successor Period from July 7, 2017 through August 26, 2017. Cost of goods sold. Cost of goods sold for the successor fifty-two week period ended August 25, 2018 were $223.9 million compared to $35.9 million for the Successor Period from July 7, 2017 through August 26, 2017. Gross profit. Gross profit for the successor fifty-two week period ended August 25, 2018 was $207.6 million, or 48.1% of net sales compared to $20.4 million, or 36.2% of net sales, for the Successor Period from July 7, 2017 through August 26, 2017. Operating expenses. Operating expenses for the successor fifty-two week period ended August 25, 2018 were $142.8 million, or 33.1% of net sales, compared to $18.5 million, or 32.9% of net sales, for the Successor Period from July 7, 2017 through August 26, 2017. Interest expense. Interest expense for the successor fifty-two week period ended August 25, 2018 was $12.6 million, or 2.9% of net sales, compared to $1.7 million, or 3.0% of net sales, for the Successor Period from July 7, 2017 through August 26, 2017. Income tax (benefit) expense. Income tax benefit for the successor fifty-two week period ended August 25, 2018 was $17.4 million compared to income tax expense of $0.3 million for the Successor Period from July 7, 2017 through August 26, 2017. Adjusted EBITDA. Adjusted EBITDA for the successor fifty-two week period ended August 25, 2018 was $78.6 million compared to $8.7 million for the Successor Period from July 7, 2017 through August 26, 2017. Comparison of Results for the Successor Period from July 7, 2017 through August 26, 2017 and the Predecessor Period from August 28, 2016 through July 6, 2017. Net sales. Net sales for the successor period from July 7, 2017 through August 26, 2017 were $56.3 million compared to $339.8 million for the predecessor period from August 28, 2016 through July 6, 2017. There was no impact to net sales as a result of the Business Combination. Cost of goods sold. Cost of goods sold for the successor period from July 7, 2017 through August 26, 2017 were $35.9 million compared to $180.0 million for the predecessor period from August 28, 2016 through July 6, 2017. As a result of the Business Combination, there was a one-time inventory fair value step-up of $6.0 million that was charged to cost of goods sold in the successor period from July 7, 2017 through August 26, 2017. Gross profit. Gross profit for the successor period from July 7, 2017 through August 26, 2017, including the effect of the one-time inventory fair value step-up, were $20.4 million, or 36.2% of net sales, compared to the predecessor period from August 28, 2016 through July 6, 2017, gross profit was $159.8 million, or 47.0% of net sales. Operating expenses. Operating expenses for the successor period from July 7, 2017 through August 26, 2017 were $18.5 million or 32.9% of net sales compared to $136.1 million or 40.1% of net sales the predecessor period from August 28, 2016 through July 6, 2017. Interest expense. Interest expense for the successor period from July 7, 2017 through August 26, 2017 was $1.7 million or 3.0% of net sales compared to $22.7 million or 6.7% of net sales for the predecessor period from August 28, 2016 through July 6, 2017. The lower interest expense in the successor period from July 7, 2017 through August 26, 2017 is the result of the reduced principal balance of the debt as well as a reduction in the rate of interest being incurred on the debt. Income tax expense. Income tax expense for the successor period from July 7, 2017 through August 26, 2017 was $0.3 million compared to $4.6 million for the predecessor period from August 28, 2016 through July 6, 2017. Higher taxes in the predecessor period relate to the impacts of the nondeductible business combination transaction costs. Adjusted EBITDA. Adjusted EBITDA decreased $55.2 million or 86.5% for the successor period from July 7, 2017 through August 26, 2017 compared to the predecessor period from August 28, 2016 through July 6, 2017. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see “Reconciliation of Adjusted EBITDA”. Pro Forma Combined Fifty-Two Weeks Ended August 26, 2017 For comparative purposes, we are presenting an unaudited pro forma combined statement of operations for the fifty-two week period ended August 26, 2017, and we discuss such pro forma combined results compared to the Predecessor’s full year 2016 results below. The unaudited pro forma combined statements of operations for the fiscal year ended August 26, 2017 presents our consolidated results of operations giving pro forma effect to the Business Combination as if it had occurred as of August 28, 2016. The pro forma combined adjustments are based on available information and upon assumptions that our management believes are reasonable in order to reflect, on a pro forma combined basis, the impact of these transactions on the historical financial information of our Predecessor and Successor entities, as applicable. The Business Combination was accounted for using the acquisition method of accounting in accordance with the FASB Accounting Standards Codification (“ASC”) 805, Business Combinations (“ASC 805”). The historical financial information has been adjusted to give pro forma effect to events that are related and/or directly attributable to the Business Combination, are factually supportable and are expected to have a continuing impact on the results of the combined company. The adjustments presented on the unaudited pro forma financial statements have been identified and presented to provide relevant information necessary for an accurate understanding of the combined company upon consummation of the Business Combination. The unaudited pro forma combined financial information contains a variety of adjustments, assumptions and estimates, is subject to numerous other uncertainties and the assumptions and adjustments as described in the accompanying notes hereto and should not be relied upon as being indicative of our results of operations had the Business Combination occurred on August 28, 2016. The unaudited pro forma combined financial information also does not project our results of operations for any future period or date. The unaudited pro forma combined financial information for the fifty-two weeks ended August 26, 2017 includes results of the Successor and Predecessor entities. The pro forma combined adjustments give effect to the items identified in the pro forma combined table below in connection with the Business Combination. Pro Forma Combined Statement of Operations For the Pro Forma Combined Fifty-Two Week Period Ended August 26, 2017 _______________ i. The amounts presented represent the Predecessor’s historical GAAP results of operations. ii. The adjustment represents a non-cash, one time inventory fair value adjustment recorded in conjunction with the Business Combination and was recognized in the successor period, and is not indicative of future cost of goods sold. iii. The adjustment represents the incremental stock-based compensation expense under the Simply Good Foods omnibus incentive plan. iv. The adjustment reflects the difference in the intangible asset amortization expense associated with the allocation of purchase price to intangible assets due to the Business Combination. The amortization expense decreased as additional indefinite lived intangible assets were identified for the successor entity than the predecessor entity. The amount of amortizable intangible assets identified in the Business Combination decreased from $125.8 million to $88.0 million. v. Business combination transaction expenses primarily consist of fees related to the Business Combination and the Company’s acquisition activities. Refer to Note 3, Business Combination, of the consolidated financial statements for additional details. vi. Predecessor warrants were accounted for as warrant liabilities, which were exercised and settled with the Business Combination. vii. Represents the adjustment necessary to arrive at interest expense associated with the term loan and revolving debt facilities of Simply Good Foods. The predecessor entity had $337.2 million outstanding as of August 27, 2016 while the successor entity had $200.0 million outstanding. The long term debt of the predecessor entity accrued interest at 6.25% on the first lien and 9.75% on the second lien while the successor debt accrues interest at 3 month LIBOR plus 4%. The significant reduction in outstanding principal, and lower interest rates, drive significant expense savings. Refer to Note 7, Long-Term Debt and Line of Credit, of the consolidated financial statements for additional details on long-term debt. viii. Represents the adjustment necessary to arrive at an effective income tax rate of 39.6%. ix. Adjusted EBITDA is a non-GAAP financial measure. For a reconciliation to its most directly comparable GAAP measure, see “Reconciliation of Adjusted EBITDA” within this section. Comparison of Results for the Fifty-Two Weeks Ended August 25, 2018 and the Pro Forma Combined Fifty-Two Weeks Ended August 26, 2017 For comparative purposes, we are presenting a statement of operations for the fifty-two week period ended August 25, 2018, compared to unaudited pro forma combined statement of operations for the fifty-two week period ended August 26, 2017. The following table presents, for the periods indicated, selected information from our unaudited pro forma combined financial results, including information presented as a percentage of net sales: Net sales. Net sales of $431.4 million represented an increase of $35.3 million, or 8.9%, for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The increase in net sales is primarily due to organic sales growth of 8.3%, driven by increased sales of our products in the U.S., offset by 0.3% from the prior year recall receivable. In addition, the acquisition of Wellness Foods drove a 0.9% increase in net sales compared to the prior year. In the third-quarter 10-Q the Company disclosed that it had historically recorded revenue on a “FOB Shipping Point” basis despite the fact that a significant portion of customer contracts indicated "FOB Destination" terms. As such, in the fourth quarter revenue was recorded on an "FOB Destination" basis, which resulted in a reduction to net sales of $7.8 million as of August 25, 2018. Cost of goods sold. Cost of goods sold increased $13.9 million, or 6.6%, for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The increase is primarily due to sales volume growth of $16.5 million offset by an improvement in supply chain costs of $2.6 million. Gross profit. Gross profit increased $21.3 million, or 11.5%, for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. Gross profit of $207.6 million, or 48.1% of net sales, for the fifty-two weeks ended August 25, 2018 increased 110 basis points from 47.0% of net sales for the fifty-two weeks ended August 26, 2017. The increase is primarily due to favorable changes in trade allowances and favorable supply chain costs, offset in part by the aforementioned recall reimbursement which had a 20 basis point benefit to gross margin in the previous year. Operating expenses. Operating expenses increased $15.1 million, or 11.9%, for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017 due to the following: • Distribution. Distribution expenses increased $1.9 million, or 10.9%, for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The increase is primarily driven by volume increases. • Selling. Selling expenses increased $1.6 million, or 9.7%, for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The increase was primarily driven by a $2.1 million increase in customer-specific advertising activity, offset by broker savings of $0.5 million. • Marketing. Marketing expenses increased $3.1 million, or 8.1%, for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The increase in expense is primarily driven by an increase in media spending and production. • General and administrative. General and administrative expenses increased $8.6 million, or 18.0%, for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The increase is related to higher professional fees of $3.0 million, employee related cost of $2.3 million, expansion of our distribution center of $1.6 million, the acquisition of Wellness Foods of $0.7 million and other increases in general and administrative expense of $1.0 million. • Depreciation and amortization. Depreciation and amortization expenses remained consistent between the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The fifty-two weeks ended August 26, 2017 has been adjusted to change the depreciable basis of intangible assets as if the Business Combination occurred at the beginning of the year. • Business transaction costs. The Company recorded $2.3 million in transaction costs for the fifty-two weeks ended August 25, 2018 primarily related to the equity offering by one of our stockholders in February and due diligence costs associated with acquisition efforts. The Company did not incur any transaction costs in the comparable period. • Gain in fair value change of contingent consideration - TRA liability. The Company recorded a $2.8 million gain in contingent consideration for the fifty-two weeks ended August 25, 2018. The gain is due to the change in the fair value of the TRA from the beneficial impact of the change in tax law offset by routine incremental fair value amortization changes. The TRA was entered into as part of the Business Combination in the prior year. The TRA is discussed in Note 9, Income Taxes, of the Consolidated Financial Statements included in this Report. Interest expense. Interest expense remained consistent between the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The fifty-two weeks ended August 26, 2017 has been adjusted based on the long-term debt of the Company as if the Business Combination occurred at the beginning of the year. Gain on foreign currency transactions. Foreign currency gain decreased $0.5 million between the fifty-two weeks ended August 25, 2018 and the fifty-two weeks ended August 26, 2017. Foreign currency transactions relate to changes in foreign currency rates in our international operations. Income tax (benefit) expense. Income tax expense decreased $36.2 million for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The difference is primarily due to the preliminary assessment of the tax law change on the Company's tax liabilities. For the fifty-two week period ended August 26, 2017, the effective tax rate assumed within the pro forma financial statements was 39.6%. For the fifty-two weeks ended August 25, 2018, a provisional gain of $31.0 million pursuant to the change in tax law resulted in a negative effective tax rate of 32.7%. The change in tax law is discussed in Note 9, Income Taxes, of the Consolidated Financial Statements included in this Report. Adjusted EBITDA. Adjusted EBITDA increased $6.1 million, or 8.4%, for the fifty-two weeks ended August 25, 2018 compared to the fifty-two weeks ended August 26, 2017. The increase is due to higher gross profit, partially offset by higher operating expenses. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see “Reconciliation of Adjusted EBITDA” below. Supplemental Pro Forma Fifty-Two Week Period Ended August 27, 2016 The following unaudited pro forma financial information has been prepared from the perspective of Atkins and its fiscal year end of August 27, 2016. The unaudited pro forma income statement for the fifty-two weeks ended August 27, 2016 presents the historical consolidated statement of operations of Atkins for the fifty-two weeks ended August 27, 2016, giving effect to the Business Combination as if it had occurred on August 30, 2015. The unaudited pro forma financial statements give effect to the Business Combination in accordance with the acquisition method of accounting for business combinations. The historical financial information has been adjusted to give pro forma effect to events that are related and/or directly attributable to the Business Combination, are factually supportable and are expected to have a continuing impact on the results of the combined company. The adjustments presented on the unaudited pro forma financial statements have been identified and presented to provide relevant information necessary for an accurate understanding of the combined company upon consummation of the Business Combination. The unaudited pro forma financial statements also reflect the impact of the Atkins license arrangement for frozen meals sold in the U.S. by Bellisio. This agreement was effective September 1, 2016 and is a seven-year license with Bellisio to license Atkins' frozen meals business. Bellisio manufactures, distributes, markets, promotes and sells Atkins frozen food products under the Atkins licensed mark. The effects of the license agreement are presented in the “Frozen License Adjustments” and “Atkins' Pro Forma” columns in the unaudited historical consolidated statement of operations for the fifty-two weeks ended August 27, 2016. The unaudited pro forma financial information is for illustrative purposes only. The financial results may have been different if the Business Combination actually been completed sooner. You should not rely on the unaudited pro forma financial information as being indicative of the historical results that would have been achieved if the Business Combination had been completed as of August 30, 2015. Pro Forma Combined Statement of Operations For the Pro Forma Fifty-Two Week Period Ended August 27, 2016 _______________ i. The amounts in this column represents the Predecessor’s historical GAAP results after removing the results of operations of the Frozen operations. ii. The adjustment represents the incremental stock based compensation expense under the Simply Good Foods omnibus incentive plan. iii. The adjustment reflects the difference in the intangible asset amortization expense associated with the allocation of purchase price to intangible assets due to the Business Combination. The amortization expense decreased as more indefinite lived intangible assets were identified for the successor entity than the predecessor entity. The amount of amortizable intangible assets identified in the Business Combination decreased from $125.8 million to $88.0 million. Refer to Note 5, Goodwill and Intangibles, of the consolidated financial statements for additional details. iv. The Simply Good Foods warrants are not warrant liabilities and are accounted for as equity warrants. The adjustment represents the corresponding decrease to expense. v. The adjustment represents interest expense associated with the term loan and revolving debt facilities of Simply Good Foods. The predecessor entity had $337.2 million outstanding as of August 27, 2016 while the successor entity had $200.0 million outstanding. The long term debt of the predecessor entity accrued interest at 6.25% on the first lien and 9.75% on the second lien while the successor debt accrues interest at 3 month LIBOR and 4%. The significant reduction in outstanding principal, and lower interest rates, drive significant expense savings. Refer to Note 7, Long-Term Debt and Line of Credit, of the Consolidated Financial Statements for additional details on long-term debt. vi. Represents the effective income tax rate of 39.6%. vii. Approximately $2.1 million of Pro Forma Frozen Licensing Selling costs were previously classified as Pro Forma Frozen Licensing Distribution expenses. Comparison of Results for the Pro Forma Combined Fifty-Two Week Period Ended August 26, 2017 and the Supplemental Pro Forma Fifty-Two Week Period Ended August 27, 2016 For comparative purposes, we are presenting a unaudited pro forma combined statement of operations for the fifty-two week period ended August 26, 2017, and we discuss such pro forma combined results compared to the supplemental unaudited pro forma statement of operations for the fifty-two week period ended August 27, 2016. The following table presents, for the periods indicated, selected information from our unaudited pro forma consolidated financial results, including information presented as a percentage of net sales: Net sales. Net sales increased $27.1 million, or 7.4%, for the fifty-two weeks ended August 26, 2017 compared to the fifty-two weeks ended August 27, 2016. The increase in net sales was driven primarily by growth of $20.0 million in Atkins core business and the December 2016 addition of Wellness Foods of $7.1 million. The growth in the core business net sales was primarily driven by increased demand, growing volume $17.4 million and improved returns of $2.6 million. The improvement to returns was principally due to the 2016 recall expense which decreased 2016 net sales. The recall was subsequently reimbursed in 2017. Cost of goods sold. Cost of goods sold increased $10.5 million, or 5.2%, for the fifty-two weeks ended August 26, 2017 compared to the fifty-two weeks ended August 27, 2016. The increase was primarily due to sales volume growth of $6.9 million and the Wellness Foods acquisition of $3.6 million. Gross profit. Gross profit increased $16.7 million, or 9.8%, for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016. Gross margin of 47.0% for the fifty-two weeks ended August 26, 2017 improved 110 bps from 45.9% for the fifty-two weeks ended August 27, 2016 due to the favorable recall expense, cost saving initiatives and favorable mix. Operating expenses. Operating expenses increased $5.8 million, or 4.8%, for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016 due to the following: • Selling. Selling expenses increased $0.2 million, or 1.0%, for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016. • Marketing. Marketing expenses increased $1.9 million, or 5.3%, for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016 to support the growth of the snacking business. • Distribution. Distribution expenses increased $2.3 million, or 14.8%, for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016. The increase in distribution expenses was primarily driven by a one-time surcharge in 2017 of $0.8 million. • General and administrative. General and administrative expenses increased $2.3 million for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016. The increase related to the acquisition of Wellness Foods and incremental costs associated with public company operations. • Depreciation and amortization. Depreciation and amortization expenses were flat for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016. • Other expense. Other expenses decreased $0.9 million for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016. Gain (loss) on foreign currency transactions. Loss on foreign currency transactions increased $1.3 million for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016. Income tax expense. Income tax expense increased $4.9 million from the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016. The difference is due to higher income from operations in 2017 compared to 2016. Adjusted EBITDA. Adjusted EBITDA increased $8.3 million, or 12.9%, for the fifty-two week period ended August 26, 2017 compared to the fifty-two week period ended August 27, 2016. The increase was driven by the increase in gross profit. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see “Reconciliation of Adjusted EBITDA”. Reconciliation of Adjusted EBITDA Adjusted EBITDA. Adjusted EBITDA is a non-GAAP financial measure commonly used in our industry and should not be construed as an alternative to net income as an indicator of operating performance or as an alternative to cash flow provided by operating activities as a measure of liquidity (each as determined in accordance with GAAP). Simply Good Foods defines Adjusted EBITDA (earnings before interest, tax, depreciation and amortization) as net income before interest expense, income tax expense, depreciation and amortization with further adjustments to exclude the following items: stock-based compensation and warrant expense, transaction and IPO readiness costs, restructuring costs, management fees, frozen media licensing fees, non-core legal costs, transactional exchange impact, change in fair value of contingent consideration - TRA liability, business transaction costs and other non-core expenses. The Company believes that the inclusion of these supplementary adjustments in presenting Adjusted EBITDA are appropriate to provide additional information to investors and reflects operating results more accurately of the on-going operations. Adjusted EBITDA may not be comparable to other similarly titled captions of other companies due to differences in calculation. The following unaudited tables below provide a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, which is net income (loss). _______________ (1) Other items consist principally of exchange impact of foreign currency transactions and other expenses. Liquidity and Capital Resources Overview We have historically funded our operations with cash flow from operations and borrowings under our credit facilities. Our principal uses for liquidity have been debt service and working capital. We believe our sources of liquidity and capital will be sufficient to finance our continued operations, growth strategy and additional expenses we are incurring as a public company for at least the next twelve months. Following the consummation of the Business Combination, we are obligated to make payments under the TRA. Although the actual timing and amount of any payments that may be made under the TRA will vary, the payments that we will be required to make could be significant. Any payments made under the TRA will reduce the amount of overall cash flow that might have otherwise been available to us. To the extent that we are unable to make payments under the TRA for any reason, the unpaid amounts generally will be deferred and accrue interest until paid. See Note 9, Income Taxes, of the Consolidated Financial Statements included in this Report for additional information on the TRA. Debt and Credit Facilities On July 7, 2017, the Company entered into a credit agreement with Barclays Bank PLC and other parties. The credit agreement provides for a term facility of $200.0 million (“Term Facility”) with a seven year maturity and a revolving credit facility of up to $75.0 million (the “Revolving Credit Facility”) with a five year maturity, under the first lien senior secured loan facilities (the “First Lien”). Substantially concurrent with the consummation of the Business Combination, the full $200.0 million of the First Lien term loan (the “Term Loan”) was drawn. No amounts were originally drawn on the Revolving Credit Facility. The interest rate per annum is based on either (i) a base rate equaling the higher of (a) the “prime rate”, (b) the federal funds effective rate plus 0.50% and (c) the Euro-currency rate applicable for an interest period of one month plus 1.00% plus (x) 3.00% margin for Term Loan or (y) 2.00% margin for Revolving Credit Facility, or (ii) London Interbank Offered Rate (“LIBOR”) adjusted for statutory reserve requirements, plus (x) 4.00% margin for the Term Loan subject to a floor of 1.00% or (y) 3.00% margin for the Revolving Credit Facility. The applicable margin for Revolving Credit Facility was adjusted after the completion of the Company’s first full fiscal quarter after the closing of the Business Combination based upon the Company’s consolidated First Lien net leverage ratio. As security for the payment or performance of its debt, the Company has pledged certain equity interests in its subsidiaries. On March 16, 2018 (the “Amendment Date”), the Company entered into an amendment (the “Repricing Amendment”) to the First Lien. As a result of the Repricing Amendment, the interest rate on the Term Loan was reduced and, as of the Amendment Date, such loans bear interest at a rate equal to, at the Company's option, either LIBOR plus an applicable margin of 3.50% or a base rate plus an applicable margin of 2.50%. The Repricing Amendment did not change the interest rate on the Revolving Credit Facility. The Revolving Credit Facility will continue to bear interest based upon the Company's consolidated First Lien net leverage ratio as of the last financial statements delivered to the administrative agent. No additional debt was incurred, or any proceeds received, by the Company in connection with the Repricing Amendment. The incremental fees paid to the administrative agent are reflected as additional debt discount and are amortized over the terms of the long-term financing agreements using the effective-interest method. The First Lien is subject to mandatory prepayments based on contractual terms. The credit facilities governing our debt arrangements contain certain financial and other covenants. The Revolving Credit Facility has a maximum total net leverage ratio equal to or less than 6.25:1.00 (with a reduction to 6.00:1.00 on and after the third anniversary of the closing date of the credit facilities) contingent on credit extensions in excess of 30% of the total amount of commitments available under the revolving credit facility, and limitations on our ability to, among other things, incur and/or undertake asset sales and other dispositions, liens, indebtedness, certain acquisitions and investments, consolidations, mergers, reorganizations and other fundamental changes, payment of dividends and other distributions to equity and warrant holders, and prepayments of material subordinated debt, in each case, subject to customary exceptions materially consistent with credit facilities of such type and size. Any failure to comply with the restrictions of the credit facilities may result in an event of default. The credit facilities governing our debt arrangements bear interest at variable rates. If market interest rates increase, variable rate debt will create higher debt service requirements, which could adversely affect our cash flow. As the Company has not drawn on the Revolving Credit Facility as of August 25, 2018 and August 26, 2017, no debt covenants were applicable as of the period then ended. As of August 25, 2018, the outstanding principal balances of the Term Loan was $198.5 million, and no amounts were drawn under the $75.0 million Revolving Credit Facility. Equity Warrants On October 4, 2018, the Company announced that it will redeem all of its public warrants to purchase common stock that remain outstanding immediately after 5:00 p.m., New York City time, on November 5, 2018 (the “Redemption Date”). Any public warrants that remain unexercised immediately after the Redemption Date will be redeemed at a redemption price of $0.01 per warrant. In addition, in accordance with the warrant agreement for the public warrants, the Company’s Board of Directors elected to require that all future exercises of the public warrants be exercised on a cashless basis. Accordingly, holders may no longer exercise public warrants in exchange for payment in cash of the $11.50 per share exercise price. Instead, a holder exercising a public warrant will be deemed to pay the $11.50 per share exercise price by the surrender of 0.61885 of a share of common stock that such holder would have been entitled to receive upon a cash exercise of each public warrant. Accordingly, by virtue of the cashless exercise of the public warrants, exercising holders of public warrants will receive 0.38115 of a share of the Company’s common stock for each public warrant surrendered for exercise. From August 26, 2018 through October 4, 2018, public warrants to purchase an aggregate of 9,886,663 shares of the Company’s common stock were exercised for cash at an exercise price of $11.50 per share, resulting in aggregate gross proceeds to the Company of approximately $113.7 million. The Company’s private warrants to purchase 6,700,000 shares of the Company’s common stock remain outstanding as of the date of this report. Cash Flows The following table sets forth the major sources and uses of cash for each of the periods set forth below (in thousands): Operating activities. Our net cash provided by operating activities was $61.0 million for the successor period ended August 25, 2018, an increase of $88.4 million compared to net cash used in operating activities of $27.4 million for the successor period ended August 26, 2017. The increase was primarily driven by higher income before taxes. The Company had $112.0 million in cash and cash equivalents as of August 25, 2018, which is sufficient to satisfy current liabilities, current maturities of long-term debt and the interest payments associated with them. Our net cash used in operating activities was $27.4 million for the successor period ending August 26, 2017, a decrease of $49.3 million compared to net cash provided by operating activities of $21.9 million for the predecessor period ending July 6, 2017. This decrease was primarily due to the transaction related expenses in the successor period offset by higher net income of approximately $2.9 million. Investing activities. Our net cash used in investing activities was $3.5 million for the successor period ended August 25, 2018, which was a decrease of $193.8 million compared to the investing activities for the successor period ended August 26, 2017. The change was due to the Business Combination in the successor period ended August 26, 2017, offset by minor increases in purchases of property and equipment . Our net cash used in investing activities was $197.3 million for the successor period ended August 26, 2017, which was an increase in cash used of $176.8 million compared to net cash used in investing activities of $20.5 million for the predecessor period. The large increase was due to the net exchange of cash in the Business Combination in the successor period of $196.8 million compared to the purchase of Wellness Foods for approximately $20.0 million (net of cash acquired) in December 2016 (predecessor period). Financing activities. Our net cash used in financing activities was $1.6 million for the successor period ended August 25, 2018, compared to net cash provided by financing activities of $280.8 million for the successor period ended August 26, 2017. The decrease is due to the proceeds from the issuance of long term debt of $191.9 million and proceeds from the issuance of equity of $97.0 million related to the Business Combination in the successor period ended August 26, 2017. Our net cash provided by financing activities was $280.8 million for the successor period ended August 26, 2017, an increase of cash provided of $334.3 million, compared to net cash used in financing activities of $53.5 million for the predecessor period. This increase in cash provided was due to the proceeds from the issuance of long term debt of $191.9 million and proceeds from the issuance of equity of $97.0 million related to the Business Combination in the successor period. Off-Balance Sheet Arrangements As of August 25, 2018, we had no material off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on its financial condition, changes in financial condition, income or expenses, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations The following table summarizes our expected material contractual payment obligations as of August 25, 2018. _______________ (1) As of August 25, 2018, the Company is obligated under multiple non-cancellable operating leases, which continue through 2023. Rent expenses, inclusive of real estate taxes, utilities and maintenance incurred under operating leases, are included in General and administrative expenses in the Company’s consolidated statements of operations. Rent expenses were $2.4 million for fifty-two week period ended August 25, 2018, $0.3 million for the successor period from July 7, 2017 through August 26, 2017, $1.7 million for the predecessor period from August 28, 2016 through July 6, 2017, respectively. Critical Accounting Policies, Judgments and Estimates General The consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the U.S. While the majority of the Company’s revenues, expenses, assets and liabilities are not based on estimates, there are certain accounting principles that require management to make estimates regarding matters that are uncertain and susceptible to change. Critical accounting policies are defined as those policies that are reflective of significant judgments, estimates and uncertainties, which could potentially result in materially different results under different assumptions and conditions. Management regularly reviews the estimates and assumptions used in the preparation of the Company’s financial statements for reasonableness and adequacy. Our significant accounting policies are discussed in Note 2, Summary of Significant Accounting Policies, of our Consolidated Financial Statements in this filing; however, the following discussion pertains to accounting policies the Company believes are most critical to the portrayal of its financial condition and results of operations and that require significant, difficult, subjective or complex judgments. Other companies in similar businesses may use different estimation policies and methodologies, which may impact the comparability of the Company’s financial condition, results of operations and cash flows to those of other companies. Business Combinations As discussed in detail in Note 3, Business Combination, of our Consolidated Financial Statements in this filing, on July 7, 2017, Simply Good Foods acquired the Atkins business from Roark. The Business Combination was funded through a combination of cash, stock and debt financing. The Business Combination is accounted for using the acquisition method of accounting. Assets acquired, liabilities assumed and non-controlling interests are recorded at their estimated fair values at the acquisition date. The excess of purchase price over fair value of the net assets acquired, including the amount assigned to identifiable intangible assets, is recorded as goodwill. ASC 805, Business Combinations, establishes a measurement period to provide the Company with a reasonable amount of time to obtain the information necessary to identify and measure various items in a business combination and cannot extend beyond one year from the acquisition date. Revenue Recognition The Company has historically recognized revenue at the time of shipment to its customers; however, upon examination of certain contractual arrangements, and as a result of the practice of refunding customers for products damaged in-transit, the risks and rewards of ownership of the products transferred at customer receipt. Accordingly, the Company concluded it should have recognized revenue upon customer receipt. These errors, along with the errors in prior annual and quarterly periods for which revenue for sales-in-transit was not appropriately deferred, are not material to the financial statements. During the fourth quarter, the Company deferred all revenue for shipments in-transit to customers totaling $7.8 million. The failure to defer revenues for sales-in-transit in the third quarter of 2018, resulted in an understatement of net sales of $8.2 million for revenue that was recorded in the third quarter that should have been deferred and recognized during the fourth quarter upon customer receipt. Trade Promotions The Company offers trade promotions through various programs to customers and consumers. Trade promotions include discounts, rebates, slotting and other marketing activities. Trade promotions are recorded as a reduction to net sales with a corresponding reduction to accounts receivable at the later of the time the incentive is offered or at the time of revenue recognition for the underlying sale. The recognition of trade promotions requires management to make estimates regarding the volume of incentive that will be redeemed and their total cost. These estimates are made using various information including historical data on performance of similar trade promotional activities, as well as the Company's best estimated of current activity. At August 25, 2018 and August 26, 2017, the allowance for trade promotions was $7.4 million and $7.8 million, respectively. Differences between estimated expense and actual redemptions are recognized as a change in management estimate in a subsequent period. These differences have historically been insignificant. Tax Receivable Arrangement As discussed in Note 3, Business Combination, and Note 9, Income Taxes, simultaneously with the closing of the Business Combination, Simply Good Foods entered into the Tax Receivable Agreement (the “TRA”). The TRA is contingent consideration and included as part of the consideration transferred in the Business Combination. The Tax Receivable Agreement obligation was recorded at its acquisition-date fair value at inception and is classified as a liability. The Tax Receivable Agreement will generally provide for the payment by Simply Good Foods to the Selling Equity holders for certain federal, state, local and non-U.S. tax benefits deemed realized in post-closing taxable periods by Simply Good Foods, Conyers Park, Atkins and Atkins eligible subsidiaries from the use of up to $100 million of the following tax attributes: (i) net operating losses available to be carried forward as of the closing of the Business Combination; (ii) certain deductions generated by the consummation of the transactions contemplated by the Merger Agreement; and (iii) remaining depreciable tax basis from the 2003 acquisition of Atkins Nutritionals, Inc. As of August 25, 2018, the estimated fair value of these contingent payments is $27.5 million, which has been recorded as a liability and represents 100% of the value of the recorded tax attributes. Subsequent changes in fair value of the contingent liability will be recognized in earnings. Goodwill and Other Intangible Assets Goodwill and indefinite-lived intangible assets are not amortized, but are evaluated for impairment annually or more often if events or circumstances indicated that potential impairment may be present. Our annual impairment tests are conducted at the beginning of the fourth quarter. We test goodwill and indefinite-lived intangible assets by performing either qualitative or quantitative assessments. In the qualitative assessment, factors including macro-economic conditions, industry and company-specific factors, legal and regulatory environments and historical company performance are evaluated in assessing fair value. If we determine that it is more likely than not that the fair value of the reporting unit is less than its carrying value, a quantitative test is then performed. Otherwise, no further testing is required. When using a quantitative approach, we compare the fair value of the reporting unit to its carrying amount, including goodwill. If the estimated fair value of the reporting unit is less than the carrying amount of the reporting unit, impairment is indicated, requiring recognition of a impairment charge for the differential. Qualitative assessments of goodwill and indefinite-lived intangible assets were performed in 2018, 2017 and 2016. Based on the results of assessment, it was determined that it is more likely than not the reporting unit had a fair value in excess of carrying value. Accordingly, no further impairment testing was completed and no impairment charges related to goodwill or indefinite-lived intangibles were recognized during the fiscal periods ended August 25, 2018, August 26, 2017 or August 27, 2016. The Company also has intangible assets that are expected to have determinable useful lives, consisting primarily of trademarks, customer relationships and licensing agreements. Costs of finite-lived intangible assets are amortized over their estimated useful lives. Finite-lived intangible assets are tested for impairment when events or circumstances indicated that the carrying amount may not be recoverable. For the fiscal periods ended August 25, 2018, August 26, 2017 or August 27, 2016 there were no impairments recorded related to finite-lived intangible assets. Income Taxes We are subject to income to income taxes in the United States and numerous other jurisdictions. Significant judgment is required in determining our provision for income tax, including evaluating uncertainties in the application of accounting principles and complex tax laws. Income taxes include federal, state and foreign taxes currently payable and deferred taxes arising from temporary differences between income for financial reporting and income tax purposes. Deferred tax assets and liabilities are determined based on the differences between the financial statement balances and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the year that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to amounts expected to be realized. New Accounting Pronouncements Refer to Note 2, Summary of Significant Accounting Policies, of our Consolidated Financial Statements in this filing for further information regarding recently issued accounting standards.

<s>[INST] Atkins fiscal year ends the last Saturday in August. Atkins’ fiscal years 2018, 2017 and 2016 ended August 25, 2018, August 26, 2017 and August 27, 2016, respectively, and were each fiftytwo week periods. Atkins’ fiscal quarters are comprised of 13 weeks each, except for fiftythree week fiscal periods for the which the fourth quarter will be comprised of fourteen weeks, and end on the thirteenth Saturday of each quarter (fourteenth Saturday of the fourth quarter, when applicable). Atkins’ fiscal quarters for fiscal 2018 ended on November 24, 2017, February 24, 2018, May 26, 2018 and August 25, 2018. As a result of the Business Combination, information is presented for the successor period for the fiftytwo week period ended August 25, 2018, the successor period from July 7, 2017 through August 26, 2017, the predecessor period from August 28, 2016 through July 6, 2017 and the fiftytwo week period ended August 27, 2016 are derived from Atkins’ audited consolidated financial statements and the notes thereto. Overview Simply Good Foods is a developer, marketer and seller of branded nutritional foods and snacking products. Our highlyfocused product portfolio consists primarily of nutrition bars, RTD shakes, snacks and confectionery products marketed under the Atkins®, SimplyProtein®, Atkins Harvest Trail and Atkins Endulge® brand names. Over the past 45 years, Atkins has become an iconic American brand that for many consumers stands for “low carb,” “low sugar” and “protein rich” nutrition. The Atkins philosophy focuses on a healthy nutritional approach with reduced levels of refined carbohydrates and refined sugars and encourages the consumption of lean protein, fiber, fruits, vegetables, and good fats. In our core Atkins snacking business, we strive to offer a complete line of nutrition bars, readytodrink shakes and confections that satisfy hunger while providing consumers with a convenient, “betterforyou” snacking alternative. Our sales, marketing and R&D capabilities enable us to distribute products into a national customer base across the mass merchandiser, grocery and drug channels. We believe that Atkins’ broad brand recognition, depth of management talent and strong cash generation position us to continue to innovate in the Atkins brand and acquire other brands, and thereby become an industry leading snacking platform. To that end, in December 2016, Atkins completed the acquisition of Wellness Foods, Inc. (“Wellness Foods”), a Canadabased developer, marketer and seller of the SimplyProtein® brand that is focused on proteinrich and lowsugar products, which our management believes has significant opportunity for expansion in the U.S. In addition to snacking products, Atkins entered into a license arrangement in 2014 for frozen meals sold in the U.S. by Bellisio Foods, Inc. Matters Affecting Comparability The Simply Good Foods Company (“Simply Good Foods”) was formed on March 30, 2017 to consummate a business combination with NCPATK Holdings, Inc. (“Atkins”) and Conyers Park Acquisition Corp (“Conyers Park”). Conyers Park, a special purpose acquisition company (“SPAC”), was formed on April 20, 2016 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. On April 10, 2017, Conyers Park and Atkins entered into a definitive merger agreement (the “Merger Agreement”). Under the terms of the agreement, Conyers Park and Atkins combined under a new holding company, Simply Good Foods, which was listed on the NASDAQ Capital Market under the symbol “SMP [/INST] Negative. </s>

Simply Good Foods Co

2019-10-30

2019-08-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and related notes included in Item 8 of this Report. In addition to historical information, the following discussion contains forward-looking statements, including, but not limited to, statements regarding the Company’s expectation for future performance, liquidity and capital resources that involve risks, uncertainties and assumptions that could cause actual results to differ materially from the Company's expectations. The Company's actual results may differ materially from those contained in or implied by any forward-looking statements. Factors that could cause such differences include those identified below and those described in “Cautionary Note Regarding Forward-Looking Statements,” and in Item 1A “Risk Factors” of this Report. The Company assumes no obligation to update any of these forward-looking statements. Our fiscal year ends the last Saturday in August. Our fiscal years 2018 and 2017 ended August 25, 2018 and August 26, 2017, respectively, and were each fifty-two week periods. Our fiscal year 2019 ended August 31, 2019 was a fifty-three week period. Atkins’ fiscal quarters are comprised of thirteen weeks each, except for fifty-three week fiscal periods for the which the fourth quarter is comprised of fourteen weeks, and end on the thirteenth Saturday of each quarter (fourteenth Saturday of the fourth quarter, when applicable). Atkins’ fiscal quarters for fiscal 2019 ended on November 24, 2018, February 23, 2019, May 25, 2019 and August 31, 2019. As a result of the Business Combination, information is presented for the successor fifty-three week period ended August 31, 2019, the successor period for the fifty-two week period ended August 25, 2018, the successor period from July 7, 2017 through August 26, 2017, and the predecessor period from August 28, 2016 through July 6, 2017, are derived from Atkins’ audited consolidated financial statements and the notes thereto. Overview Simply Good Foods is a developer, marketer and seller of branded nutritional foods and snacking products. Our highly-focused product portfolio consists primarily of nutrition bars, RTD shakes, snacks and confectionery products marketed under the Atkins®, SimplyProtein®, and Atkins Endulge® brand names. Our goal is to lead the nutritious snacking movement with trusted brands that offer a variety of convenient, innovative, great-tasting, “better-for-you” snacks and meal replacements. Over the past 45 years, Atkins has become an iconic American brand that for many consumers stands for “low carb,” “low sugar” and “protein rich” nutrition. The Atkins philosophy focuses on a healthy nutritional approach with reduced levels of refined carbohydrates and sugars and encourages the consumption of lean protein, fiber, fruits, vegetables, and healthy fats. In our core Atkins snacking business, we strive to offer a complete line of nutrition bars, ready-to-drink shakes and confections that satisfy hunger while providing consumers with a convenient, “better-for-you” snacking alternative. Our sales, marketing and R&D capabilities enable us to distribute products into a national customer base across the mass merchandiser, grocery and drug channels. We believe that Atkins’ broad brand recognition, our depth of management talent and strong cash generation position us to continue to innovate in the Atkins brand and acquire other brands, and thereby become an industry leading snacking platform. To that end, in December 2016, Atkins completed the acquisition of Wellness Foods, a Canada-based developer, marketer and seller of the SimplyProtein® brand that is focused on protein-rich and low-sugar products. Quest Acquisition and Related Financing On August 21, 2019, we entered into a stock purchase agreement (the “Purchase Agreement”) to acquire Quest Nutrition, LLC (“Quest”), a healthy lifestyle food company (the “Acquisition”). The Acquisition is expected to close by the end of the 2019 calendar year, subject to satisfaction of customary closing conditions. There is no financing condition for the Acquisition. On October 9, 2019, we completed an underwritten public offering of 13,379,205 shares of our common stock at a price per share of $26.16 (the “Offering”), resulting in net proceeds to us of approximately $350.0 million, after deducting underwriting discounts and commissions and our estimated fees and expenses for the Offering. We intend to use these net proceeds to pay a portion of the purchase price and related fees and expenses for the Acquisition, or for general corporate purposes if the acquisition is not consummated. We plan to fund the remainder of the Acquisition by using a significant portion of the approximately $265 million of cash on hand and committed financing pursuant to debt commitments from Barclays, Credit Suisse and Goldman Sachs. Matters Affecting Comparability The Simply Good Foods Company was formed on March 30, 2017 to consummate a business combination with Atkins and Conyers Park. Conyers Park, a special purpose acquisition company, was formed on April 20, 2016 for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. On April 10, 2017, Conyers Park and Atkins entered into a definitive merger agreement (the “Merger Agreement”). Under the terms of the agreement, Conyers Park and Atkins combined under a new holding company, Simply Good Foods, which was listed on the Nasdaq Capital Market under the symbol “SMPL” as of closing of the Business Combination. On July 7, 2017 (the “Closing Date”) Simply Good Foods completed the business combination with Conyers Park and Atkins (the “Business Combination”). As a result, Simply Good Foods owns all of the equity in Atkins. As a result of the Business Combination, Simply Good Foods is the acquirer for accounting purposes and the successor while Atkins is the acquiree and accounting predecessor. Our financial statement presentation includes the financial statements of Atkins as “Predecessor” for periods prior to the Closing Date and of Simply Good Foods for periods after the Closing Date, including the consolidation of Atkins. Change in Accounting Principle During the fourth quarter of fiscal 2019, we changed our accounting principle related to the presentation of third party delivery costs associated with shipping and handling activities previously included as operating expenses in Distribution in the Consolidated Statements of Operations and Comprehensive Income (Loss). In the new accounting principle, the Company is presenting these expenses within cost of goods sold (“COGS”) in the Consolidated Statements of Operations and Comprehensive Income (Loss). In connection with the change in accounting principle, the Company also changed its definition of shipping and handling costs to include costs paid to third-party warehouse operators associated with delivering product to a customer, previously included in General and administrative and depreciation and amortization of the assets at the third-party warehouse, previously included in Depreciation and amortization. Under the previous definition of shipping and handling costs, the Company only included third-party delivery costs in Distribution. Amounts presented for the successor fifty-two week period ended August 25, 2018, the successor period from July 7, 2017 through August 26, 2017, and the predecessor period from August 28, 2016 through July 6, 2017 have been adjusted in accordance with this accounting principle change. See Note 2 to the Consolidated Financial Statements included herein for additional information on the accounting principle change. Our Reportable Segment Our business is organized around one reportable segment based on our go-to-market strategies, the objectives of the business and how our chief decision maker, our President and Chief Executive Officer, monitors operating performance and allocates resources. Key Financial Definitions Net sales. Net sales consists primarily of product sales less cost of promotional activities, slotting fees and other sales credits and adjustments, including product returns. The Company also includes licensing revenue from the frozen meals business in net sales. Cost of goods sold. Cost of goods sold consists primarily of the costs we pay to our contract manufacturing partners to produce the products sold. These costs include the purchase of raw ingredients, packaging, shipping and handling, warehousing, depreciation of warehouse equipment, and a tolling charge for the contract manufacturer. Cost of goods sold includes products provided at no charge as part of promotions and the non-food materials provided with customer orders. Operating expenses. Operating expenses consist primarily of selling and marketing, general and administrative, depreciation and amortization, and other expenses. The following is a brief description of the components of operating expenses: • Selling and marketing. Selling and marketing expenses are comprised of broker commissions, customer marketing, media and other marketing costs. • General and administrative. General and administrative expenses are comprised of expenses associated with corporate and administrative functions that support our business, including fees for employee salaries, professional services, insurance and other general corporate expenses. • Depreciation and amortization. Depreciation and amortization costs consist of costs associated with the depreciation of fixed assets and capitalized leasehold improvements and amortization of intangible assets. Depreciation and amortization excludes depreciation of warehouse equipment, which is included in cost of goods sold. • Business transaction costs. Business transaction costs are comprised of legal, due diligence and accounting firm expenses associated with the process of actively pursuing potential business combinations. • Loss (gain) in fair value change of contingent consideration - TRA liability. Gain in fair value change of contingent consideration - TRA liability charges relate to fair value adjustments of the Tax Receivable Agreement (the “TRA”) liability. Results of Operations In assessing the performance of our business, we consider a number of key performance indicators used by management and typically used by our competitors, including the non-GAAP measures of Adjusted EBITDA. Because not all companies use identical calculations, this presentation of Adjusted EBITDA may not be comparable to other similarly titled measures of other companies. See “Reconciliation of Adjusted EBITDA” below for a reconciliation of EBITDA and Adjusted EBITDA to net income for each applicable period. Comparison of Results for the Fifty-Three Weeks Ended August 31, 2019 and the Fifty-Two Weeks Ended August 25, 2018 The following table presents, for the periods indicated, selected information from our consolidated financial results, including information presented as a percentage of net sales: (1) During the fifty-three weeks ended August 31, 2019, certain reclassifications were made to previously reported amounts to conform to the current presentation. On the consolidated statement of operations, outbound freight previously included in Distribution, distribution center expenses previously included in General and administrative, and depreciation for equipment used in warehouse operations were reclassified to Cost of goods sold. 2018 reflects adjusted amounts in accordance with this accounting principle change. See Note 2 to the consolidated financial statements included herein for additional information on the accounting principle change. (2) During the fifty-three weeks ended August 31, 2019, the Company combined Selling and Marketing within one financial statement line. 2018 reflects adjusted amounts. Net sales. Net sales for the successor fifty-three week period ended August 31, 2019 were $523.4 million compared to $431.4 million for the successor fifty-two week period ended August 25, 2018. The net sales increase of 21.3% was driven by volume growth. Net price realization was a slight benefit, partially offset by a shift in non-price related customer activity. The fifty-third week of fiscal 2019 was a 1.8% contribution to full year sales growth. Cost of goods sold. Cost of goods sold for the successor fifty-three week period ended August 31, 2019 were $306.0 million compared to $251.1 million for the successor fifty-two week period ended August 25, 2018. The cost of goods sold increase is driven by sales volume growth and increased distribution center expenses. These increases are partially offset by logistics efficiencies. Gross profit. Gross profit for the successor fifty-three week period ended August 31, 2019 was $217.4 million, or 41.5% of net sales compared to $180.4 million, or 41.8% of net sales, for the successor fifty-two week period ended August 25, 2018, a decrease of 30 basis point. Gross margin is effected by non-price related customer activity that is a shift from selling and marketing expense. Operating expenses. Operating expenses for the successor fifty-three week period ended August 31, 2019 were $144.6 million, or 27.6% of net sales, compared to $115.6 million, or 26.8% of net sales, for the successor fifty-two week period ended August 25, 2018 due to the following: • Selling and marketing. Selling and marketing expenses increased $8.4 million, or 14.2%, for the successor fifty-three week period ended August 31, 2019 compared to the successor fifty-two week period ended August 25, 2018. The increase is primarily due to an increase in television media and e-commerce investments, offset by a shift in non-price related customer activity. • General and administrative. General and administrative expenses increased $12.3 million, or 24.9%, for the successor fifty-three week period ended August 31, 2019 compared to the successor fifty-two week period ended August 25, 2018. The increase is due to higher incentive compensation of $5.3 million, internal resource investments of $3.3 million, and a legal settlement of $3.5 million. • Depreciation and amortization. Depreciation and amortization expenses for the successor fifty-three week period ended August 31, 2019 were flat compared to the successor fifty-two week period ended August 25, 2018. • Business transaction costs. Business transaction costs increased $4.8 million for the successor fifty-three week period ended August 31, 2019 compared to the successor fifty-two week period ended August 25, 2018. The increase is primarily due to the pending acquisition of Quest, as announced August 21, 2019 and discussed in “Recent Developments” in Item 1. Business. The $2.3 million recorded in the successor fifty-two week period ended August 25, 2018 is comprised of expenses relating to business development activities. • Loss (gain) in fair value change of contingent consideration - TRA liability. The successor fifty-three week period ended August 31, 2019 included a loss in fair value change of contingent consideration of $0.5 million. The increase is due to the timing of the settlement of the TRA liability during the successor fifty-three week period ended August 31, 2019. The gain in the successor fifty-two week period ended August 25, 2018 reflects the effect of the change in tax law in the prior year. Interest income. Interest income increased $3.8 million for the successor fifty-three week period ended August 31, 2019 compared to the successor fifty-three week period ended August 31, 2019, due to the Company’s increased cash balance resulting from warrant exercises during the successor fifty-three week period ended August 31, 2019 and an increase in market interest rates. Interest expense. Interest expense for the successor fifty-three week period ended August 31, 2019 was $13.6 million compared to $12.6 million for the successor fifty-two week period ended August 25, 2018, an increase due to changes in market interest rates. Gain on settlement of TRA liability. The Company recorded a $1.5 million gain in connection with the settlement of the TRA liability in the fifty-three week period ended August 31, 2019. The TRA settlement is discussed in Note 10 of the Consolidated Statements of Operations and Comprehensive Income (Loss) included in this Report. (Loss) gain on foreign currency transactions. A loss of $0.5 million in foreign currency transactions was recorded for the fifty-three week period ended August 31, 2019 compared to a foreign currency gain of $0.1 million for the fifty-two week period ended August 25, 2018. The change relates to changes in foreign currency rates related to international operations. Income tax (benefit) expense. Income tax expense for the successor fifty-three week period ended August 31, 2019 was $16.8 million compared to income tax benefit of $17.4 million for the successor fifty-two week period ended August 25, 2018. The increase in our income tax expense is primarily attributed to the one-time benefit of $29.0 million related to the tax law change and remeasurement of deferred tax liabilities recorded in the fifty-two week period ended August 25, 2018, which did not apply for the fifty-three week period ended August 31, 2019. Adjusted EBITDA. Adjusted EBITDA for the successor fifty-three week period ended August 31, 2019 was $98.7 million compared to $78.6 million for the successor fifty-two week period ended August 25, 2018. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see “Reconciliation of Adjusted EBITDA” below. Comparison of Results for the Successor Fifty-Two Weeks Ended August 25, 2018, the Successor Period from July 7, 2017 through August 26, 2017 and the Predecessor Period from August 28, 2016 through July 6, 2017 The following table presents, for the periods indicated, selected information from our consolidated financial results, including information presented as a percentage of net sales: (1) During the fifty-three weeks ended August 31, 2019, certain reclassifications were made to previously reported amounts to conform to the current presentation. On the consolidated statement of operations, outbound freight previously included in Distribution, distribution center expenses previously included in General and administrative, and depreciation for equipment used in warehouse operations were reclassified to Cost of goods sold. 2018 and 2017 reflect adjusted amounts in accordance with this accounting principle change. See Note 2 to the consolidated financial statements included herein for additional information on the accounting principle change. (2) During the fifty-three weeks ended August 31, 2019, the Company combined Selling and Marketing within one financial statement line. 2018 and 2017 reflect adjusted amounts. Comparison of Results for the Successor Fifty-Two Weeks Ended August 25, 2018 and the Successor Period from July 7, 2017 through August 26, 2017 Net sales. Net sales for the successor fifty-two week period ended August 25, 2018 were $431.4 million compared to $56.3 million for the successor period from July 7, 2017 through August 26, 2017. Cost of goods sold. Cost of goods sold for the successor fifty-two week period ended August 25, 2018 were $251.1 million compared to $39.6 million for the successor period from July 7, 2017 through August 26, 2017. Gross profit. Gross profit for the successor fifty-two week period ended August 25, 2018 was $180.4 million, or 41.8% of net sales compared to $16.8 million, or 29.7% of net sales, for the successor period from July 7, 2017 through August 26, 2017. Operating expenses. Operating expenses for the successor fifty-two week period ended August 25, 2018 were $115.6 million, or 26.8% of net sales, compared to $14.9 million, or 26.4% of net sales, for the successor period from July 7, 2017 through August 26, 2017. Interest expense. Interest expense for the successor fifty-two week period ended August 25, 2018 was $12.6 million, or 2.9% of net sales, compared to $1.7 million, or 3.0% of net sales, for the successor period from July 7, 2017 through August 26, 2017. Income tax (benefit) expense. Income tax benefit for the successor fifty-two week period ended August 25, 2018 was $17.4 million compared to income tax expense of $0.3 million for the successor period from July 7, 2017 through August 26, 2017. Adjusted EBITDA. Adjusted EBITDA for the successor fifty-two week period ended August 25, 2018 was $78.6 million compared to $8.7 million for the successor period from July 7, 2017 through August 26, 2017. Comparison of Results for the Successor Period from July 7, 2017 through August 26, 2017 and the Predecessor Period from August 28, 2016 through July 6, 2017. Net sales. Net sales for the successor period from July 7, 2017 through August 26, 2017 were $56.3 million compared to $339.8 million for the predecessor period from August 28, 2016 through July 6, 2017. There was no effect to net sales as a result of the Business Combination. Cost of goods sold. Cost of goods sold for the successor period from July 7, 2017 through August 26, 2017 were $39.6 million compared to $200.0 million for the predecessor period from August 28, 2016 through July 6, 2017. As a result of the Business Combination, there was a one-time inventory fair value step-up of $6.0 million that was charged to cost of goods sold in the successor period from July 7, 2017 through August 26, 2017. Gross profit. Gross profit for the successor period from July 7, 2017 through August 26, 2017, including the effect of the one-time inventory fair value step-up, were $16.8 million, or 29.7% of net sales, compared to the predecessor period from August 28, 2016 through July 6, 2017, gross profit was $139.8 million, or 41.1% of net sales. Operating expenses. Operating expenses for the successor period from July 7, 2017 through August 26, 2017 were $14.9 million or 26.4% of net sales compared to $116.1 million or 34.2% of net sales the predecessor period from August 28, 2016 through July 6, 2017. Interest expense. Interest expense for the successor period from July 7, 2017 through August 26, 2017 was $1.7 million or 3.0% of net sales compared to $22.7 million or 6.7% of net sales for the predecessor period from August 28, 2016 through July 6, 2017. The lower interest expense in the successor period from July 7, 2017 through August 26, 2017 is the result of the reduced principal balance of the debt as well as a reduction in the rate of interest being incurred on the debt. Income tax expense. Income tax expense for the successor period from July 7, 2017 through August 26, 2017 was $0.3 million compared to $4.6 million for the predecessor period from August 28, 2016 through July 6, 2017. Higher taxes in the predecessor period relate to the effects of the nondeductible business combination transaction costs. Adjusted EBITDA. Adjusted EBITDA decreased $55.2 million or 86.5% for the successor period from July 7, 2017 through August 26, 2017 compared to the predecessor period from August 28, 2016 through July 6, 2017. For a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, see “Reconciliation of Adjusted EBITDA”. Reconciliation of Adjusted EBITDA Adjusted EBITDA. Adjusted EBITDA is a non-GAAP financial measure commonly used in our industry and should not be construed as an alternative to net income as an indicator of operating performance or as an alternative to cash flow provided by operating activities as a measure of liquidity (each as determined in accordance with GAAP). Simply Good Foods defines Adjusted EBITDA (earnings before interest, tax, depreciation and amortization) as net income before interest expense, income tax expense, depreciation and amortization with further adjustments to exclude the following items: stock-based compensation and warrant expense, transaction and IPO readiness costs, restructuring costs, management fees, frozen media licensing fees, non-core legal costs, transactional exchange impact, change in fair value of contingent consideration - TRA liability, business transaction costs and other non-core expenses. Management uses Adjusted EBITDA to evaluate operating performance and this financial measure is among the primary measures used by management for planning and forecasting of future periods. Adjusted EBITDA is also frequently used by analysts, investors, and other interested parties to evaluate companies in our industry. The Company believes that the inclusion of these supplementary adjustments in presenting Adjusted EBITDA is relevant and useful for investors because it provides additional information to investors, reflects operating results more accurately of the on-going operations, allows investors to view results in a manner similar to the method used by management and facilitates comparison of the Company’s results with the results of other companies that have different financing and capital structures. The components of the Company’s computation of Adjusted EBITDA may not be comparable to other similarly titled captions of other companies due to differences in calculation. The following unaudited tables below provide a reconciliation of Adjusted EBITDA to its most directly comparable GAAP measure, which is net income (loss). _______________ (1) Other items consist principally of exchange impact of foreign currency transactions and other expenses. Liquidity and Capital Resources Overview We have historically funded our operations with cash flow from operations and borrowings under our credit facilities. Our principal uses for liquidity have been debt service and working capital. We believe our sources of liquidity and capital will be sufficient to finance our continued operations, growth strategy, and additional expenses we expect to incur including the pending acquisition of Quest for at least the next twelve months. Debt and Credit Facilities On July 7, 2017, the Company entered into a credit agreement with Barclays Bank PLC and other parties. The credit agreement provides for a term facility of $200.0 million (“Term Facility”) with a seven year maturity and a revolving credit facility of up to $75.0 million (the “Revolving Credit Facility”) with a five year maturity, under the first lien senior secured loan facilities (the “First Lien”). Substantially concurrent with the consummation of the Business Combination, the full $200.0 million of the First Lien term loan (the “Term Loan”) was drawn. No amounts were originally drawn on the Revolving Credit Facility. The interest rate per annum is based on either (i) a base rate equaling the higher of (a) the “prime rate”, (b) the federal funds effective rate plus 0.50% and (c) the Euro-currency rate applicable for an interest period of one month plus 1.00% plus (x) 3.00% margin for Term Loan or (y) 2.00% margin for Revolving Credit Facility, or (ii) London Interbank Offered Rate (“LIBOR”) adjusted for statutory reserve requirements, plus (x) 4.00% margin for the Term Loan subject to a floor of 1.00% or (y) 3.00% margin for the Revolving Credit Facility. The applicable margin for Revolving Credit Facility was adjusted after the completion of the Company’s first full fiscal quarter after the closing of the Business Combination based upon the Company’s consolidated First Lien net leverage ratio. As security for the payment or performance of its debt, the Company has pledged certain equity interests in its subsidiaries. On March 16, 2018 (the “Amendment Date”), the Company entered into an amendment (the “Repricing Amendment”) to the First Lien. As a result of the Repricing Amendment, the interest rate on the Term Loan was reduced and, as of the Amendment Date, such loans bear interest at a rate equal to, at the Company's option, either LIBOR plus an applicable margin of 3.50% or a base rate plus an applicable margin of 2.50%. The Repricing Amendment did not change the interest rate on the Revolving Credit Facility. The Revolving Credit Facility will continue to bear interest based upon the Company's consolidated First Lien net leverage ratio as of the last financial statements delivered to the administrative agent. No additional debt was incurred, or any proceeds received, by the Company in connection with the Repricing Amendment. The incremental fees paid to the administrative agent are reflected as additional debt discount and are amortized over the terms of the long-term financing agreements using the effective-interest method. The credit facilities governing our debt arrangements contain certain financial and other covenants. The Revolving Credit Facility has a maximum total net leverage ratio equal to or less than 6.25:1.00 (with a reduction to 6.00:1.00 on and after the third anniversary of the closing date of the credit facilities) contingent on credit extensions in excess of 30% of the total amount of commitments available under the revolving credit facility, and limitations on our ability to, among other things, incur and/or undertake asset sales and other dispositions, liens, indebtedness, certain acquisitions and investments, consolidations, mergers, reorganizations and other fundamental changes, payment of dividends and other distributions to equity and warrant holders, and prepayments of material subordinated debt, in each case, subject to customary exceptions materially consistent with credit facilities of such type and size. Any failure to comply with the restrictions of the credit facilities may result in an event of default. The credit facilities governing our debt arrangements bear interest at variable rates. If market interest rates increase, variable rate debt will create higher debt service requirements, which could adversely affect our cash flow. As the Company has not drawn on the Revolving Credit Facility as of August 31, 2019 and August 25, 2018, no debt covenants were applicable as of the period then ended. As of August 31, 2019, the outstanding principal balances of the Term Loan was $196.5 million, and no amounts were drawn under the $75.0 million Revolving Credit Facility. Acquisition Financing On August 21, 2019, we entered into a stock purchase agreement (the “Purchase Agreement”) to acquire Quest Nutrition, LLC (“Quest”), a healthy lifestyle food company (the “Acquisition”), for approximately $1.0 billion. The Acquisition is expected to close by the end of the 2019 calendar year, subject to satisfaction of customary closing conditions. There is no financing condition for the Acquisition. On October 9, 2019, we completed an underwritten public offering of 13,379,205 shares of our common stock at a price per share of $26.16 (the “Offering”), resulting in net proceeds to us of approximately $350.0 million, after deducting underwriting discounts and commissions and our estimated fees and expenses for the Offering. We intend to use these net proceeds to pay a portion of the purchase price and related fees and expenses for the Acquisition, or for general corporate purposes if the acquisition is not consummated. We plan to fund the remainder of the Acquisition by using a significant portion of the approximately $265 million of cash on hand and committed financing pursuant to debt commitments from Barclays, Credit Suisse and Goldman Sachs. Equity Warrants From August 26, 2018 through October 5, 2018, public warrants to purchase an aggregate of 9,866,451 shares of the Company’s common stock were exercised for cash at an exercise price of $11.50 per share, resulting in aggregate gross proceeds to the Company of $113.5 million. On October 4, 2018, the Company delivered a notice for the redemption (the “Redemption Notice”) of all of its public warrants that remained unexercised immediately after November 5, 2018. Holders who exercised public warrants following the Redemption Notice were required to do so on a cashless basis. Accordingly, holders were no longer permitted to exercise public warrants in exchange for payment in cash of $11.50 per share. Instead, a holder exercising a public warrant was deemed to have paid the $11.50 per share exercise price by the surrender of 0.61885 of a share of common stock that the holder would have been entitled to receive upon a cash exercise of each public warrant. Exercising holders received 0.38115 of a share of the Company’s common stock for each public warrant surrendered for exercise. Following the Redemption Notice, 3,499,639 public warrants were exercised on a cashless basis. An aggregate of 1,333,848 shares of the Company’s common stock were issued in connection with these exercises of the public warrants. All remaining public warrants were redeemed as of November 5, 2018 for an immaterial amount. The Company’s private warrants to purchase 6,700,000 shares of the Company’s common stock remain outstanding as of the date of this Report. Cash Flows The following table sets forth the major sources and uses of cash for each of the periods set forth below (in thousands): Operating activities. Our net cash provided by operating activities was $73.0 million for the successor period ended August 31, 2019, an increase of $12.0 million compared to net cash provided by operating activities of $61.0 million for the successor period ended August 25, 2018. The increase was primarily driven by higher income before taxes. Our net cash provided by operating activities was $61.0 million for the successor period ended August 25, 2018, an increase of $88.4 million compared to net cash used in operating activities of $27.4 million for the successor period ended August 26, 2017. The increase was primarily driven by higher income before taxes. Investing activities. Our net cash used in investing activities was $1.8 million for the successor period ended August 31, 2019, which was a decrease of $1.7 million compared to the investing activities for the successor period ended August 25, 2018. The decrease is primarily the result of a payment for a working capital adjustment of $1.8 million to the former owners of Atkins in the prior period. Our net cash used in investing activities was $3.5 million for the successor period ended August 25, 2018, which was a decrease of $193.8 million compared to the investing activities for the successor period ended August 26, 2017. The change was due to the Business Combination in the successor period ended August 26, 2017, offset by minor increases in purchases of property and equipment. Financing activities. Our net cash provided by financing activities was $83.4 million for the successor period ended August 31, 2019, compared to net cash used in financing activities of $1.6 million for the successor period ended August 25, 2018. Net cash provided by financing activities for the successor period ended August 31, 2019 includes $113.5 million of cash received from warrant exercises, and is partially offset by the payment of the TRA liability of $26.5 million, repurchases of common stock of $2.1 million and debt principal payments of $2.0 million. Our net cash used in financing activities was $1.6 million for the successor period ended August 25, 2018, compared to net cash provided by financing activities of $280.8 million for the successor period ended August 26, 2017. The decrease is due to the procee ds from the issuance of long term debt of $191.9 million and proceeds from the issuance of equity of $97.0 million related to the Business Combination in the successor period ended August 26, 2017. The Company had $266.3 million in cash and cash equivalents as of August 31, 2019, which is sufficient to satisfy a portion of the pending acquisition of Quest, current liabilities, current maturities of long-term debt and the interest payments associated with them. Off-Balance Sheet Arrangements As of August 31, 2019, we had no material off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on its financial condition, changes in financial condition, income or expenses, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations The following table summarizes our expected material contractual payment obligations as of August 31, 2019. This table does not include any obligations related to the financing or any other aspect of the Acquisition. _______________ (1) As of August 31, 2019, the Company is obligated under multiple non-cancellable operating leases, which continue through 2024. Rent expenses, inclusive of real estate taxes, utilities and maintenance incurred under operating leases, are included in general and administrative expenses in the Company’s consolidated statements of operations. Rent expenses were $2.2 million for fifty-three week period ended August 31, 2019, $2.4 million for the fifty-two week period ended August 25, 2018, $0.3 million for the successor period from July 7, 2017 through August 26, 2017, and $1.7 million for the predecessor period from August 28, 2016 through July 6, 2017, respectively. Critical Accounting Policies, Judgments and Estimates General The consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the U.S. While the majority of the Company’s revenue, expenses, assets and liabilities are not based on estimates, there are certain accounting principles that require management to make estimates regarding matters that are uncertain and susceptible to change. Critical accounting policies are defined as those policies that are reflective of significant judgments, estimates and uncertainties, which could potentially result in materially different results under different assumptions and conditions. Management regularly reviews the estimates and assumptions used in the preparation of the Company’s financial statements for reasonableness and adequacy. Our significant accounting policies are discussed in Note 3, Summary of Significant Accounting Policies, of our Consolidated Financial Statements in this filing; however, the following discussion pertains to accounting policies the Company believes are most critical to the portrayal of its financial condition and results of operations and that require significant, difficult, subjective or complex judgments. Other companies in similar businesses may use different estimation policies and methodologies, which may affect the comparability of the Company’s financial condition, results of operations and cash flows to those of other companies. Revenue Recognition The Company recognizes revenue when performance obligations under the terms of a contract with its customer are satisfied. The Company has determined that fulfilling and delivering products is a single performance obligation. Revenue is recognized at the point in time when the Company has satisfied its performance obligation and the customer has obtained control of the products. This generally occurs at the time of delivery to the customer's location. Revenue is measured as the amount of consideration expected to be received in exchange for transferring products, including estimates of variable consideration. The most common forms of variable consideration include trade programs, consumer incentives, coupon redemptions, allowances for unsaleable product, and any additional amounts where a distinct good or service cannot be identified or the value cannot be reasonably estimated. Estimates of variable consideration are made using various information including historical data on performance of similar promotional activities and market data from IRI, and the Company's best estimates of current activity. The Company reviews these estimates regularly and makes revisions as necessary. The Company does not have any material significant payments terms as payment is received shortly after the time of sale. Trade Promotions The Company offers trade promotions through various programs to customers and consumers. Trade promotions include discounts, rebates, slotting and other marketing activities. Trade promotions are recorded as a reduction to net sales with a corresponding reduction to accounts receivable at the time of revenue recognition for the underlying sale. The recognition of trade promotions requires management to make estimates regarding the volume of incentive that will be redeemed and their total cost. These estimates are made using various information including historical data on performance of similar trade promotional activities, market data from IRI, and the Company's best estimates of current activity. At August 31, 2019 and August 25, 2018, the allowance for trade promotions was $10.3 million and $7.4 million, respectively. Differences between estimated expense and actual redemptions are recognized as a change in management estimate in a subsequent period. These differences have historically been insignificant. Goodwill and Other Intangible Assets Goodwill and indefinite-lived intangible assets are not amortized, but are evaluated for impairment annually or more often if events or circumstances indicated that potential impairment may be present. Our annual impairment tests are conducted at the beginning of the fourth quarter. We test goodwill and indefinite-lived intangible assets by performing either qualitative or quantitative assessments. In the qualitative assessment, factors including macro-economic conditions, industry and company-specific factors, legal and regulatory environments and historical company performance are evaluated in assessing fair value. If we determine that it is more likely than not that the fair value of the reporting unit is less than its carrying value, a quantitative test is then performed. Otherwise, no further testing is required. When using a quantitative approach, we compare the fair value of the reporting unit to its carrying amount, including goodwill. If the estimated fair value of the reporting unit is less than the carrying amount of the reporting unit, impairment is indicated, requiring recognition of a impairment charge for the differential. During fiscal 2019, we elected to perform quantitative assessments of goodwill and indefinite-lived intangible assets. The inputs and assumptions used require considerable management judgment and are based on expectations of future operating performance. Based on the results of the assessments, it was determined that the fair value of goodwill and indefinite-lived assets exceeded their carrying values. Accordingly, no further impairment testing was completed and no impairment charges related to goodwill or indefinite-lived intangibles were recognized during the fiscal period ended August 31, 2019. Qualitative assessments of goodwill and indefinite-lived intangible assets were performed in 2018 and 2017. Based on the results of assessment, it was determined that it is more likely than not the reporting unit had a fair value in excess of carrying value. Accordingly, no further impairment testing was completed and no impairment charges related to goodwill or indefinite-lived intangibles were recognized during the fiscal periods ended August 25, 2018 or August 26, 2017. The Company also has intangible assets that are expected to have determinable useful lives, consisting primarily of trademarks, customer relationships and licensing agreements. Costs of finite-lived intangible assets are amortized over their estimated useful lives. Finite-lived intangible assets are tested for impairment when events or circumstances indicated that the carrying amount may not be recoverable. For the fiscal periods ended August 31, 2019, August 25, 2018 or August 26, 2017 there were no impairments recorded related to finite-lived intangible assets. Income Taxes We are subject to income to income taxes in the United States and numerous other jurisdictions. Significant judgment is required in determining our provision for income tax, including evaluating uncertainties in the application of accounting principles and complex tax laws. Income taxes include federal, state and foreign taxes currently payable and deferred taxes arising from temporary differences between income for financial reporting and income tax purposes. Deferred tax assets and liabilities are determined based on the differences between the financial statement balances and the tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the year that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to amounts expected to be realized. New Accounting Pronouncements Refer to Note 3, Summary of Significant Accounting Policies, of our Consolidated Financial Statements in this filing for further information regarding recently issued accounting standards.

<s>[INST] Our fiscal year ends the last Saturday in August. Our fiscal years 2018 and 2017 ended August 25, 2018 and August 26, 2017, respectively, and were each fiftytwo week periods. Our fiscal year 2019 ended August 31, 2019 was a fiftythree week period. Atkins’ fiscal quarters are comprised of thirteen weeks each, except for fiftythree week fiscal periods for the which the fourth quarter is comprised of fourteen weeks, and end on the thirteenth Saturday of each quarter (fourteenth Saturday of the fourth quarter, when applicable). Atkins’ fiscal quarters for fiscal 2019 ended on November 24, 2018, February 23, 2019, May 25, 2019 and August 31, 2019. As a result of the Business Combination, information is presented for the successor fiftythree week period ended August 31, 2019, the successor period for the fiftytwo week period ended August 25, 2018, the successor period from July 7, 2017 through August 26, 2017, and the predecessor period from August 28, 2016 through July 6, 2017, are derived from Atkins’ audited consolidated financial statements and the notes thereto. Overview Simply Good Foods is a developer, marketer and seller of branded nutritional foods and snacking products. Our highlyfocused product portfolio consists primarily of nutrition bars, RTD shakes, snacks and confectionery products marketed under the Atkins®, SimplyProtein®, and Atkins Endulge® brand names. Our goal is to lead the nutritious snacking movement with trusted brands that offer a variety of convenient, innovative, greattasting, “betterforyou” snacks and meal replacements. Over the past 45 years, Atkins has become an iconic American brand that for many consumers stands for “low carb,” “low sugar” and “protein rich” nutrition. The Atkins philosophy focuses on a healthy nutritional approach with reduced levels of refined carbohydrates and sugars and encourages the consumption of lean protein, fiber, fruits, vegetables, and healthy fats. In our core Atkins snacking business, we strive to offer a complete line of nutrition bars, readytodrink shakes and confections that satisfy hunger while providing consumers with a convenient, “betterforyou” snacking alternative. Our sales, marketing and R&D capabilities enable us to distribute products into a national customer base across the mass merchandiser, grocery and drug channels. We believe that Atkins’ broad brand recognition, our depth of management talent and strong cash generation position us to continue to innovate in the Atkins brand and acquire other brands, and thereby become an industry leading snacking platform. To that end, in December 2016, Atkins completed the acquisition of Wellness Foods, a Canadabased developer, marketer and seller of the SimplyProtein® brand that is focused on proteinrich and lowsugar products. Quest Acquisition and Related Financing On August 21, 2019, we entered into a stock purchase agreement (the “Purchase Agreement”) to acquire Quest Nutrition, LLC (“Quest”), a healthy lifestyle food company (the “Acquisition”). The Acquisition is expected to close by the end of the 2019 calendar year, subject to satisfaction of customary closing conditions. There is no financing condition for the Acquisition. On October 9, 2019, we completed an underwritten public offering of 13,379,205 shares of our common stock at a price per share of $26.16 (the “Offering”), resulting in net proceeds to us of approximately $350.0 million, after deducting underwriting discounts and commissions and our estimated fees and expenses for the Offering. We intend to use these net proceeds to pay a portion of the purchase price and related fees and expenses for the Acquisition, [/INST] Positive. </s>

Strongbridge Biopharma plc

2018-03-12

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion summarizes the significant factors affecting the operating results, financial condition, liquidity and cash flows of our company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with the financial statements and the related notes thereto included elsewhere in this Annual Report. The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity and capital resources and all other non-historical statements in this discussion are forward-looking statements and are based on the current beliefs of our management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report, particularly in the section titled “Risk Factors.” Overview We are a global commercial-stage biopharmaceutical company focused on the development and commercialization of therapies for rare diseases with significant unmet needs. Our first commercial product is Keveyis (dichlorphenamide), the first and only treatment approved by the U.S. Food and Drug Administration, or the FDA, for hyperkalemic, hypokalemic, and related variants of PPP, a group of rare hereditary disorders that cause episodes of muscle weakness or paralysis. Keveyis, for which we hold the U.S. marketing rights, has orphan drug exclusivity status in the United States through August 7, 2022. On January 16, 2018 we entered into a License and Assignment Agreement with Aeterna Zentaris GmbH, pursuant to which we acquired the U.S. and Canadian rights to manufacture and commercialize Macrilen (macimorelin). Macrilen is an oral growth hormone secretagogue receptor agonist to be used in the diagnosis of patients with AGHD. Macrilen has been granted orphan drug designation in the United States and has patents with expiration dates through late 2027. We expect to launch Macrilen in the United States in mid-2018. In addition to our two commercial products, we have two clinical-stage product candidates for rare endocrine diseases, Recorlev and veldoreotide. Recorlev (levoketoconazole) is a cortisol synthesis inhibitor currently being studied for the treatment of endogenous Cushing's syndrome. Veldoreotide is a next-generation somatostatin analog being investigated for the treatment of acromegaly, with potential additional applications in Cushing's syndrome and applications in other conditions amenable to somatostatin receptor activation. Both Recorlev and veldoreotide have received orphan designation from the FDA and the EMA. Given the well-identified and concentrated prescriber base addressing our target markets, we intend to continue to use a small, focused sales force to effectively market Keveyis, Macrilen and any future products, in the United States, the European Union and other key global markets. We believe that our ability to execute on our strategy is enhanced by the significant commercial and clinical development experience of key members of our management team. Since the introduction of our new management team in August 2014, we have been building a rare disease, franchise-based business model focused on expansion through a disciplined in-licensing and acquisition strategy. In pursuit of our growth strategy, we have raised over $275 million in equity and debt financings since December 2014. We will continue to identify and evaluate the acquisition of products and product candidates that would be complementary to our existing rare neuromuscular and endocrine franchises or that would form the basis for new rare disease franchises. We believe this approach will enable us to maximize our commercial potential by further leveraging our existing resources and expertise. We incurred a net loss attributable to Strongbridge Biopharma plc of $113.5 million for the year ended December 31, 2017. At December 31, 2017, our accumulated deficit was $242.9 million. In December 2017, we received letters from the offices of United States Senators Amy Klobuchar, Susan Collins and Tammy Baldwin, and Senator Claire McCaskill, Ranking Member of the Homeland Security and Governmental Affairs Committee, that request information relating to the marketing and sales of Keveyis. The letters request information principally relating to the pricing of Keveyis, among other things. We are cooperating with these voluntary requests for information. Financial Operations Overview Net Revenue We sell Keveyis to one specialty pharmacy provider (the “Customer”), who is the exclusive distributor of Keveyis in the United States. The Customer subsequently resells Keveyis to patients, which are covered by payors that may provide for government-mandated or privately negotiated rebates with respect to the purchase of the Keveyis. We recognize revenues from sales of Keveyis when we satisfy a performance obligation by transferring control of Keveyis to the Customer. Transfer of control occurs upon receipt of Keveyis by the Customer. We expense incremental costs related to the set-up of the contract with the Customer when incurred, as these costs did not meet the criteria for capitalization. We expect to launch Macrilen in the United States in mid-2018 and will recognize revenue in accordance with the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 606, Revenue Recognition. Cost of Sales Cost of sales includes third-party acquisition costs, third-party warehousing and product distribution charges. Selling, General and Administrative Expenses Selling, general and administrative expenses include personnel costs, costs for outside professional services and other allocated expenses. Personnel costs consist of salaries, bonuses, benefits, travel and stock-based compensation. Outside professional services consist of legal, accounting and audit services, commercial evaluation and strategy services, sales, marketing and other consulting services. We expect to incur additional selling, general and administrative costs as a result of our initial and on-going commercial activities in support of Keveyis and Macrilen. Research and Development Expenses Our research and development expenses consist primarily of costs incurred in connection with the development of our product candidates, including: · personnel-related costs, such as salaries, bonuses, benefits, travel and other related expenses, including stock-based compensation; · expenses incurred under our agreements with CROs, clinical sites, contract laboratories, medical institutions and consultants that plan and conduct our preclinical studies and clinical trials, including, in the case of consultants, stock-based compensation; · costs associated with regulatory filings; · upfront and milestone payments under in-license or acquisition agreements with third parties; · costs of acquiring preclinical study and clinical trial materials, and costs associated with formulation and process development; and · depreciation, maintenance and other facility-related expenses. We expense all research and development costs as incurred. Clinical development expenses for our product candidates are a significant component of our current research and development expenses as we progress our product candidates into and through clinical trials. Product candidates in later stage clinical development generally have higher research and development costs than those in earlier stages of development, primarily due to increased size and duration of the clinical trials. We recognize costs for each grant project, preclinical study or clinical trial that we conduct based on our evaluation of the progress to completion, including the use of information and data provided to us by our external research and development vendors and clinical sites. We expect our research and development expenses to increase in absolute dollars in the future as we continue to in-license or acquire product candidates and as we advance our existing and any future product candidates into and through clinical trials and pursue regulatory approval of our product candidates. The process of conducting the necessary clinical research to obtain regulatory approval of a product candidate is costly and time consuming. The probability that any of our product candidates receives regulatory approval and eventually is able to generate revenue depends on a variety of factors, including the quality of our product candidates, early clinical data, investment in our clinical program, competition, manufacturing capability and commercial viability. As a result of these uncertainties, we are unable to determine the duration and completion costs of our research and development projects or if, when and to what extent we will generate revenue from the commercialization and sale of any of our product candidates, if approved. We may never succeed in achieving regulatory approval for any of our product candidates. We do not allocate personnel-related research and development costs, including stock-based compensation or other indirect costs, to specific programs, as they are deployed across multiple projects under development. Interest Expense Interest expense represents interest paid to our lenders throughout 2017, amortization of our debt discount, and issuance costs associated with loan and security agreements. Amortization of Intangible Asset Amortization of intangible asset relates to the amortization of our product rights to Keveyis, which we acquired in December of 2016. This intangible asset is being amortized over an eight-year period using the straight-line method. Other Income (Expense), Net Other income (expense), net, consists of unrealized (loss)/gain on the remeasurement of the fair value of warrant liability, interest expense recognized on our long-term debt, the loss on the early extinguishment of our pre-existing long-term debt, interest income generated from our cash and cash equivalents, foreign exchange gains and losses and gains and losses on investments. Our consolidated financial statements are reported in U.S. dollars, which is also our functional currency. Transactions in foreign currencies are remeasured into our functional currency at the rate of exchange prevailing at the date of the transaction. Any monetary assets and liabilities arising from these transactions are remeasured into our functional currency at exchange rates prevailing at the balance sheet date or on settlement. Resulting gains and losses are recorded in foreign currency loss in other income (expense) in our consolidated statements of operations. Critical Accounting Policies and Significant Judgments and Estimates This operating and financial review of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to our financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies to be the most critical to the judgments and estimates used in the preparation of our financial statements. Revenue Recognition Revenues from sales of Keveyis are recognized when we satisfy a performance obligation by transferring control of Keveyis to the Customer. Transfer of control occurs upon receipt of Keveyis by the Customer. We expense incremental costs related to the set-up of the contract with the Customer when incurred, as these costs did not meet the criteria for capitalization. Warrant Liability The fair values of certain outstanding warrants were measured using the Black-Scholes option-pricing model. Inputs used to determine estimated fair value of the warrant liabilities include the estimated fair value of the underlying stock at the valuation date, the estimated term of the warrants, risk-free interest rates, expected dividends and the expected volatility of the underlying stock. The significant unobservable inputs used in the fair value measurement of the warrant liabilities were the fair value of the underlying stock at the valuation date and the estimated term of the warrants. Generally, increases (decreases) in the fair value of the underlying stock and estimated term would result in a directionally similar impact to the fair value measurement. Intangible Assets Certain intangible assets were acquired as part of an asset purchase, and have been capitalized at their acquisition date at fair value. Acquired definite life intangible assets are amortized using the straight-line method over their respective estimated useful lives or another appropriate method. The Company evaluates the potential impairment of intangible assets if events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. In connection with the Asset Purchase and Supply Agreement we entered into with Taro Pharmaceuticals North America, Inc., we paid Taro an upfront payment in two installments of $1 million in December 2016 and $7.5 million in March 2017. We have concluded that the supply price payable by us exceeds fair value and, therefore, have used a discounted cash flow method with a probability assumption to value the payments in excess of fair value at $29.3 million, for which we have recorded an intangible asset and corresponding liability. This liability will be amortized as we purchase inventory over the term of the agreement. In addition, we incurred transaction costs of $2.4 million resulting in the recording of an Intangible Asset of $40.2 million. This intangible asset is being amortized over an eight-year period using the straight-line method. Purchased identifiable intangible assets with indefinite lives, such as in-process research and development, are evaluated for impairment annually in accordance with our policy and whenever events or changes in circumstances indicate that it is more likely than not that the fair value of these assets has been reduced. To test these assets for impairment, we compare the fair value of the asset to its carrying value. The method we use to estimate the fair value measurements of indefinite-lived intangible assets is based on the income approach. For the impairment analysis for the year ended December 31, 2017, significant unobservable inputs used in the income approach valuation method include discount rates, royalty rates and probabilities of product candidate advancement from one clinical trial phase to the next. The probabilities of product candidate advancement we used were based on standalone statistical analysis on a phase-by-phase basis. As of December 31, 2017, there were material events that led to the impairment of our intangible assets. We recorded a $20.7 million impairment for our veldoreotide in-process research and development (“IPR&D”) for the year ended December 31, 2017. Goodwill We test goodwill for impairment on an annual basis or whenever events occur that may indicate possible impairment. This analysis requires us to make a series of critical assumptions to (1) evaluate whether any impairment exists and (2) measure the amount of impairment. Because we have one operating segment, when testing for a potential impairment of goodwill, we are required to estimate the fair value of our business as a whole and determine the carrying value. If the estimated fair value is less than the carrying value of our business, then we are required to estimate the fair value of all identifiable assets and liabilities in a manner similar to a purchase price allocation for an acquired business. Only after this process is completed can the goodwill impairment be determined, if any. We did not record a charge for impairment for the years ended December 31, 2017, 2016 and 2015. As of December 31, 2017, there were no events or changes in circumstances indicating possible impairment. Stock-Based Compensation We account for stock based compensation awards in accordance with FASB ASC Topic 718, Compensation-Stock Compensation (“ASC 718”). ASC 718 requires all stock based payments including grants of stock options and restricted stock and modifications to existing stock options, to be recognized in the consolidated statements of operations based on their fair values. Our stock based awards are subject to either service based or performance based vesting conditions. Vesting of certain awards could also be accelerated upon achievement of defined market based vesting conditions. Certain awards also contain a combination of service and market conditions or performance and market conditions. We account for employee stock based awards at grant date fair value. If we issue awards with an exercise price denominated in a currency other than our functional currency, trading currency or the currency for which we compensate our employee, we account for these as liabilities. We account for non employee and liability-classified stock based awards based on the then current fair values at each financial reporting date until the performance is complete for non employee awards, or until the award is settled (exercised) for liability-classified awards. Changes in the amounts attributed to these awards between the reporting dates are included in stock based compensation expense (credit) in our statements of operations. We include liability-classified stock options in non current liabilities in our balance sheets as their settlement (exercise) does not require use of cash, cash equivalents or other current assets. We record compensation expense for service based awards over the vesting period of the award on a straight-line basis. Compensation expense related to awards with performance based vesting conditions is recognized over the requisite service period using the accelerated attribution method to the extent achievement of the performance condition is probable. For those awards in which the performance condition was the completion of our initial public offering (“IPO”), we did not recognize compensation expense until the close of the IPO as we did not deem the IPO probable until it occurred. Compensation expense for awards with service and market-based vesting conditions is recognized using the accelerated attribution method over the shorter of the requisite service period or the implied period associated with achievement of the market based vesting provisions. We estimate the fair value of our awards with service conditions using the Black Scholes option pricing model, which requires the input of subjective assumptions, including (i) the expected stock price volatility, (ii) the expected term of the award, (iii) the risk-free interest rate and (iv) expected dividends. Due to the lack of historical and implied volatility data of our common stock, we based our estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. We selected companies with comparable characteristics to us, including enterprise value, risk profiles and position within the industry, and with historical share price information sufficient to meet the expected term of the stock based awards. We compute historical volatility data using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of the stock based awards. We estimate the fair value of our awards with market conditions using a Monte Carlo simulation to determine the probability of satisfying the market condition. We make this estimate using the conditions that exist at the grant date. The derived service period, which may be the requisite service period, is also determined at this time. Compensation cost for our awards with a market condition is recognized ratably using the accelerated attribution method if the award is subject to graded vesting over the requisite service period. The compensation cost for our awards with a market condition is not reversed if the market condition is not satisfied. We have estimated the expected term of employee service-based stock options using the “simplified” method, whereby the expected term equals the arithmetic average of the vesting term and the original contractual term of the option, due to our lack of sufficient historical data. We have estimated the expected term of employee awards with service and market conditions using a Monte Carlo simulation model. This approach involves generating random stock price paths through a lattice type structure. Each path results in a certain financial outcome, such as accelerated vesting or specific option payout. We have estimated the expected term of nonemployee service and performance based awards based on the remaining contractual term of such awards. The risk free interest rates for periods within the expected term of the option are based on the Swedish Government Bond rate or the U.S. Treasury Bond rate with a maturity date commensurate with the expected term of the associated award. We have never paid dividends, and do not expect to pay dividends in the foreseeable future. We account for forfeitures as they occur as opposed to estimating forfeitures. We record stock based compensation expense only for those awards that are expected to vest. Income Taxes On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act makes broad and complex changes to the U.S. tax code, including, but not limited to, reducing the top U.S. federal corporate tax rate from 35 percent to 21 percent; requiring companies to pay a one-time transition tax on certain un-repatriated earnings of foreign subsidiaries; generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; eliminating the corporate alternative minimum tax (AMT) and changing how existing AMT credits can be realized; creating the base erosion anti-abuse tax (BEAT), a new minimum tax; creating a new limitation on deductible interest expense; and changing rules related to uses and limitations of net operating loss carryforwards created in tax years beginning after December 31, 2017. The Tax Act reduces our U.S. corporate income tax rate from 34% to 21%, effective January 1, 2018. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse. As a result of the reduction in the U.S. corporate income tax rate from 34% to 21% under the Tax Act, we revalued our ending net deferred tax assets and liabilities at December 31, 2017. The Tax Act provided for a one-time transition tax on the deemed repatriation of post-1986 undistributed foreign subsidiary earnings and profits (“E&P”). Strongbridge did not have to recognize any income tax expense related to the transition tax as they own no controlled foreign corporations. The global intangible low-taxed income tax and base erosion provisions are effective for taxable years beginning after December 31, 2017. The Company does not currently expect these provisions to have a material impact on its tax rate as they do not own any controlled foreign corporations and they are currently below the gross receipts threshold for purposes of the base erosion provisions. Due to the timing of the new tax law and the substantial changes it brings, the Staff of the Securities and Exchange Commission (the "SEC") issued Staff Accounting Bulletin No. 118 ("SAB 118"), which provides registrants a measurement period to report the impact of the new US tax law. During the measurement period, provisional amounts for the effects of the law are recorded to the extent a reasonable estimate can be made. To the extent that all information necessary is not available, prepared or analyzed, companies may recognize provisional estimated amounts for a period of up to one year following enactment of the TCJA. The Company recorded amounts as provisional and will continue to monitor for future updates to guidance or interpretations issued by the IRS. We recognize interest and penalties related to uncertain tax positions in income tax expense. As of December 31, 2017, 2016 and 2015, we had no accrued interest or penalties related to uncertain tax positions and no amounts have been recognized in our statements of operations. Results of Operations Comparison of the Years Ended December 31, 2017 and 2016 The following table sets forth our results of operations for the years ended December 31, 2017 and 2016. Net Revenue and Cost of Sales. Net revenue of $7.0 million and cost of sales of $1.5 million for the year ended December 31, 2017 resulted from our initial commercial sales of Keveyis following our product launch in April 2017. Selling, General and Administrative Expenses The following table summarizes our selling, general and administrative expenses during the years ended December 31, 2017 and 2016: Total selling, general and administrative expenses were $36.3 million and $14.9 million for the years ended December 31, 2017 and 2016, respectively. The $11.5 million increase during 2017 in outside professional and consulting services was primarily due to costs incurred for the launch and subsequent commercialization of Keveyis. Compensation and related personnel costs increased by $9.9 million during 2017 primarily due to increased headcount of commercial personnel. Research and Development Expenses The following table summarizes our research and development expenses during the years ended December 31, 2017 and 2016: Total research and development expenses were $17.3 million and $20.0 million for the years ended December 31, 2017 and 2016, respectively. The $3.7 million decrease during 2017 in expenses for product development and supporting activities was primarily due to a $2.3 million decrease in expenses for veldoreotide development activity and a $1.6 million decrease in development expenses related to programs we discontinued during 2016 (COR-004 and BioPancreate). Compensation and other personnel costs increased by $0.4 million during 2017 due to increased headcount in research and development. Stock-based compensation expense increased by $0.5 million during 2017 due to the granting of new awards to newly hired employees during 2017. Amortization of Intangible Asset Amortization of intangible asset was $5.0 million for the year ended December 31, 2017 as we began amortizing the Keveyis product rights acquired in December 2016. We recorded no amortization of intangible asset for the year ended December 31, 2016. Impairment of Intangible Asset Impairment of intangible assets was $20.7 million and $15.8 million for the years ended December 31, 2017 and 2016, respectively. The increase was due to a $20.7 million impairment charge recorded in the third quarter of 2017 related to our veldoreotide in-process research and development offset by impairment charges recorded in 2016. Other Income (Expense), Net Total other income (expense), net, increased by $37.3 million for the year ended December 31, 2017 as compared to the year ended December 31, 2016. The increase was primarily due to a $30.9 million change in the fair value of our warrant liability, primarily resulting from an increase in our stock price, $4.3 million in interest expense and $3.5 million of expense relating to the loss on the early extinguishment of debt. Income Tax (Expense) Benefit We recorded income tax expense of $1.8 million for the year ended December 31, 2017 as a result of recording full valuation allowances against our deferred tax asset and deferred tax liability. We recorded income tax benefit of $2.6 million for the year ended December 31, 2016 primarily due to impairment of the value of intellectual property held by our BioPancreate subsidiary and certain permanent deductions at Strongbridge U.S. Inc. Comparison of the Years Ended December 31, 2016 and 2015 The following table sets forth our results of operations for the years ended December 31, 2016 and 2015. Selling, General and Administrative Expenses The following table summarizes our selling, general and administrative expenses during the years ended December 31, 2016 and 2015: Total selling, general and administrative expenses were $14.9 million and $22.7 million for the years ended December 31, 2016 and 2015, respectively. The $2.4 million decrease in outside professional and consulting services was primarily due to decreased legal fees in support of general corporate matters, employee recruiting fees, and consulting fees for general business efforts. Selling, general and administrative expenses for the year ended December 31, 2015 also included $4.0 million of legal and accounting fees related to the redomiciliation of the Company from Sweden to Ireland and the indirect activities necessary to prepare the Company’s financial records for the U.S. initial public offering completed in October 2015. Selling, general and administrative expenses for the year ended December 31, 2015 also included $3.4 million of transaction fees and expenses related to the acquisition of veldoreotide from Aspireo Pharmaceuticals, the license of COR-004 from Antisense Therapeutics, and other business development activities. Compensation and other related personnel costs increased by $1.1 million, and non-cash stock-based compensation by $0.9 million, during the year ended December 31, 2016 due to increased headcount of administrative personnel during the 2016 period. Research and Development Expenses The following table summarizes our research and development expenses during the years ended December 31, 2016 and 2015: Total research and development expenses were $20.0 million and $20.1 million for the years ended December 31, 2016 and 2015, respectively. The $2.6 million increase in clinical development and supporting activities was primarily attributed to a $3.0 million increase in expense to the ongoing clinical trials for Recorlev, and a $1.4 million increase due to the initiation of the development activity for veldoreotide, partially offset by reduced development spend due to discontinued programs for COR-004 and BioPancreate. Research and development expenses for the year ended December 31, 2015 included $3.9 million of the $5.0 million in aggregate cash paid to Antisense Therapeutics upon entering into a license agreement with them in May 2015, with the remaining $1.1 million of cash paid recorded as the initial carrying value of our investment in the equity of Antisense therapeutics. Compensation and other personnel costs increased by $1.3 million for the year ended December 31, 2016 as compared to the same period in 2015 due to increased headcount of research and development personnel during the 2016 period. Stock-based compensation expense decreased $0.2 million due to the departure of certain research and development personnel. Other Expense, Net The following table summarizes our other expense, net, during the years ended December 31, 2016 and 2015: Total other expense, net, increased for the year ended December 31, 2016 as compared to the year ended December 31, 2015. The decrease in other expense, is mostly due to the impairment of our Antisense investment in 2015 of $.5 million as well as a loss on our Radnor lease of $0.2 million, whereas in 2016 we returned the license to Antisense and incurred a loss on termination charge of $1.1 million. We also recorded an unrealized gain on the fair value of our warrants. Income Tax Benefit We recorded income tax benefit of $2.6 million for the year ended December 31, 2016 and $0.5 million for the year ended December 31, 2015. For the year ended December 31, 2016, the benefit was primarily due to our subsidiary BioPancreate’s write-off of intellectual property and certain permanent deductions at our subsidiary Strongbridge U.S. Inc. Additionally, Strongbridge U.S. Inc. is more likely than not to recognize it’s deferred tax assets. In December 31, 2015 the benefit was due to the generation of U.S. state and federal net operating loss carry forwards and federal tax credit carry forwards. The income tax benefit for U.S. state and federal net operating loss carry forwards and the federal tax credit carry forwards has been recognized to the extent it is supported by the deferred tax liabilities recorded in connection with the acquisition of BioPancreate. Net Loss Attributable to Non-Controlling Interest We recorded a net loss attributable to non-controlling interest of $122,000 for the year ended December 31, 2016. The non-controlling interest resulted from the 0.418% of Cortendo AB shares not acquired by Strongbridge Biopharma plc pursuant to the exchange offer that expired September 3, 2015. In September 2016, the non-controlling interest was acquired by the Company. Liquidity and Capital Resources Our operations have been financed primarily by net proceeds from the issuance of ordinary shares and the issuance of debt. Our primary uses of capital have been third-party expenses associated with the commercialization of Keveyis, the planning and conduct of clinical trials, costs of process development services and manufacturing of our product candidates, and compensation-related expenses. We expect our funding requirements for operating activities to increase in 2018 and possibly beyond due to expenses associated with the commercialization of Keveyis and Macrilen, the execution of the Phase 3 SONICS and LOGICS clinical trials for Recorlev, and selling, general and administrative expenses. We also expect our cash needs to increase to fund potential in-licenses, acquisitions or similar transactions as we pursue our strategy. These expenses may be offset only in part by sales of Keveyis and Macrilen. In addition, beginning in September 2020, we may be required to make quarterly principal payments to repay amounts borrowed under our credit facility. Cash used to fund operating expenses is affected by the timing of when we pay expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. We believe that our cash resources will be sufficient to allow us to fund planned operations for at least 12 months beyond the issuance date of these financial statements, which is after the expected receipt of data from the Recorlev SONICS and LOGICS Phase 3 clinical trials. Our future funding requirements will depend on many factors, including the following: · the amount of revenue that we receive from sales of Keveyis and Macrilen; · the cost and timing of establishing sales, marketing, distribution and administrative capabilities; · the scope, rate of progress, results and cost of our clinical trials testing and other related activities for Recorlev and veldoreotide; · whether we borrow any additional amounts under our credit facility; · the number and characteristics of product candidates that we pursue, including any additional product candidates we may in-license or acquire; · the cost of filing, prosecuting, defending and enforcing our patent claims and other intellectual property rights; · the cost of defending potential intellectual property disputes, including patent infringement actions brought by third parties against us or our product candidates; · the cost, timing and outcomes of regulatory approvals; · the terms and timing of any collaborative, licensing and other arrangements that we may establish, including any required milestone and royalty payments thereunder; and · the emergence of competing technologies and their achieving commercial success before we do or other adverse market developments. We expect to continue to incur losses. Our ability to achieve and maintain profitability is dependent upon the successful commercialization of Keveyis and Macrilen, the development, regulatory approval and commercialization of our product candidates and achieving a level of revenues adequate to support our cost structure. We may never achieve profitability, and unless and until we do, we will continue to need to raise additional capital. If we need to raise additional capital to fund our operations and complete our ongoing and planned clinical trials, funding may not be available to us on acceptable terms, or at all. We plan to continue to fund our operations and capital funding needs through equity or debt financing, along with revenues from Keveyis and Macrilen, our proceeds from our term loan facility with CRG Servicing LLC (described below) and proceeds from our at-the-market (ATM) facility. The sale of additional equity would result in additional dilution to our shareholders. The incurrence of debt financing would result in debt service obligations and the instruments governing such debt could provide for operating and financing covenants that would restrict our operations. If we are not able to secure adequate additional funding, we may be forced to make reductions in spending, extend payment terms with suppliers, liquidate assets where possible or suspend or curtail planned programs. In addition, lack of funding would limit any strategic initiatives to in-license or acquire additional product candidates or programs. Term Loan Agreement with CRG Servicing LLC The Company and our subsidiaries are parties to a Term Loan Agreement with CRG Servicing LLC (“CRG”), as administrative and collateral agent, and the lenders named therein (the “Lenders”). Pursuant to the terms of the Term Loan Agreement, as amended (the “Loan Agreement”), we may borrow up to $100 million from the Lenders under the Loan Agreement. We have borrowed $85.0 million under the Loan Agreement as of the date of this Annual Report. The Loan Agreement provides for additional disbursements of (i) up to $10.0 million (the “Third Tranche”), contingent upon our achievement of certain revenue milestones and a market capitalization condition or before June 30, 2018, as described in the Loan Agreement and (ii) up to $5.0 million (the “Fourth Tranche”), contingent upon our achievement of certain revenue milestones and a market capitalization condition on or before December 31, 2018, as described in the Loan Agreement. The Loan Agreement has a six-year term with three and a half years (to December 31, 2020) of interest-only payments after which quarterly principal and interest payments will be due through the June 30, 2023 maturity date. Amounts borrowed under the Loan Agreement accrue interest at an annual fixed rate of 12.50%, of which 4.0% may, at our election, be deferred during the first three years of the term of the loan (which may be extended for the entire term of the loan subject to the satisfaction of certain conditions under the Loan Agreement) by adding such amount to the principal loan amount (PIK Loans). We are also required to pay the Lenders a final payment fee upon repayment of the loans in full. We may prepay all or a portion of the outstanding principal and accrued unpaid interest under the Loan Agreement at any time upon prior notice to the Lenders subject to a prepayment fee during the first five years of the term of each loan (which reduces each year) and no prepayment fee thereafter. In certain circumstances, including a change of control and certain asset sales or licensing transactions, we are required to prepay all or a portion of the loan, including the applicable prepayment premium on the amount of the outstanding principal to be prepaid. As security for its obligations under the Loan Agreement, we have entered into security agreements, whereby we have granted to CRG, as collateral agent, a lien on substantially all of our assets, including intellectual property. The Loan Agreement requires us to maintain cash and cash equivalents of $3.0 million and, each year through the end of 2022, to meet a minimum total annual revenue threshold. In the event that we do not meet the minimum total annual revenue threshold for a particular year, then we can retroactively cure the shortfall by either issuing additional equity in exchange for cash or incurring certain additional permitted indebtedness, in each case, in an amount equal to twice the shortfall. Any such amounts are required to be applied to prepay the loans. The Loan Agreement also contains customary affirmative and negative covenants for a credit facility of this size and type, including covenants that limit or restrict our ability to, among other things, incur indebtedness, grant liens, merge or consolidate, dispose of assets, make investments, make acquisitions, enter into transactions with affiliates, pay dividends or make distributions, license intellectual property rights on an exclusive basis or repurchase stock, in each case subject to customary exceptions. The Loan Agreement includes customary events of default that include, among other things, non-payment, inaccuracy of representations and warranties, covenant breaches, a material adverse change (as defined in the Loan Agreement), cross default to material indebtedness or material agreements, bankruptcy and insolvency, material judgments, a change of control, certain ERISA-related events and certain injunctions applicable to the sale of our products. The occurrence and continuance of an event of default could result in the acceleration of the obligations under the Loan Agreement. Under certain circumstances, a default interest rate of an additional 4.00% per annum will apply on all outstanding obligations during the existence of an event of default under the Loan Agreement. As a condition to the Loan Agreement, the Lenders purchased an aggregate of 429,799 of our ordinary shares from us for an aggregate purchase price of $3.0 million. In addition, pursuant to the terms of the Loan Agreement, we have issued to CRG, or its designees, warrants to purchase an aggregate of (i) 394,289 ordinary shares at an exercise price of $7.37 per share and (ii) 1,248,250 ordinary shares at an exercise price of $10.00 per share. If we borrow the Third Tranche, we must issue to CRG, or its designees, one or more additional warrants to purchase a number of our ordinary shares equal to an aggregate of 0.20% of our ordinary shares outstanding following such issuance on a fully diluted basis (inclusive of the ordinary shares underlying all such warrants issued), at an exercise price equal to 110% of the closing price of our ordinary shares on the date immediately preceding the Third Tranche disbursement date. If we borrow the Fourth Tranche, we must issue to the Lenders, or their designees, one or more additional warrants to purchase a number of our ordinary shares equal to an aggregate of 0.25% of our ordinary shares outstanding following such issuance on a fully diluted basis (inclusive of the ordinary shares underlying all such warrants issued), at an exercise price equal to 140% of the 10-day volume weighted average price (VWAP) per ordinary share for the consecutive 10-day trading period ending on the trading day immediately prior to the Fourth Tranche disbursement date. Each of the warrants issued or to be issued to CRG will be exercisable at any time prior to seven years following its issue date and will contain customary provisions for assumption or exchange upon a change of control or a sale of all or substantially all of our assets. December 2016 Private Placement On December 22, 2016, we sold 14,000,000 ordinary shares at a price of $2.50 per ordinary share, together with warrants to purchase 7,000,000 ordinary shares, in a private offering for approximately $23.4 million, after deducting underwriting discounts and commissions and offering expenses payable by us. October 2017 Public Offering of Ordinary Shares On October 6, 2017, we sold 4,000,000 ordinary shares in a public offering at a price to the public of $6.25 per share for net proceeds of approximately $23.4 million, after deducting underwriting discounts and commissions and offering expenses payable by us. January 2018 Public Offering of Ordinary Shares On January 25, 2018, we sold 5,000,000 ordinary shares in a public offering at a price to the public of $6.75 per ordinary share for net proceeds of approximately $31.7 million, after deducting underwriting discounts and commissions and offering expenses payable by us. On February 26, 2018, we sold an additional 255,683 ordinary shares to the underwriters in connection with their partial exercise of the option to purchase additional shares that was granted to them under the underwriting agreement for additional net proceeds of approximately $1.6 million, after deducting underwriting discounts and commissions and offering expenses payable by us. At-The-Market Facility We have entered into an Equity Distribution Agreement with JMP Securities LLC (“JMP Securities”), pursuant to which we may offer and sell ordinary shares having an aggregate offering price of up to $40,000,000 from time to time through JMP Securities, acting as agent. As of December 31, 2017, we have issued an aggregate of 10,300 ordinary shares to JMP Securities under the Equity Distribution Agreement for aggregate net proceeds of approximately $73,000 and paid fees to JMP of $2,000. Cash Flows Comparison for the Years Ended December 31, 2017 and 2016: Operating Activities Net cash used in operating activities was $45.3 million for the year ended December 31, 2017, compared to $31.7 million for the year ended December 31, 2016. The increase in net cash used in operating activities resulted primarily from expenses during 2017 to support the commercialization of Keveyis. Investing Activities Net cash used in investing activities in 2017 was from our scheduled payment of $7.5 million to Taro in connection with our acquisition of the U.S. marketing rights of Keveyis, and the $3.4 million cash used in investing activities in 2016 was the result of our initial payment and transaction costs incurred with our acquisition of the U.S. marketing rights of Keveyis. Financing Activities Net cash provided by financing activities was $43.5 million for the year ended December 31, 2017, a decrease of $6.8 million from the year ended December 31, 2016. The decrease in net cash provided by financing activities resulted primarily from a decrease of $5.9 million in proceeds received from the issuance of ordinary shares. Contractual Obligations and Other Commitments The following is a summary of our contractual obligations and other commitments as of December 31, 2017: We enter into agreements in the normal course of business with CROs for clinical trials and with vendors for preclinical studies and other services and products for operating purposes, which are cancelable at any time by us, generally upon 30 days prior written notice. Future payment obligations under these agreements are not included in this table of contractual obligations. We are obligated to make future payments to third parties under license agreements, including sublicense fees, royalties and payments that become due and payable upon the achievement of development and commercialization milestones. As the amount and timing of sublicense fees and the achievement and timing of these milestones are not probable and estimable, such commitments have not been included on our consolidated balance sheets or in the contractual obligations table above. Off-Balance Sheet Arrangements We do not have variable interests in variable interest entities or any off-balance sheet arrangements. Recent Accounting Pronouncements See Note 2 Summary of significant accounting policies and basis of presentation - Recently adopted accounting pronouncements to our consolidated financial statements.

<s>[INST] Overview We are a global commercialstage biopharmaceutical company focused on the development and commercialization of therapies for rare diseases with significant unmet needs. Our first commercial product is Keveyis (dichlorphenamide), the first and only treatment approved by the U.S. Food and Drug Administration, or the FDA, for hyperkalemic, hypokalemic, and related variants of PPP, a group of rare hereditary disorders that cause episodes of muscle weakness or paralysis. Keveyis, for which we hold the U.S. marketing rights, has orphan drug exclusivity status in the United States through August 7, 2022. On January 16, 2018 we entered into a License and Assignment Agreement with Aeterna Zentaris GmbH, pursuant to which we acquired the U.S. and Canadian rights to manufacture and commercialize Macrilen (macimorelin). Macrilen is an oral growth hormone secretagogue receptor agonist to be used in the diagnosis of patients with AGHD. Macrilen has been granted orphan drug designation in the United States and has patents with expiration dates through late 2027. We expect to launch Macrilen in the United States in mid2018. In addition to our two commercial products, we have two clinicalstage product candidates for rare endocrine diseases, Recorlev and veldoreotide. Recorlev (levoketoconazole) is a cortisol synthesis inhibitor currently being studied for the treatment of endogenous Cushing's syndrome. Veldoreotide is a nextgeneration somatostatin analog being investigated for the treatment of acromegaly, with potential additional applications in Cushing's syndrome and applications in other conditions amenable to somatostatin receptor activation. Both Recorlev and veldoreotide have received orphan designation from the FDA and the EMA. Given the wellidentified and concentrated prescriber base addressing our target markets, we intend to continue to use a small, focused sales force to effectively market Keveyis, Macrilen and any future products, in the United States, the European Union and other key global markets. We believe that our ability to execute on our strategy is enhanced by the significant commercial and clinical development experience of key members of our management team. Since the introduction of our new management team in August 2014, we have been building a rare disease, franchisebased business model focused on expansion through a disciplined inlicensing and acquisition strategy. In pursuit of our growth strategy, we have raised over $275 million in equity and debt financings since December 2014. We will continue to identify and evaluate the acquisition of products and product candidates that would be complementary to our existing rare neuromuscular and endocrine franchises or that would form the basis for new rare disease franchises. We believe this approach will enable us to maximize our commercial potential by further leveraging our existing resources and expertise. We incurred a net loss attributable to Strongbridge Biopharma plc of $113.5 million for the year ended December 31, 2017. At December 31, 2017, our accumulated deficit was $242.9 million. In December 2017, we received letters from the offices of United States Senators Amy Klobuchar, Susan Collins and Tammy Baldwin, and Senator Claire McCaskill, Ranking Member of the Homeland Security and Governmental Affairs Committee, that request information relating to the marketing and sales of Keveyis. The letters request information principally relating to the pricing of Keveyis, among other things. We are cooperating with these voluntary requests for information. Financial Operations Overview Net Revenue We sell Keveyis to one specialty pharmacy provider (the “Customer”), who is the exclusive distributor of Keveyis in the United States. The Customer subsequently resells Keveyis to patients, which are covered by payors that may provide for governmentmandated or privately negotiated rebates with respect to the purchase of the Keveyis. We recognize revenues from sales of Keveyis when we satisfy a performance obligation by transferring control of Keveyis to the Customer. Transfer of control occurs upon receipt of Keveyis by the Customer. We [/INST] Negative. </s>

Strongbridge Biopharma plc

2019-02-27

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion summarizes the significant factors affecting the operating results, financial condition, liquidity and cash flows of our company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with the financial statements and the related notes thereto included elsewhere in this Annual Report. The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity and capital resources and all other non-historical statements in this discussion are forward-looking statements and are based on the current beliefs of our management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report, particularly in the section titled “Risk Factors.” Overview We are a global, commercial-stage biopharmaceutical company focused on the development and commercialization of therapies for rare diseases with significant unmet needs. Our first commercial product is Keveyis (dichlorphenamide), the first and only treatment approved by the FDA for hyperkalemic, hypokalemic, and related variants of PPP, a group of rare hereditary disorders that cause episodes of muscle weakness or paralysis. In January 2018, Strongbridge Ireland Ltd., one of our wholly-owned subsidiaries, acquired the U.S. and Canadian rights to Macrilen (macimorelin), the first and only oral drug approved by the FDA for the diagnosis of patients with adult growth hormone deficiency. We launched Macrilen in the United States in July 2018. In December 2018, we sold Strongbridge Ireland Ltd., to Novo. As consideration for the sale, we received $145 million from Novo plus the right to receive tiered royalties on net sales of Macrilen through 2027. In addition, we entered into a services agreement with Novo pursuant to which it will fund, for a period of three years (subject to our right to terminate the arrangement upon six months’ notice), the costs of 23 of our field-based employees to provide full-time ongoing services to Novo, including the promotion of Macrilen in the United States. We will also be entitled to a performance fee of up to $1.5 million per contract year if certain conditions are met by our field-based employees under the services arrangement, which conditions will be determined and measured by a joint committee comprised of members from Novo and from Strongbridge, with a majority of members from Novo. Novo also purchased 5.2 million of our ordinary shares at a purchase price of $7.00 per share. The excess price paid per share over the fair value of the stock, was included in the gain on sale of our subsidiary. We have two clinical-stage product candidates for rare endocrine diseases, Recorlev and veldoreotide. Recorlev (levoketoconazole) is a cortisol synthesis inhibitor currently being studied for the treatment of endogenous Cushing's syndrome. Veldoreotide is a next-generation somatostatin analog being investigated for potential applications in conditions amenable to somatostatin receptor activation, such as acromegaly. Both Recorlev and veldoreotide have received orphan designation from the FDA and the EMA. We are building a rare disease, franchise-based business model focused on expansion through a disciplined in-licensing and acquisition strategy. We will continue to identify and evaluate the acquisition of products and product candidates for licensing or acquisition that would be complementary to our existing rare neuromuscular and endocrine franchises or that would form the basis for new rare disease franchises. We believe this approach will enable us to maximize our commercial potential by further leveraging our existing resources and expertise. In December 2017, we received letters from the offices of U. S. Senators Amy Klobuchar, Susan Collins and Tammy Baldwin, and Senator Claire McCaskill, Ranking Member of the Homeland Security and Governmental Affairs Committee, that request information relating to the marketing and sales of Keveyis. The letters request information principally relating to the pricing of Keveyis, among other things. We are cooperating with these voluntary requests for information. Financial Operations Overview Net Revenue Our product sales in 2018, resulted from sales of Keveyis and Macrilen. We will no longer record product sales from Macrilen following the sale of our rights to Macrilen to Novo in December 2018. We recognize net product sales at the time our products are received by our customers (primarily wholesalers and specialty pharmacies). The products are subsequently sold to patients, who are covered by payors that may provide for government-mandated or privately negotiated rebates with respect to the purchase of our products. We expense incremental costs related to the set-up of the contracts with our customers when incurred, as these costs do not meet the criteria for capitalization. Cost of Sales Cost of sales includes third-party acquisition costs, third-party warehousing and product distribution charges. Selling, General and Administrative Expenses Selling, general and administrative expenses include personnel costs, costs for outside professional services and other allocated expenses. Personnel costs consist of salaries, bonuses, benefits, travel and stock-based compensation. Outside professional services consist of legal, accounting and audit services, commercial evaluation and strategy services, sales, marketing and other consulting services. Research and Development Expenses Our research and development expenses consist primarily of costs incurred in connection with the development of our product candidates, including: · personnel-related costs, such as salaries, bonuses, benefits, travel and other related expenses, including stock-based compensation; · expenses incurred under our agreements with CROs, clinical sites, contract laboratories, medical institutions and consultants that plan and conduct our preclinical studies and clinical trials, including, in the case of consultants, stock-based compensation; · costs associated with regulatory filings; · upfront and milestone payments under in-license or acquisition agreements with third parties; · costs of acquiring preclinical study and clinical trial materials, and costs associated with formulation and process development; and · depreciation, maintenance and other facility-related expenses. We expense all research and development costs as incurred. Clinical development expenses for our product candidates are a significant component of our current research and development expenses as we progress our product candidates into and through clinical trials. Product candidates in later stage clinical development generally have higher research and development costs than those in earlier stages of development, primarily due to increased size and duration of the clinical trials. We recognize costs for each grant project, preclinical study or clinical trial that we conduct based on our evaluation of the progress to completion, including the use of information and data provided to us by our external research and development vendors and clinical sites. We expect our research and development expenses to increase in absolute dollars in the future as we continue to in-license or acquire product candidates and as we advance our existing and any future product candidates into and through clinical trials and pursue regulatory approval of our product candidates. The process of conducting the necessary clinical research to obtain regulatory approval of a product candidate is costly and time consuming. The probability that any of our product candidates receives regulatory approval and eventually is able to generate revenue depends on a variety of factors, including the quality of our product candidates, early clinical data, investment in our clinical program, competition, manufacturing capability and commercial viability. As a result of these uncertainties, we are unable to determine the duration and completion costs of our research and development projects or if, when and to what extent we will generate revenue from the commercialization and sale of any of our product candidates, if approved. We may never succeed in achieving regulatory approval for any of our product candidates. We do not allocate personnel-related research and development costs, including stock-based compensation or other indirect costs, to specific programs, as they are deployed across multiple projects under development. Interest Expense Interest expense represents interest paid to our lender, amortization of our debt discount, and issuance costs associated with loan and security agreements. In December 2018, we extinguished all of our outstanding debt. Amortization of Intangible Assets Amortization of intangible assets relates to the amortization of our product rights to Keveyis and Macrilen. Both intangible assets were (and Keveyis will continue to be) amortized using the straight-line method, using an amortization period of eight years for Keveyis and ten years for Macrilen. In December 2018, we sold the rights to Macrilen and, therefore, will no longer record amortization of the related intangible asset. Other Income (Expense), Net Other income (expense), net, consists of our gain on the sale of our subsidiary, unrealized gain (loss) on the remeasurement of the fair value of warrant liability, interest expense recognized on our long-term debt, the loss on the extinguishment of our pre-existing long-term debt, interest income generated from our cash and cash equivalents, foreign exchange gains and losses and gains and losses on investments. Critical Accounting Policies and Estimates This operating and financial review of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to our financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies and estimates are critical. Revenue Recognition We follow Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers (“ASC 606”). Topic 606 applies to all contracts with customers, except for contracts that are within the scope of other standards, such as leases, insurance, collaboration arrangements and financial instruments. Under Topic 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. To determine revenue recognition for arrangements that an entity determines are within the scope of Topic 606, the entity performs the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. Revenues from sales of our products are recorded at the net sales price (transaction price), which includes estimates of variable consideration for which reserves are established and that result from rebates, co-pay assistance and other allowances that are offered by us and the patients’ payors. These reserves are based on the amounts earned or to be claimed on the related sales and are classified as reductions of accounts receivable (if the amount is payable to our customer) or a current liability (if the amount is payable to a party other than our customer). Where appropriate, these estimates may take into consideration a range of possible outcomes that are probability-weighted for relevant factors such as our historical experience, current contractual and statutory requirements, specific known market events and trends, industry data and forecasted customer buying and payment patterns. Overall, these reserves reflect our best estimates of the amount of consideration to which we are entitled based on the terms of the contract. For a complete discussion of accounting for net product revenue, see Note 3, "Revenue recognition" to our consolidated financial statements. Warrant Liability The fair values of certain outstanding warrants were measured using the Black-Scholes option-pricing model. Inputs used to determine estimated fair value of the warrant liabilities include the fair value of the underlying stock at the valuation date, the term of the warrants, risk-free interest rates, expected dividends and the expected volatility of the underlying stock. The significant unobservable inputs used in the fair value measurement of the warrant liabilities were the fair value of the underlying stock at the valuation date and the estimated term of the warrants. Generally, increases (decreases) in the fair value of the underlying stock and estimated term would result in a directionally similar impact to the fair value measurement. Intangible Assets Certain intangible assets were acquired as part of an asset purchase and have been capitalized at their acquisition date at fair value. Acquired definite life intangible assets are amortized using the straight-line method over their respective estimated useful lives. The Company evaluates the potential impairment of intangible assets if events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. In connection with the Asset Purchase and Supply Agreement we entered into with Taro Pharmaceuticals North America, Inc., we paid Taro an upfront payment in two installments of $1 million in December 2016 and $7.5 million in March 2017. We have concluded that the supply price payable by us exceeds fair value and, therefore, have used a discounted cash flow method with a probability assumption to value the payments in excess of fair value at $29.3 million, for which we have recorded an intangible asset and corresponding liability. This liability is amortized as we purchase inventory over the term of the agreement. In addition, we incurred transaction costs of $2.4 million resulting in the recording of an intangible asset of $40.2 million. This intangible asset is being amortized over an eight-year period using the straight-line method. We entered into a License and Assignment Agreement in 2018 with Aeterna Zentaris GmbH, pursuant to which we acquired the U.S. and Canadian rights to manufacture and commercialize Macrilen (macimorelin) for $24 million and incurred transaction costs of $0.7 million, resulting in an initial intangible asset of $24.7 million. We recorded any royalty liability as an increase to the intangible asset. This asset was being amortized over a ten-year period using the straight-line method, until the sale of our subsidiary that held this asset in December 2018. As of December 31, 2018, no impairment of intangible assets has been identified. Goodwill We test goodwill for impairment on an annual basis or whenever events occur that may indicate possible impairment. This analysis requires us to make a series of critical assumptions to (1) evaluate whether any impairment exists and (2) measure the amount of impairment. Because we have one operating segment, when testing for a potential impairment of goodwill, we are required to estimate the fair value of our business as a whole and determine the carrying value. If the estimated fair value is less than the carrying value of our business, then we are required to estimate the fair value of all identifiable assets and liabilities in a manner similar to a purchase price allocation for an acquired business. Only after this process is completed can the goodwill impairment be determined, if any. We did not record a charge for impairment for the years ended December 31, 2018, 2017 and 2016. As of December 31, 2018, there were no events or changes in circumstances indicating possible impairment. Stock-Based Compensation We account for stock-based compensation awards in accordance with Financial Accounting Standards Board (“FASB”) ASC Topic 718, Compensation-Stock Compensation (“ASC 718”). ASC 718 requires all stock-based payments including grants of stock options and restricted stock and modifications to existing stock options, to be recognized in the consolidated statements of operations based on their fair values. Our stock-based awards are subject to either service-based or performance-based vesting conditions. Vesting of certain awards could also be accelerated upon achievement of defined market-based vesting conditions. Certain awards also contain a combination of service and market conditions or performance and market conditions. We account for employee stock-based awards at grant date fair value. If we issue awards with an exercise price denominated in a currency other than our functional currency, trading currency or the currency for which we compensate our employee, we account for these as liabilities. We record compensation expense for service-based awards over the vesting period of the award on a straight-line basis. Compensation expense related to awards with performance-based vesting conditions is recognized over the requisite service period using the accelerated attribution method to the extent achievement of the performance condition is probable. Compensation expense for awards with service and market-based vesting conditions is recognized using the accelerated attribution method over the shorter of the requisite service period or the implied period associated with achievement of the market-based vesting provisions. We estimate the fair value of our awards with service conditions using the Black Scholes option pricing model, which requires the input of subjective assumptions, including (i) the expected stock price volatility, (ii) the expected term of the award, (iii) the risk-free interest rate and (iv) expected dividends. Due to the lack of historical and implied volatility data of our ordinary shares, we based our estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. We selected companies with comparable characteristics to us, including enterprise value, risk profiles and position within the industry, and with historical share price information sufficient to meet the expected term of the stock-based awards. We compute historical volatility data using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of the stock-based awards. We estimate the fair value of our awards with market conditions using a Monte Carlo simulation to determine the probability of satisfying the market condition. We make this estimate using the conditions that exist at the grant date. The derived service period, which may be the requisite service period, is also determined at this time. Compensation cost for our awards with a market condition is recognized ratably using the accelerated attribution method if the award is subject to graded vesting over the requisite service period. The compensation cost for our awards with a market condition is not reversed if the market condition is not satisfied. We have estimated the expected term of employee service-based stock options using the “simplified” method, whereby the expected term equals the arithmetic average of the vesting term and the original contractual term of the option, due to our lack of sufficient historical data. We have estimated the expected term of employee awards with service and market conditions using a Monte Carlo simulation model. This approach involves generating random stock price paths through a lattice type structure. Each path results in a certain financial outcome, such as accelerated vesting or specific option payout. We have estimated the expected term of nonemployee service and performance-based awards based on the remaining contractual term of such awards. The risk-free interest rates for periods within the expected term of the option are based on the Swedish Government Bond rate or the U.S. Treasury Bond rate with a maturity date commensurate with the expected term of the associated award. We have never paid dividends, and do not expect to pay dividends in the foreseeable future. We account for forfeitures as they occur as opposed to estimating forfeitures. We record stock-based compensation expense only for those awards that are expected to vest. Income Taxes The Tax Act, which was enacted in 2017, made broad and complex changes to the U.S. tax code, including, but not limited to, reducing the top U.S. federal corporate tax rate from 35 percent to 21 percent; requiring companies to pay a one-time transition tax on certain un-repatriated earnings of foreign subsidiaries; generally eliminating U.S. federal income taxes on dividends from foreign subsidiaries; requiring a current inclusion in U.S. federal taxable income of certain earnings of controlled foreign corporations; eliminating the corporate alternative minimum tax (“AMT”) and changing how existing AMT credits can be realized; creating the base erosion anti-abuse tax (“BEAT”), a new minimum tax; creating a new limitation on deductible interest expense; and changing rules related to uses and limitations of net operating loss carryforwards created in tax years beginning after December 31, 2017. The Tax Act reduced our U.S. corporate income tax rate from 34% to 21%, effective January 1, 2018. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse. As a result of the reduction in the U.S. corporate income tax rate from 34% to 21% under the Tax Act, we revalued our ending net deferred tax assets and liabilities at December 31, 2017. The Tax Act provided for a one-time transition tax on the deemed repatriation of post-1986 undistributed foreign subsidiary earnings and profits (“E&P”). We did not have to recognize any income tax expense related to the transition tax as we own no controlled foreign corporations. The global intangible low-taxed income tax and base erosion provisions are effective for taxable years beginning after December 31, 2017. The Company does not currently expect these provisions to have a material impact on its tax rate as they do not own any controlled foreign corporations and they are currently below the gross receipts threshold for purposes of the base erosion provisions. In accordance with Staff Accounting Bulletin No. 118 (“SAB 118”), we have finalized the accounting for the Tax Act and have recorded no additional amount during the current year. We recognize interest and penalties related to uncertain tax positions in income tax expense. As of December 31, 2018, 2017 and 2016, we had no accrued interest or penalties related to uncertain tax positions and no amounts have been recognized in our statements of operations. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table sets forth our results of operations for the years ended December 31, 2018 and 2017. Net Revenue and Cost of Sales. Net revenue was $18.0 million, and cost of sales were $4.0 million for the year ended December 31, 2018, an increase of $11.0 million and $2.5 million, respectively, compared to the year ended December 31, 2017. The increase in product sales is due to increased Keveyis sales of $9.8 million compared to the prior period due to increased volume. We also recorded $1.2 million in sales of Macrilen, which we launched in July 2018. Selling, General and Administrative Expenses The following table summarizes our selling, general and administrative expenses during the years ended December 31, 2018 and 2017: Selling, general and administrative expenses were $63.3 million for the year ended December 31, 2018, an increase of $27.0 million compared to the year ended December 31, 2017. Compensation and other personnel costs increased by $13.4 million during the year ended December 31, 2018, primarily due to increased headcount of commercial personnel for the continued commercialization of Keveyis and our launch of Macrilen. Outside professional and consulting services increased $11.0 million due to expenses relating to the commercialization of Keveyis and our launch of Macrilen. Research and Development Expenses The following table summarizes our research and development expenses during the years ended December 31, 2018 and 2017: Research and development expenses were $25.4 million for the year ended December 31, 2018, an increase of $8.2 million compared to the year ended December 31, 2017. The $5.7 million increase in expenses for product development and supporting activities was primarily due to additional clinical development expenses for Recorlev and life cycle management activities for Keveyis. Compensation and other personnel costs increased by $1.8 million for the year ended December 31, 2018 as compared to the same period in 2017 due to increased headcount. Amortization of Intangible Assets Amortization of intangible assets was $7.2 million for the year ended December 31, 2018, an increase of $2.2 million, due to the commencement of amortization of the Macrilen product rights that we acquired in January 2018. We subsequently sold the subsidiary that held the asset to Novo in December 2018. Other Income (Expense), Net Other income (expense), net, increased by $152.3 million for the year ended December 31, 2018 as compared to the year ended December 31, 2017. The increase was primarily due to a $130.8 million gain on the sale of our subsidiary and a $16.3 million unrealized gain on the fair value of our warrant liability in 2018, offset in part by a $8.2 million increase in interest expense and $21.5 million loss on extinguishment of debt. The 2017 period included a $30.2 million unrealized loss on the fair value of our warrant liability and a $3.5 million of expense relating to the loss on the extinguishment of debt. Income Tax Expense We recorded income tax expense of $0.5 million for the year ended December 31, 2018 as a result of tax liability expected in connection with the intercompany transfer of intellectual property. We recorded income tax expense of $1.8 million for the year ended December 31, 2017 as a result of recording full valuation allowances against our deferred tax asset and deferred tax liability. Liquidity and Capital Resources We believe that our cash resources of $122.5 million at December 31, 2018 will be sufficient to allow us to fund planned operations for at least 12 months beyond the issuance date of these financial statements. We expect our funding requirements for operating activities to decrease in 2019 as compared to 2018, due in large part to increased sales of Keveyis and from anticipated payments from Novo Nordisk in the form of royalty income, performance incentives, and subsidy of 23 of our field-based employees. Our funding requirements in future years, however, could increase due to expenses associated with the execution of SONICS, LOGICS, and OPTICS clinical trials for Recorlev and the commercialization of Recorlev, if approved. Our cash needs could also increase in 2019 or future years to fund potential in-licenses, acquisitions or similar transactions as we pursue our strategy. Cash used to fund operating expenses is affected by the timing of when we pay expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. Our future funding requirements will depend on many factors, including the following: · the amount of revenue that we receive from sales of Keveyis and royalty income from Macrilen; · the cost and timing of establishing sales, marketing, distribution and administrative capabilities; · the scope, rate of progress, results and cost of our clinical trials testing and other related activities for Recorlev and veldoreotide; · the number and characteristics of product candidates that we pursue, including any additional product candidates we may in-license or acquire; · the cost of filing, prosecuting, defending and enforcing our patent claims and other intellectual property rights; · the cost of defending potential intellectual property disputes, including patent infringement actions brought by third parties against us or our product candidates; · the cost, timing and outcomes of regulatory approvals; · the terms and timing of any collaborative, licensing and other arrangements that we may establish, including any required milestone and royalty payments thereunder; and · the emergence of competing technologies and their achieving commercial success before we do or other adverse market developments. Although we recorded net income in 2018, we expect to incur losses in future years. Our ability to achieve and maintain profitability is dependent upon the continued successful commercialization of Keveyis, the development, regulatory approval and commercialization of our product candidates and achieving a level of revenues, including royalty revenue from Macrilen sales, adequate to support our cost structure. We may never achieve profitability, and unless and until we do, we will continue to need to raise additional capital. If we need to raise additional capital to fund our operations and complete our ongoing and planned clinical trials, funding may not be available to us on acceptable terms, or at all. We plan to continue to fund our operations and capital funding needs through equity or debt financing, along with revenues from Keveyis sales and Macrilen royalties, and proceeds from our at-the-market (“ATM”) facility. The sale of additional equity would result in additional dilution to our shareholders. The incurrence of debt financing would result in debt service obligations and the instruments governing such debt could provide for operating and financing covenants that would restrict our operations. If we are not able to secure adequate additional funding, we may be forced to make reductions in spending, extend payment terms with suppliers, liquidate assets where possible or suspend or curtail planned programs. In addition, lack of funding would limit any strategic initiatives to in-license or acquire additional product candidates or programs. October 2017 Public Offering of Ordinary Shares On October 6, 2017, we sold 4,000,000 ordinary shares in a public offering at a price to the public of $6.25 per share for net proceeds of approximately $23.4 million, after deducting underwriting discounts and commissions and offering expenses payable by us. January 2018 Public Offering of Ordinary Shares On January 25, 2018, we sold 5,000,000 ordinary shares in a public offering at a price to the public of $6.75 per ordinary share for net proceeds of approximately $31.7 million, after deducting underwriting discounts and commissions and offering expenses payable by us. On February 26, 2018, we sold an additional 255,683 ordinary shares to the underwriters in connection with their partial exercise of the option to purchase additional shares that was granted to them under the underwriting agreement for additional net proceeds of approximately $1.6 million, after deducting underwriting discounts and commissions and offering expenses payable by us. At-The-Market Facility We have entered into an Equity Distribution Agreement with JMP Securities LLC (“JMP Securities”), pursuant to which we may offer and sell ordinary shares having an aggregate offering price of up to $40,000,000 from time to time through JMP Securities, acting as agent. During the year ended December 31, 2018, we sold an aggregate of 1,281,903 ordinary shares under the ATM facility for net proceeds of approximately $8.6 million after payment of fees of $0.3 million to JMP Securities. As of December 31, 2018, we have approximately $31.1 million available for sale under our ATM facility. Cash Flows Comparison for the Years Ended December 31, 2018 and 2017: Operating Activities Net cash used in operating activities was $84.6 million for the year ended December 31, 2018 compared to $45.3 million for the year ended December 31, 2017. The increase in net cash used in operating activities resulted primarily from expenditures during 2018 to support the commercialization of Keveyis and the launch of Macrilen, offset in part by increased net revenues resulting from sales of Keveyis and Macrilen. Investing Activities Net cash provided by investing activities was $134.3 million for the year ended December 31, 2018 compared to net cash used by investing activities for the year ended December 31, 2017 of $7.5 million. The increase in net cash provided by investing activities was primarily due to the $159.3 million proceeds from our sale of Macrilen product rights and Strongbridge Ireland Limited. Financing Activities Net cash provided by financing activities was $15.2 million for the year ended December 31, 2018 compared to net cash provided by financing activities of $43.5 million for the year ended December 31, 2017. The decrease in net cash provided by financing activities resulted primarily from our payment to CRG Servicing LLC (“CRG”) in December 2018 of $94.5 million to pay off our outstanding debt, offset by receipt in January 2018 of $44.9 million in proceeds from the amendment to our senior credit facility with CRG, and $65.8 million in net proceeds from issuance of our ordinary shares and exercise of warrants and stock options. Contractual Obligations and Other Commitments The following is a summary of our contractual obligations and other commitments as of December 31, 2018: We enter into agreements in the normal course of business with vendors for clinical trials, preclinical studies, and other services and products for operating purposes. Future payment obligations under these agreements, which are cancelable at any time by us, generally upon 30 days prior written notice, are not included in this table of contractual obligations. We are obligated to make future payments to third parties due to payments that become due and payable upon the achievement certain commercialization milestones. As the amount and timing of these milestones are not probable and estimable, such commitments have not been included on our consolidated balance sheets or in the contractual obligations table above. Off-Balance Sheet Arrangements We do not have variable interests in variable interest entities or any off-balance sheet arrangements. Recent Accounting Pronouncements See Note 2, “Summary of significant accounting policies and basis of presentation - Recently issued accounting pronouncements” to our consolidated financial statements.

<s>[INST] Overview We are a global, commercialstage biopharmaceutical company focused on the development and commercialization of therapies for rare diseases with significant unmet needs. Our first commercial product is Keveyis (dichlorphenamide), the first and only treatment approved by the FDA for hyperkalemic, hypokalemic, and related variants of PPP, a group of rare hereditary disorders that cause episodes of muscle weakness or paralysis. In January 2018, Strongbridge Ireland Ltd., one of our whollyowned subsidiaries, acquired the U.S. and Canadian rights to Macrilen (macimorelin), the first and only oral drug approved by the FDA for the diagnosis of patients with adult growth hormone deficiency. We launched Macrilen in the United States in July 2018. In December 2018, we sold Strongbridge Ireland Ltd., to Novo. As consideration for the sale, we received $145 million from Novo plus the right to receive tiered royalties on net sales of Macrilen through 2027. In addition, we entered into a services agreement with Novo pursuant to which it will fund, for a period of three years (subject to our right to terminate the arrangement upon six months’ notice), the costs of 23 of our fieldbased employees to provide fulltime ongoing services to Novo, including the promotion of Macrilen in the United States. We will also be entitled to a performance fee of up to $1.5 million per contract year if certain conditions are met by our fieldbased employees under the services arrangement, which conditions will be determined and measured by a joint committee comprised of members from Novo and from Strongbridge, with a majority of members from Novo. Novo also purchased 5.2 million of our ordinary shares at a purchase price of $7.00 per share. The excess price paid per share over the fair value of the stock, was included in the gain on sale of our subsidiary. We have two clinicalstage product candidates for rare endocrine diseases, Recorlev and veldoreotide. Recorlev (levoketoconazole) is a cortisol synthesis inhibitor currently being studied for the treatment of endogenous Cushing's syndrome. Veldoreotide is a nextgeneration somatostatin analog being investigated for potential applications in conditions amenable to somatostatin receptor activation, such as acromegaly. Both Recorlev and veldoreotide have received orphan designation from the FDA and the EMA. We are building a rare disease, franchisebased business model focused on expansion through a disciplined inlicensing and acquisition strategy. We will continue to identify and evaluate the acquisition of products and product candidates for licensing or acquisition that would be complementary to our existing rare neuromuscular and endocrine franchises or that would form the basis for new rare disease franchises. We believe this approach will enable us to maximize our commercial potential by further leveraging our existing resources and expertise. In December 2017, we received letters from the offices of U. S. Senators Amy Klobuchar, Susan Collins and Tammy Baldwin, and Senator Claire McCaskill, Ranking Member of the Homeland Security and Governmental Affairs Committee, that request information relating to the marketing and sales of Keveyis. The letters request information principally relating to the pricing of Keveyis, among other things. We are cooperating with these voluntary requests for information. Financial Operations Overview Net Revenue Our product sales in 2018, resulted from sales of Keveyis and Macrilen. We will no longer record product sales from Macrilen following the sale of our rights to Macrilen to Novo in December 2018. We recognize net product sales at the time our products are received by our customers (primarily wholesalers and specialty pharmacies). The products are subsequently sold to patients, who are covered by payors that may provide for governmentmandated or privately negotiated rebates with respect to the purchase of our products. We expense incremental costs related to the setup of the contracts with our customers when incurred, as these costs do not meet the criteria for capitalization. Cost of Sales Cost of sales includes thirdparty acquisition costs, thirdparty warehousing and product distribution charges. Selling, General and Administrative Expenses Selling, general [/INST] Positive. </s>

Strongbridge Biopharma plc

2020-02-28

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion summarizes the significant factors affecting the operating results, financial condition, liquidity and cash flows of our company as of and for the periods presented below. The following discussion and analysis should be read in conjunction with the financial statements and the related notes thereto included elsewhere in this Annual Report. The statements in this discussion regarding industry outlook, our expectations regarding our future performance, liquidity and capital resources and all other non-historical statements in this discussion are forward-looking statements and are based on the current beliefs of our management, as well as assumptions made by, and information currently available to, our management. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Annual Report, particularly in the section titled “Risk Factors.” Overview We are a global, commercial-stage biopharmaceutical company focused on the development and commercialization of therapies for rare diseases with significant unmet needs. Our first commercial product is Keveyis (dichlorphenamide), the first and only treatment approved by the U.S. Food and Drug Administration (the “FDA”) for hyperkalemic, hypokalemic, and related variants of primary periodic paralysis (“PPP”), a group of rare hereditary disorders that cause episodes of muscle weakness or paralysis. We have two clinical-stage product candidates for rare endocrine diseases, Recorlev and veldoreotide. Recorlev (levoketoconazole) is a cortisol synthesis inhibitor currently being studied for the treatment of endogenous Cushing's syndrome. Veldoreotide is a next-generation somatostatin analog being investigated for potential applications in conditions amenable to somatostatin receptor activation. Both Recorlev and veldoreotide have received orphan designation from the FDA and the European Medicines Agency (“EMA”). In January 2018, Strongbridge Ireland Limited., one of our wholly-owned subsidiaries, acquired the U.S. and Canadian rights to Macrilen (macimorelin), the first and only oral drug approved by the FDA for the diagnosis of patients with adult growth hormone deficiency. We launched Macrilen in the United States in July 2018. In December 2018, we sold Strongbridge Ireland Ltd. to Novo Nordisk Healthcare AG (“Novo”) for $145 million plus the right to receive tiered royalties on net sales of Macrilen through 2027. In addition, Strongbridge U.S. Inc, another of our wholly-owned subsidiaries, entered into an agreement with Novo Nordisk Inc., a subsidiary of Novo (“NNI”), pursuant to which NNI was to fund the costs of 23 of our field-based employees to provide full-time ongoing services to NNI, including the promotion of Macrilen in the United States, for a period of three years. Novo also purchased 5.2 million of our ordinary shares at a purchase price of $7.00 per share. In December 2019, we reached an agreement with Novo to terminate the services agreement. We received a $6 million payment in connection with such termination, and we will no longer provide services to Novo. Financial Operations Overview Product Revenue, net Revenues from sales of our products are recorded at the net sales price (transaction price), which includes estimates of variable consideration for which reserves are established and that result from rebates, co-pay assistance and other allowances that are offered by us and the patients’ payors. These reserves are based on the amounts earned or to be claimed on the related sales and are classified as reductions of accounts receivable (if the amount is payable to our customer) or a current liability (if the amount is payable to a party other than our customer). Where appropriate, these estimates may take into consideration a range of possible outcomes that are probability-weighted for relevant factors such as our historical experience, current contractual and statutory requirements, specific known market events and trends, industry data and forecasted customer buying and payment patterns. Overall, these reserves reflect our best estimates of the amount of consideration to which we are entitled based on the terms of the contract. For a complete discussion of accounting for net product revenue, see Note 3, "Revenue recognition" to our consolidated financial statements. Cost of Sales Cost of sales includes third-party acquisition costs, third-party warehousing and product distribution charges. Selling, General and Administrative Expenses Selling, general and administrative expenses include personnel costs, costs for outside professional services and other allocated expenses. Personnel costs consist of salaries, bonuses, benefits, travel and stock-based compensation. Outside professional services consist of legal, accounting and audit services, commercial evaluation and strategy services, sales, market access, marketing, investor relations, public relations, recruiting and other consulting services. Research and Development Expenses We expense all research and development costs as incurred. Our research and development expenses consist primarily of costs incurred in connection with the development of our product candidates, including: · personnel-related costs, such as salaries, bonuses, benefits, travel and other related expenses, including stock-based compensation; · expenses incurred under our agreements with CROs, clinical sites, contract laboratories, medical institutions and consultants that plan and conduct our preclinical studies and clinical trials. We recognize costs for each grant project, preclinical study or clinical trial that we conduct based on our evaluation of the progress to completion, including the use of information and data provided to us by our external research and development vendors and clinical sites. · costs associated with regulatory filings; and · costs of acquiring preclinical study and clinical trial materials, and costs associated with formulation and process development; and We do not allocate personnel-related research and development costs, including stock-based compensation or other indirect costs, to specific programs, as they are deployed across multiple projects under development. Amortization of Intangible Asset Amortization of intangible assets relates to the amortization of our product rights to Keveyis. This intangible asset is being amortized over an eight-year period using the straight-line method. Other Income, Net Other income, net, consists of unrealized gain and losses on the remeasurement of the fair value of warrant liability, interest income generated from our cash and cash equivalents, foreign exchange gains and losses, and gains and losses on investments. We also record income and expenses relating to our service agreement with Novo Nordisk Inc (NNI) to fund the costs of 23 of our field-based employees to provide full-time ongoing services to NNI, including the promotion of Macrilen in the United States in Other Income. In December 2019, we reached an agreement with Novo to terminate the services agreement. We received a $6 million payment in connection with such termination; which is reflected in Other Income; we will no longer provide services to Novo. Critical Accounting Policies and Estimates This operating and financial review of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to our financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe the following accounting policies and estimates are critical. Revenue Recognition Revenues from sales of our products are recorded at the net sales price (transaction price), which includes estimates of variable consideration for which reserves are established and that result from rebates, co-pay assistance and other allowances that are offered by us and the patients’ payors. These reserves are based on the amounts earned or to be claimed on the related sales and are classified as reductions of accounts receivable (if the amount is payable to our customer) or a current liability (if the amount is payable to a party other than our customer). Where appropriate, these estimates may take into consideration a range of possible outcomes that are probability-weighted for relevant factors such as our historical experience, current contractual and statutory requirements, specific known market events and trends, industry data and forecasted customer buying and payment patterns. Overall, these reserves reflect our best estimates of the amount of consideration to which we are entitled based on the terms of the contract. For a complete discussion of accounting for net product revenue, see Note 3, "Revenue recognition" to our consolidated financial statements. Warrant Liability The fair values of certain outstanding warrants were measured using the Black-Scholes option-pricing model. Inputs used to determine estimated fair value of the warrant liabilities include the fair value of the underlying stock at the valuation date, the term of the warrants, risk-free interest rates, and the expected volatility of the underlying stock. The significant unobservable inputs used in the fair value measurement of the warrant liabilities were the fair value of the underlying stock at the valuation date and the estimated term of the warrants. Generally, increases (decreases) in the fair value of the underlying stock and estimated term result in a directionally similar impact to the periodic fair value measurement of outstanding warrants. Intangible Assets Certain intangible assets were acquired as part of an asset purchase and have been capitalized at their acquisition date at fair value. Acquired definite life intangible assets are amortized using the straight-line method over their respective estimated useful lives. We evaluate the potential impairment of intangible assets if events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. In connection with the Asset Purchase and Supply Agreement we entered into with Taro Pharmaceuticals North America, Inc., we paid Taro an upfront payment in two installments of $1 million in December 2016 and $7.5 million in March 2017. We have concluded that the supply price payable by us exceeds fair value and, therefore, have used a discounted cash flow method with a probability assumption to value the payments in excess of fair value at $29.3 million, for which we have recorded an intangible asset and corresponding liability. This liability is amortized as we purchase inventory over the term of the agreement. In addition, we incurred transaction costs of $2.4 million resulting in the recording of an intangible asset of $40.2 million. This intangible asset is being amortized over an eight-year period using the straight-line method. As of December 31, 2019, no impairment of intangible assets has been identified. Goodwill We test goodwill for impairment on an annual basis or whenever events occur that may indicate possible impairment. This analysis requires us to make a series of critical assumptions to (1) evaluate whether any impairment exists and (2) measure the amount of impairment. Because we have one operating segment, when testing for a potential impairment of goodwill, we are required to estimate the fair value of our business as a whole and determine the carrying value. If the estimated fair value is less than the carrying value of our business, then we are required to estimate the fair value of all identifiable assets and liabilities in a manner similar to a purchase price allocation for an acquired business. Only after this process is completed can the goodwill impairment be determined, if any. We did not record a charge for impairment for the years ended December 31, 2019 and 2018. As of December 31, 2019, there were no events or changes in circumstances indicating possible impairment. Stock-based compensation We account for stock-based compensation awards in accordance with Financial Accounting Standards Board (“FASB”) ASC Topic 718, Compensation-Stock Compensation (“ASC 718”). ASC 718 requires all stock-based payments including grants of stock options and restricted stock and modifications to existing stock options, to be recognized in the consolidated statements of operations based on their fair values. We record compensation expense for service-based awards over the vesting period of the award on a straight-line basis. Compensation expense related to awards with performance-based vesting conditions is recognized over the requisite service period using the accelerated attribution method to the extent achievement of the performance condition is probable. We estimate the fair value of our awards with service conditions using the Black-Scholes option pricing model, which requires the input of subjective assumptions, including (i) the expected stock price volatility, (ii) the expected term of the award, (iii) the risk-free interest rate and (iv) expected dividends. We have estimated the expected term of employee service-based stock options using the “simplified” method, whereby the expected term equals the arithmetic average of the vesting term and the original contractual term of the option, due to our lack of sufficient historical data. The risk-free interest rates for periods within the expected term of the option are based on the U.S. Treasury Bond rate with a maturity date commensurate with the expected term of the associated award. We have never paid dividends, and do not expect to pay dividends in the foreseeable future. We account for forfeitures as they occur as opposed to estimating forfeitures. We record stock-based compensation expense only for those awards that are expected to vest. Income Taxes Deferred tax assets and liabilities are recognized for the future tax consequences of differences between the carrying amounts and tax bases of assets and liabilities and operating loss carryforwards and other attributes using enacted rates expected to be in effect when those differences reverse. Valuation allowances are provided against deferred tax assets that are not more likely than not to be realized. We assess our ability to realize deferred tax assets. Changes in future earnings projections, among other factors, may cause us to adjust our valuation allowance on deferred tax assets. Any such adjustments would impact our income tax expense in the period in which it is determined that these factors have changed. We recognize interest and penalties related to uncertain tax positions in income tax expense. As of December 31, 2019, and 2018, we had no accrued interest or penalties related to uncertain tax positions and no amounts have been recognized in our statements of operations. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table sets forth our results of operations for the years ended December 31, 2019 and 2018. Net Product Sales and Cost of Sales. Net product sales were $21.7 million for the year ended December 31, 2019, an increase of $3.6 million compared to the year ended December 31, 2018. Product sales from Keveyis increased by $4.7 million due to the continued sales growth of Keveyis. Included in the year ended December 31, 2018 is $1.1 million from Macrilen sales, the rights to which we sold in December 2018. Selling, General and Administrative Expenses The following table summarizes our selling, general and administrative expenses during the years ended December 31, 2019 and 2018: Selling, general and administrative expenses were $49.1 million for the year ended December 31, 2019, a decrease of $14.3 million compared to the year ended December 31, 2018. Outside professional and consulting services decreased $12.2 million during the year ended December 31, 2019, with $2.7 million of this decrease due to a reduction in expenses relating to Keveyis and $8.4 million of this decrease due to the prior year period including expenses associated with the launch of Macrilen, the rights to which we sold in December 2018. Compensation and other personnel costs decreased $5.7 million due to employee costs associated with Macrilen being reimbursed by Novo. In 2019, we incurred a one-time charge of $3.2 million for severance costs. Research and Development Expenses The following table summarizes our research and development expenses during the years ended December 31, 2019 and 2018: Research and development expenses were $30.9 million for the year ended December 31, 2019, an increase of $5.5 million compared to the year ended December 31, 2018. The $1.7 million increase in expenses for product development and supporting activities was primarily due to additional clinical development expenses associated with Recorlev and $2.4 million expenses for preclinical development relates to life cycle work for Keveyis and work relating to veldoreotide. Amortization of Intangible Assets Amortization of intangible assets was $5.0 million for the year ended December 31, 2019 a decrease of $2.2 million due to the prior year including amortization of the intangible asset related to Macrilen, the rights to which we sold in December 2018. Other Income, Net Total other income, net, decreased by $94.9 million for the year ended December 31, 2019 as compared to the year ended December 31, 2018. The decrease was primarily due to our gain on sale of subsidiary of $130.8 million, which occurred in December 2018. The 2018 period included offsets of $12.5 million of interest expense and $21.5 million loss on extinguishment of debt. In 2019, we had a $5.0 million decrease in the unrealized gain on the fair value of our warrant liability in 2019, primarily resulting from a decrease in our stock price. In addition, during the 2019 period, we recorded $12.6 million in income relating to our field based service agreement with NNI, which includes the $6 million payment from Novo to terminate the agreement. We incurred $6.7 million of field services related expenses in 2019. Income Tax Expense We recorded income tax expense of $1.8 million for the year ended December 31, 2019 arising from intercompany interest income. Liquidity and Capital Resources We believe that our cash, cash equivalent and marketable securities of $78.1 million at December 31, 2019 will be sufficient to allow us to fund planned operations for at least 12 months beyond the issuance date of these financial statements. Cash used to fund operating expenses is affected by the timing of when we pay expenses, as reflected in the change in our outstanding accounts payable and accrued expenses. Our future funding requirements will depend on many factors, including the following: · the amount of revenue that we receive from sales of Keveyis; · the cost and timing of establishing sales, marketing, distribution and administrative capabilities; · the scope, rate of progress, results and cost of our clinical trials testing and other related activities for Recorlev and veldoreotide; · the number and characteristics of product candidates that we pursue, including any additional product candidates we may in-license or acquire; · the cost of filing, prosecuting, defending and enforcing our patent claims and other intellectual property rights; · the cost of defending potential intellectual property disputes, including patent infringement actions brought by third parties against us or our product candidates; · the cost, timing and outcomes of regulatory approvals; · the terms and timing of any collaborative, licensing and other arrangements that we may establish, including any required milestone and royalty payments thereunder; and · the emergence of competing technologies and their achieving commercial success before we do or other adverse market developments. We may never achieve profitability, and unless and until we do, we will continue to need to raise additional capital. We plan to continue to fund our operations and capital funding needs through equity, debt financing or other financings along with revenues from Keveyis. There can be no assurances, however, that additional funding will be available on terms acceptable to us. January 2018 Public Offering of Ordinary Shares On January 25, 2018, we sold 5,000,000 ordinary shares in a public offering at a price to the public of $6.75 per ordinary share for net proceeds of approximately $31.7 million, after deducting underwriting discounts and commissions and offering expenses payable by us. On February 26, 2018, we sold an additional 255,683 ordinary shares to the underwriters in connection with their partial exercise of the option to purchase additional shares that was granted to them under the underwriting agreement for additional net proceeds of approximately $1.6 million, after deducting underwriting discounts and commissions and offering expenses payable by us. At-The-Market Facility We have entered into an Equity Distribution Agreement with JMP Securities LLC (“JMP Securities”), pursuant to which we may offer and sell ordinary shares having an aggregate offering price of up to $40,000,000 from time to time through JMP Securities, acting as agent. During the year ended December 31, 2018, we sold an aggregate of 1,281,903 ordinary shares under the ATM facility for net proceeds of approximately $8.6 million after payment of fees of $0.3 million to JMP Securities. As of December 31, 2019, we have approximately $31.1 million available for sale under our ATM facility. Cash Flows Comparison for the Years Ended December 31, 2019 and 2018: Operating Activities Net cash used in operating activities was $44.8 million for the year ended December 31, 2019 compared to $84.6 million for the year ended December 31, 2018. The decrease in net cash used in operating activities resulted from an increase in total revenues of $2.6 million, a decrease in inventory purchases of $2.1 million and reduced expenditures in our commercial activities for Keveyis and Macrilen, which we sold in December 2018. The prior period had expenditures for the launch of Macrilen, the rights to which we sold in December 2018. Investing Activities Net cash used in investing activities was $20.8 million for the year ended December 31, 2019 due to purchasing of marketable securities. Net cash provided by investing was $134.3 million for the year ended December 31, 2018, primarily due to the $159.3 million proceeds from our sale of Macrilen product rights and Strongbridge Ireland Limited. Financing Activities Net cash provided by financing activities was $87,000 for the year ended December 31, 2019 compared to net cash provided by financing activities of $15.2 million for the year ended December 31, 2018. The decrease in net cash provided by financing activities resulted primarily from our payment to CRG Servicing LLC (“CRG”) in December 2018 of $94.5 million to pay off our outstanding debt, offset by receipt in January 2018 of $44.9 million in proceeds from the amendment to our senior credit facility with CRG, and $65.8 million in net proceeds from issuance of our ordinary shares and exercise of warrants and stock options. Contractual Obligations and Other Commitments The following is a summary of our contractual obligations and other commitments as of December 31, 2019: We enter into agreements in the normal course of business with vendors for clinical trials, preclinical studies, and other services and products for operating purposes. Future payment obligations under these agreements, which are cancelable at any time by us, generally upon 30 days prior written notice, are not included in this table of contractual obligations. We are obligated to make future payments to third parties due to payments that become due and payable upon the achievement of certain commercialization milestones. As the amount and timing of these milestones are not probable and estimable, such commitments have not been included on our consolidated balance sheets or in the contractual obligations table above. Off-Balance Sheet Arrangements We do not have variable interests in variable interest entities or any off-balance sheet arrangements. Recent Accounting Pronouncements See Note 2, “Summary of significant accounting policies and basis of presentation - Recently issued accounting pronouncements” to our consolidated financial statements.

<s>[INST] Overview We are a global, commercialstage biopharmaceutical company focused on the development and commercialization of therapies for rare diseases with significant unmet needs. Our first commercial product is Keveyis (dichlorphenamide), the first and only treatment approved by the U.S. Food and Drug Administration (the “FDA”) for hyperkalemic, hypokalemic, and related variants of primary periodic paralysis (“PPP”), a group of rare hereditary disorders that cause episodes of muscle weakness or paralysis. We have two clinicalstage product candidates for rare endocrine diseases, Recorlev and veldoreotide. Recorlev (levoketoconazole) is a cortisol synthesis inhibitor currently being studied for the treatment of endogenous Cushing's syndrome. Veldoreotide is a nextgeneration somatostatin analog being investigated for potential applications in conditions amenable to somatostatin receptor activation. Both Recorlev and veldoreotide have received orphan designation from the FDA and the European Medicines Agency (“EMA”). In January 2018, Strongbridge Ireland Limited., one of our whollyowned subsidiaries, acquired the U.S. and Canadian rights to Macrilen (macimorelin), the first and only oral drug approved by the FDA for the diagnosis of patients with adult growth hormone deficiency. We launched Macrilen in the United States in July 2018. In December 2018, we sold Strongbridge Ireland Ltd. to Novo Nordisk Healthcare AG (“Novo”) for $145 million plus the right to receive tiered royalties on net sales of Macrilen through 2027. In addition, Strongbridge U.S. Inc, another of our whollyowned subsidiaries, entered into an agreement with Novo Nordisk Inc., a subsidiary of Novo (“NNI”), pursuant to which NNI was to fund the costs of 23 of our fieldbased employees to provide fulltime ongoing services to NNI, including the promotion of Macrilen in the United States, for a period of three years. Novo also purchased 5.2 million of our ordinary shares at a purchase price of $7.00 per share. In December 2019, we reached an agreement with Novo to terminate the services agreement. We received a $6 million payment in connection with such termination, and we will no longer provide services to Novo. Financial Operations Overview Product Revenue, net Revenues from sales of our products are recorded at the net sales price (transaction price), which includes estimates of variable consideration for which reserves are established and that result from rebates, copay assistance and other allowances that are offered by us and the patients’ payors. These reserves are based on the amounts earned or to be claimed on the related sales and are classified as reductions of accounts receivable (if the amount is payable to our customer) or a current liability (if the amount is payable to a party other than our customer). Where appropriate, these estimates may take into consideration a range of possible outcomes that are probabilityweighted for relevant factors such as our historical experience, current contractual and statutory requirements, specific known market events and trends, industry data and forecasted customer buying and payment patterns. Overall, these reserves reflect our best estimates of the amount of consideration to which we are entitled based on the terms of the contract. For a complete discussion of accounting for net product revenue, see Note 3, "Revenue recognition" to our consolidated financial statements. Cost of Sales Cost of sales includes thirdparty acquisition costs, thirdparty warehousing and product distribution charges. Selling, General and Administrative Expenses Selling, general and administrative expenses include personnel costs, costs for outside professional services and other allocated expenses. Personnel costs consist of salaries, bonuses, benefits, travel and stockbased compensation. Outside professional services consist of legal, accounting and audit services, commercial evaluation and strategy services, sales, market access, marketing, investor relations, public relations, recruiting and other consulting services. Research and Development Expenses We expense all research and development costs as incurred. Our research and development expenses consist primarily of costs incurred in connection with the development of our product candidates, including: · personnelrelated costs, such as salaries [/INST] Negative. </s>

Graf Industrial Corp.

2019-04-01

2018-12-31

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS References to the “Company,” “our,” “us” or “we” refer to Graf Industrial Corp. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a blank check company incorporated in Delaware on June 26, 2018 and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses that the Company has not yet identified (“business combination”). We are not limited to a particular industry or sector for purposes of consummating a business combination. Our sponsor is Graf Acquisition LLC, a Delaware limited liability company (the “sponsor”). Our registration statement for the initial public offering (the “initial public offering”) was declared effective on October 15, 2018. On October 18, 2018, we consummated the initial public offering of 22,500,000 units (the “units” and, with respect to the shares of common stock included in the units offered, the “public shares”), generating gross proceeds of  $225 million and incurred underwriting commissions of $4.5 million. On October 25, 2018, we consummated the closing of the sale of 1,876,512 additional units upon receiving notice of the underwriters’ election to partially exercise their overallotment option (the “over-allotment”), generating additional gross proceeds of approximately $18.8 million, and incurring $375,302 in underwriting commissions. Simultaneously with the closing of the initial public offering and the over-allotment, we consummated the private placement (“private placement”) of 14,150,605 warrants (the “private placement warrants”) at a price of  $0.50 per private placement warrant, with our sponsor, Graf Acquisition LLC, a Delaware limited liability company (the “sponsor”), generating gross proceeds of approximately $7.08 million. Upon the closing of the initial public offering, the over-allotment and the private placement, approximately $243.8 million ($10.00 per Unit) of the net proceeds of the sale of the units in the initial public offering and the private placement was placed in a U.S.-based trust account maintained by Continental Stock Transfer & Trust Company, acting as trustee (“trust account”). The proceeds held in the trust account were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act 1940, as amended (the “Investment Company Act”), with a maturity of 180 days or less until the earlier of: (i) the completion of a business combination, (ii) the redemption of any public shares properly submitted in connection with a stockholder vote to amend our second amended and restated certificate of incorporation (the “second amended and restated certificate of incorporation”) to modify the substance or timing of our obligation to redeem 100% of its public shares if we do not complete a business combination within 18 months from the closing of its initial public offering or to provide for redemption in connection with a business combination and (iii) the redemption of our public shares if the Company is unable to complete a business combination within 18 months from the closing of its initial public offering, subject to applicable law. In order to protect the amounts held in the trust account, our sponsor had agreed to be liable to us if and to the extent any claims by a third party for services rendered or products sold to us, or a prospective target business with which we have entered into a written letter of intent, confidentiality or similar agreement or business combination agreement, reduce the amount of funds in the trust account to below the lesser of  (i) $10.00 per public share or (ii) the actual amount per public share held in the trust account as of the date of the liquidation of the trust account, if less than $10.00 per share due to reductions in the value of the trust assets, less taxes payable, provided that such liability will not apply to any claims by a third party or prospective target business who executed a waiver of any and all rights to the monies held in the trust account (whether or not such waiver is enforceable) nor will it apply to any claims under the Company’s indemnity of the underwriters of the initial public offering against certain including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). However, we have not asked the sponsor to reserve for such indemnification obligations, nor have we independently verified whether the sponsor has sufficient funds to satisfy its indemnity obligations and believe that the sponsor’s only assets are securities of ours. Therefore, we cannot assure that the sponsor would be able to satisfy those obligations. None of our officers or directors will indemnify us for claims by third parties including, without limitation, claims by vendors and prospective target businesses. Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the sponsor will not be responsible to the extent of any liability for such third party claims. We will seek to reduce the possibility that the sponsor will have to indemnify the trust account due to claims of creditors by endeavoring to have all vendors, service providers, prospective target businesses or other entities with which we do business, execute agreements with us waiving any right, title, interest or claim of any kind in or to monies held in the trust account. Our management has broad discretion with respect to the specific application of the net proceeds of the initial public offering, the Over-Allotment, and the private placement, although substantially all of the net proceeds are intended to be applied toward consummating a business combination. Liquidity and Capital Resources As of December 31, 2018, we had approximately $1.4 million in its operating bank account, approximately $1.1 million of investment income available in the trust account to pay for franchise and income taxes (less up to $100,000 of interest to pay dissolution expenses), and a working capital surplus of approximately $1.0 million. Through December 31, 2018, our liquidity needs have been satisfied through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the founder shares to our sponsor, $130,100 in loans and advances from our sponsor and officer, and the net proceeds from the consummation of the private placement not held in Trust. We repaid the loans and advances to our sponsor and officer on October 18, 2018. In addition, in order to finance transaction costs in connection with a business combination, our sponsor or an affiliate of our sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (“working capital loans”). As of December 31, 2018, there were no working capital loans under this arrangement. Results of Operations Our entire activity since inception up to December 31, 2018 related to our formation, commencement of the initial public offering, and since the closing of the initial public offering, the search for a prospective initial business combination. We will not be generating any operating revenues until the closing and completion of our initial business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the period from June 26, 2018 (inception) through December 31, 2018, we had net income of approximately $4.1 million, which consisted of approximately $1.1 million in investment income, approximately $3.4 million in change in fair value of warrant liabilities, offset by approximately $180,000 in general and administrative costs, approximately $103,000 in franchise tax expense, and approximately $215,000 in income tax expense. Related Party Transactions Founder Shares On June 26, 2018, the sponsor purchased 8,625,000 shares (the “founder shares”) of our common stock for an aggregate price of $25,000. On September 13, 2018, the sponsor returned to us, at no cost, 2,156,250 shares of common stock, which we cancelled, resulting in the sponsor holding 6,468,750 founder shares. On October 9, 2018, the sponsor transferred 25,000 founder shares at the same per-share price paid by the sponsor to each of Keith Abell and Sabrina McKee, two of our directors (then director-nominees), resulting in the sponsor holding 6,418,750 founder shares. The founder shares initially included an aggregate of up to 843,750 shares subject to forfeiture by the sponsor to the extent that the underwriters’ over-allotment is not exercised in full or in part, so that the own, on an as-converted basis, 20% of our issued and outstanding shares after the initial public offering. On October 25, 2018, the underwriters partially exercised their over-allotment option; thus, an aggregate of 374,622 founder shares were forfeited. The sponsor had agreed, subject to certain limited exceptions, not to transfer, assign or sell any of its founder shares until the earlier to occur of: (A) one year after the completion of a business combination or (B) subsequent to a business combination, (x) if the last sale price of the common stock equals or exceeds $12.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after a business combination, or (y) the date on which we complete a liquidation, merger, capital stock exchange or other similar transaction that results in all of our stockholders having the right to exchange their shares of common stock for cash, securities or other property. Private Placement Simultaneously with the closing of the initial public offering and the over-allotment, we consummated the private placement of 14,150,605 private placement warrants at a price of  $0.50 per private placement warrant, with the sponsor generating gross proceeds of approximately $7.08 million. The private placement warrants have the same terms as the warrants sold as components of the units in the initial public offering. Each private placement warrant is exercisable for one-half of one share of common stock at a price of $11.50 per whole share, provided that if we have not consummated a business combination within 15 months from the closing of the initial public offering, each private placement warrant will entitle the holder thereof to purchase three-quarters of one share of common stock at a price of  $11.50 per whole share, subject to adjustment in either case. A portion of the proceeds from the sale of the private placement warrants was added to the proceeds from the initial public offering to be held in the trust account. If we do not complete a business combination within the combination period, the private placement warrants will expire worthless. Related Party Loans As of December 31, 2018, the sponsor had loaned us an aggregate of  $130,000 to cover expenses related to the initial public offering pursuant to a promissory note (the “promissory note”) and James A. Graf had advanced us $100 in connection with the initial establishment of a bank account. The promissory note and the advance from James A. Graf were non-interest bearing. We repaid the promissory note and the advances to James A. Graf on October 18, 2018. In addition, in order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (“working capital loans”). If we complete a business combination, the Company would repay the working capital loans out of the proceeds of the trust account released to us. Otherwise, the working capital loans would be repaid only out of funds held outside the trust account. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the working capital loans but no proceeds held in the trust account would be used to repay the working capital loans. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. The working capital loans would either be repaid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1,500,000 of such working capital loans may be convertible into additional warrants at a price of  $0.50 (or $0.75 if the Company has not consummated a business combination within 15 months from the closing of the initial public offering) per warrant. As of December 31, 2018, there were no working capital loans under this arrangement. Administrative Support Agreement We agreed commencing on the effective date of the initial public offering through the earlier of our consummation of a business combination and its liquidation, to reimburse an affiliate of its sponsor up to $5,000 per month for office space, utilities and secretarial and administrative support on an at-cost basis to the extent such office space, utilities and support is not contracted with us directly. We recorded and paid approximately $2,000 in expenses in connection with such agreement on the accompanying Statement of Operations for the period from June 26, 2018 (inception) through December 31, 2018. Contractual Obligations Registration Rights The holders of the founder shares, private placement warrants (and any shares of common stock issuable upon the exercise of the private placement warrants), and securities that may be issued upon conversion of working capital loans will be entitled to registration rights pursuant to a registration rights agreement to be signed prior to or on the effective date of initial public offering, requiring us to register such securities for resale. The holders of the majority of these securities are entitled to make up to three demands, excluding short form demands, that we register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of a business combination and rights to require us to register for resale such securities pursuant to Rule 415 under the Securities Act. However, the registration rights agreement provides that we will not permit any registration statement filed under the Securities Act to become effective until termination of the applicable lock-up period. We will bear the expenses incurred in connection with the filing of any such registration statements. Underwriting Agreement We granted the underwriters a 45-day option from the date of the prospectus relating to the initial public offering to purchase up to 3,375,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. The underwriters partially exercised this option on October 25, 2018 to purchase 1,876,512 additional units. The underwriters were entitled to a cash underwriting discount of $0.20 per Unit, or approximately $4.88 million in the aggregate, which was paid upon the closing of the initial public offering. Business Combination Marketing Agreement We have engaged EarlyBirdCapital and Oppenheimer & Co. Inc. as advisors in connection with the business combination. We will pay EarlyBirdCapital and Oppenheimer & Co. Inc. for such services upon the consummation of the business combination (i) a cash fee in an amount equal to 3.5% of the gross proceeds of the initial public offering (exclusive of any applicable finders’ fees which might become payable) an amount equal to up to 40% of which may, in our discretion, be allocated by us to other FINRA members, plus (ii) 150,000 shares of common stock to be issued to EarlyBirdCapital and/or its designees. EarlyBirdCapital and/or its designees will be entitled to registration rights requiring us to register such shares for resale. We have agreed to use its best efforts to effect such registration in connection with the consummation of the business combination or, if not then reasonably practicable, to use our best efforts to file a registration statement covering such shares within 15 days of the closing of the business combination. Pursuant to the terms of the business combination marketing agreement, no fee will be due if we do not complete a business combination. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We had identified the following as its critical accounting policies: Common stock subject to possible redemption All of the 24,376,512 public shares contain a redemption feature which allows for the redemption of common shares under our Liquidation or Tender Offer/Stockholder Approval provisions. In accordance with FASB ASC 480, redemption provisions not solely within our control require the security to be classified outside of permanent equity. Ordinary liquidation events, which involve the redemption and liquidation of all of the entity’s equity instruments, are excluded from the provisions of FASB ASC 480. Although we did not specify a maximum redemption threshold, its charter provides that in no event will we redeem our public shares in an amount that would cause our net tangible assets (stockholders’ equity) to be less than $5,000,001. We recognize changes in redemption value immediately as they occur and adjusts the carrying value of the security at the end of each reporting period. Increases or decreases in the carrying amount of redeemable common stock shall be affected by charges against additional paid-in capital. Accordingly, at December 31, 2018, 22,576,796 public shares were classified outside of permanent equity. Net Income Per Common Share Net income per share is computed by dividing net income by the weighted-average number of common stock outstanding during the periods. We had not considered the effect of the warrants sold in the initial Public Offering (including warrants issued in connection with the consummation of the over-allotment) and private placement to purchase an aggregate of 19,263,559 shares of our common stock in the calculation of diluted income per share, since their inclusion would be anti-dilutive under the treasury stock method. Our statement of operations includes a presentation of income per share for common stock subject to redemption in a manner similar to the two-class method of income per share. Net income per share, basic and diluted for public share is calculated by dividing the interest income earned on the trust account of approximately $1.1 million, net of applicable taxes and funds available to be withdrawn from Trust, resulting in a total of approximately $808,000, by the weighted average number of public shares outstanding for the period. Net income per share, basic and diluted for founder shares is calculated by dividing the net income, less income attributable to public shares, by the weighted average number of founder shares outstanding for the period. Recent Accounting Pronouncements In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, Disclosure Update and Simplification, amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders’ equity for interim financial statements. Under the amendments, an analysis of changes in each caption of stockholders’ equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. We anticipate our first presentation of changes in stockholders’ equity, in accordance with the new guidance, will be included in its Form 10-Q for the quarter ended March 31, 2019. Management does not believe that any other recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements. Off-Balance Sheet Arrangements As of December 31, 2018, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As such, our financial statements may not be comparable to companies that comply with public company effective dates.

<s>[INST] References to the “Company,” “our,” “us” or “we” refer to Graf Industrial Corp. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements that involve risks and uncertainties. Overview We are a blank check company incorporated in Delaware on June 26, 2018 and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses that the Company has not yet identified (“business combination”). We are not limited to a particular industry or sector for purposes of consummating a business combination. Our sponsor is Graf Acquisition LLC, a Delaware limited liability company (the “sponsor”). Our registration statement for the initial public offering (the “initial public offering”) was declared effective on October 15, 2018. On October 18, 2018, we consummated the initial public offering of 22,500,000 units (the “units” and, with respect to the shares of common stock included in the units offered, the “public shares”), generating gross proceeds of  $225 million and incurred underwriting commissions of $4.5 million. On October 25, 2018, we consummated the closing of the sale of 1,876,512 additional units upon receiving notice of the underwriters’ election to partially exercise their overallotment option (the “overallotment”), generating additional gross proceeds of approximately $18.8 million, and incurring $375,302 in underwriting commissions. Simultaneously with the closing of the initial public offering and the overallotment, we consummated the private placement (“private placement”) of 14,150,605 warrants (the “private placement warrants”) at a price of  $0.50 per private placement warrant, with our sponsor, Graf Acquisition LLC, a Delaware limited liability company (the “sponsor”), generating gross proceeds of approximately $7.08 million. Upon the closing of the initial public offering, the overallotment and the private placement, approximately $243.8 million ($10.00 per Unit) of the net proceeds of the sale of the units in the initial public offering and the private placement was placed in a U.S.based trust account maintained by Continental Stock Transfer & Trust Company, acting as trustee (“trust account”). The proceeds held in the trust account were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act 1940, as amended (the “Investment Company Act”), with a maturity of 180 days or less until the earlier of: (i) the completion of a business combination, (ii) the redemption of any public shares properly submitted in connection with a stockholder vote to amend our second amended and restated certificate of incorporation (the “second amended and restated certificate of incorporation”) to modify the substance or timing of our obligation to redeem 100% of its public shares if we do not complete a business combination within 18 months from the closing of its initial public offering or to provide for redemption in connection with a business combination and (iii) the redemption of our public shares if the Company is unable to complete a business combination within 18 months from the closing of its initial public offering, subject to applicable law. In order to protect the amounts held in the trust account, our sponsor had agreed to be liable to us if and to the extent any claims by a third party for services rendered or products sold to us, or a prospective target business with which we have entered into a written letter of intent, confidentiality or similar agreement or business combination agreement, reduce the amount of funds in the trust account to below the lesser of  (i) $10.00 per public share or (ii) the actual amount per public share held in the trust account as of the date of the liquidation of the trust account, if less than $10.00 per share due to reductions [/INST] Negative. </s>

Graf Industrial Corp.

2020-03-10

2019-12-31

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS References to the “Company,” “our,” “us” or “we” refer to Graf Industrial Corp. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a blank check company incorporated in Delaware on June 26, 2018 and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses that the Company has not yet identified (a “business combination”). We are not limited to a particular industry or sector for purposes of consummating a business combination. Our sponsor is Graf Acquisition LLC, a Delaware limited liability company (the “sponsor”). Our registration statement on Form S-1 for the initial public offering (the “initial public offering”) was declared effective on October 15, 2018. On October 18, 2018, we consummated the initial public offering of 22,500,000 units (the “units” and, with respect to the shares of common stock included in the units offered, the “public shares”), generating gross proceeds of $225 million and incurring underwriting commissions of $4.5 million. On October 25, 2018, we consummated the closing of the sale of 1,876,512 additional units upon receiving notice of the underwriters’ election to partially exercise their overallotment option (the “over-allotment”), generating additional gross proceeds of approximately $18.8 million, and incurring $0.4 million in underwriting commissions. Each unit consists of one share of common stock and one redeemable warrant (a “public warrant”). Each public warrant entitled the holder to purchase one-half of one share of common stock at a price of $11.50 per share, provided, that if we have not consummated a business combination within 15 months from the closing of the initial public offering, each public warrant will entitle the holder thereof to purchase three-quarters of one share of common stock at a price of $11.50 per share (such adjustment from one-half of one share to three-quarters of one share, the “warrant adjustment provision”), subject to adjustment in either case. Simultaneously with the closing of the initial public offering and the over-allotment, we consummated the private placement (“private placement”) of 14,150,605 warrants (the “private placement warrants”) at a price of $0.50 per private placement warrant, with our sponsor, generating gross proceeds of approximately $7.08 million. Each private placement warrant has the same terms as the public warrants. We currently have outstanding warrants to purchase as aggregate of 19,263,558 shares of our common stock. As of December 31, 2019, our management had deemed that it was probable that the warrant adjustment provision would come into effect. The shares of common stock underlying our outstanding warrants increased by 9,631,779 shares on January 18, 2020, totaling 28,895,338. Upon the closing of the initial public offering, the over-allotment and the private placement, approximately $243.8 million ($10.00 per Unit) of the net proceeds of the sale of the units in the initial public offering and the private placement warrants in the private placement was placed in a U.S.-based trust account at J.P. Morgan Chase Bank, N.A. maintained by Continental Stock Transfer & Trust Company, acting as trustee (the “trust account”). The proceeds held in the trust account were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act 1940, as amended (the “Investment Company Act”), with a maturity of 180 days or less or in any open ended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a-7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a business combination, (ii) the redemption of any public shares properly submitted in connection with a stockholder vote to amend our second amended and restated certificate of incorporation (the “second amended and restated certificate of incorporation”) to modify the substance or timing of our obligation to redeem 100% of its public shares if we do not complete a business combination within 18 months from the closing of its initial public offering or to provide for redemption in connection with a business combination and (iii) the redemption of our public shares if the Company is unable to complete a business combination within 18 months from the closing of its initial public offering, subject to applicable law. In order to protect the amounts held in the trust account, our sponsor has agreed to be liable to us if and to the extent any claims by a third party for services rendered or products sold to us, or a prospective target business with which we have entered into a written letter of intent, confidentiality or similar agreement or business combination agreement, reduce the amount of funds in the trust account to below the lesser of  (i) $10.00 per public share or (ii) the actual amount per public share held in the trust account as of the date of the liquidation of the trust account, if less than $10.00 per share due to reductions in the value of the trust assets, less taxes payable, provided that such liability will not apply to any claims by a third party or prospective target business who executed a waiver of any and all rights to the monies held in the trust account (whether or not such waiver is enforceable) nor will it apply to any claims under the Company’s indemnity of the underwriters of the initial public offering against certain including liabilities under the Securities Act of 1933, as amended (the “Securities Act”). However, we have not asked the sponsor to reserve for such indemnification obligations, nor have we independently verified whether the sponsor has sufficient funds to satisfy its indemnity obligations and we believe that the sponsor’s only assets are securities of ours. Therefore, we cannot assure that the sponsor would be able to satisfy those obligations. None of our officers or directors will indemnify us for claims by third parties including, without limitation, claims by vendors and prospective target businesses. Moreover, in the event that an executed waiver is deemed to be unenforceable against a third party, the sponsor will not be responsible to the extent of any liability for such third party claims. We will seek to reduce the possibility that the sponsor will have to indemnify the trust account due to claims of creditors by endeavoring to have all vendors, service providers, prospective target businesses or other entities with which we do business, execute agreements with us waiving any right, title, interest or claim of any kind in or to monies held in the trust account. Our management has broad discretion with respect to the specific application of the net proceeds of the initial public offering, the over-allotment, and the private placement, although substantially all of the net proceeds are intended to be applied toward consummating a business combination. Going Concern As of December 31, 2019, we had approximately $698,000 outside of the trust account, approximately $5.2 million of investment income available in the trust account to pay for franchise and income taxes (less up to $100,000 of interest to pay dissolution expenses), and a working capital surplus of approximately $699,000 (excluding the warrant liability and tax obligations). Through December 31, 2019, our liquidity needs have been satisfied through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the founder shares (as defined herein) to our sponsor, $130,100 in loans and advances from our sponsor and officer, the net proceeds from the consummation of the private placement not held in Trust, and investment income released from Trust Account of approximately $1.1 million since inception for tax obligations. We repaid the loans and advances to our sponsor and officer on October 18, 2018. In addition, in order to finance transaction costs in connection with a business combination, our sponsor or an affiliate of our sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (“working capital loans”). To date, we have no borrowings under the working capital loans. In connection with our assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” management has determined that the mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate after April 18, 2020. Results of Operations Our entire activity since inception up to December 31, 2019 related to our formation, commencement of the initial public offering, and since the closing of the initial public offering, the search for a prospective initial business combination. We will not be generating any operating revenues until the closing and completion of our initial business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2019, we had a net loss of approximately $13.9 million, which consisted of approximately $17.4 million in change in fair value of warrant liabilities, approximately $617,000 in general and administrative costs, approximately $100,000 in franchise tax expense, and approximately $1.1 million in income tax expense, offset by approximately $5.2 million in investment income. For the period from June 26, 2018 (inception) through December 31, 2018, we had net income of approximately $4.1 million, which consisted of approximately $1.1 million in investment income, approximately $3.4 million in change in fair value of warrant liabilities, offset by approximately $180,000 in general and administrative costs, approximately $103,000 in franchise tax expense, and approximately $215,000 in income tax expense. Related Party Transactions Founder Shares On June 26, 2018, the sponsor purchased 8,625,000 shares (the “founder shares”) of our common stock for an aggregate price of $25,000. On September 13, 2018, the sponsor returned to us, at no cost, 2,156,250 shares of common stock, which we cancelled, resulting in the sponsor holding 6,468,750 founder shares. On October 9, 2018, the sponsor transferred 25,000 founder shares at the same per-share price paid by the sponsor to each of Keith Abell and Sabrina McKee, two of our directors (then director-nominees), resulting in the sponsor holding 6,418,750 founder shares. In addition, on October 17, 2019, our sponsor transferred 18,000 founder shares to Julie J. Levenson, one of our directors, resulting in our sponsor holding 6,026,128 founder shares. The founder shares initially included an aggregate of up to 843,750 shares subject to forfeiture by the sponsor to the extent that the underwriters’ over-allotment was not exercised in full or in part, so that out sponsor would own, on an as-converted basis, 20% of our issued and outstanding shares after the initial public offering. On October 25, 2018, the underwriters partially exercised their over-allotment option; thus, an aggregate of 374,622 founder shares was forfeited. Our sponsor has agreed, subject to certain limited exceptions, not to transfer, assign or sell any of its founder shares until the earlier to occur of: (A) one year after the completion of a business combination or (B) subsequent to a business combination, (x) if the last sale price of the common stock equals or exceeds $12.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after a business combination, or (y) the date on which we complete a liquidation, merger, capital stock exchange or other similar transaction that results in all of our stockholders having the right to exchange their shares of common stock for cash, securities or other property. Private Placement Simultaneously with the closing of the initial public offering and the over-allotment, we consummated the private placement of 14,150,605 private placement warrants at a price of $0.50 per private placement warrant, with the sponsor generating gross proceeds of approximately $7.08 million. The private placement warrants have the same terms as the warrants sold as components of the units in the initial public offering. A portion of the proceeds from the sale of the private placement warrants was added to the proceeds from the initial public offering to be held in the trust account. If we do not complete a business combination within 18 months from the closing of the initial public offering (by April 18, 2020) (the “combination period”), the private placement warrants will expire worthless. Related Party Loans During the period from June 26, 2018 (inception) through December 31, 2018, the sponsor had loaned us an aggregate of $130,000 to cover expenses related to the initial public offering pursuant to a promissory note (the “promissory note”) and James A. Graf had advanced us $100 in connection with the initial establishment of a bank account. The promissory note and the advance from James A. Graf were non-interest bearing. We repaid the promissory note and the advances to James A. Graf on October 18, 2018. There were no related party loans issued during the year ended December 31, 2019. In addition, in order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (“working capital loans”). If we complete a business combination, the Company would repay the working capital loans out of the proceeds of the trust account released to us. Otherwise, the working capital loans would be repaid only out of funds held outside the trust account. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the working capital loans but no proceeds held in the trust account would be used to repay the working capital loans. Except for the foregoing, the terms of such working capital loans, if any, have not been determined and no written agreements exist with respect to such loans. The working capital loans would either be repaid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1,500,000 of such working capital loans may be convertible into additional warrants at a price of $0.50 (or $0.75 if the Company has not consummated a business combination within 15 months from the closing of the initial public offering) per warrant. As of December 31, 2019, there were no working capital loans. Administrative Support Agreement We agreed commencing on the effective date of the initial public offering through the earlier of our consummation of a business combination and its liquidation, to reimburse an affiliate of its sponsor up to $5,000 per month for office space, utilities and secretarial and administrative support on an at-cost basis to the extent such office space, utilities and support is not contracted with us directly. We recorded and paid approximately $10,000 and $2,000 in expenses in connection with such agreement on the accompanying Statements of Operations for the year ended December 31, 2019 and for the period from June 26, 2018 (inception) through December 31, 2018, respectively. Contractual Obligations Registration Rights The holders of the founder shares, private placement warrants (and any shares of common stock issuable upon the exercise of the private placement warrants), and securities that may be issued upon conversion of working capital loans are entitled to registration rights pursuant to a registration rights agreement signed prior to the effective date of initial public offering, requiring us to register such securities for resale. The holders of the majority of these securities are entitled to make up to three demands, excluding short form demands, that we register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the completion of a business combination and rights to require us to register for resale such securities pursuant to Rule 415 under the Securities Act. However, the registration rights agreement provides that we will not permit any registration statement filed under the Securities Act to become effective until termination of the applicable lock-up period. We will bear the expenses incurred in connection with the filing of any such registration statements. Underwriting Agreement We granted the underwriters a 45-day option from the date of the prospectus relating to the initial public offering to purchase up to 3,375,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. The underwriters partially exercised this option on October 25, 2018 to purchase 1,876,512 additional units. The underwriters were entitled to a cash underwriting discount of $0.20 per Unit, or approximately $4.88 million in the aggregate, which was paid upon the closing of the initial public offering. Business Combination Marketing Agreement We have engaged EarlyBirdCapital and Oppenheimer & Co. Inc. as advisors in connection with the business combination. We will pay EarlyBirdCapital and Oppenheimer & Co. Inc. for such services upon the consummation of the business combination (i) a cash fee in an amount equal to 3.5% of the gross proceeds of the initial public offering (exclusive of any applicable finders’ fees which might become payable) an amount equal to up to 40% of which may, in our discretion, be allocated by us to other FINRA members, plus (ii) 150,000 shares of common stock to be issued to EarlyBirdCapital and/or its designees. EarlyBirdCapital and/or its designees will be entitled to registration rights requiring us to register such shares for resale. We have agreed to use its best efforts to effect such registration in connection with the consummation of the business combination or, if not then reasonably practicable, to use our best efforts to file a registration statement covering such shares within 15 days of the closing of the business combination. Pursuant to the terms of the business combination marketing agreement, no fee will be due if we do not complete a business combination. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We had identified the following as its critical accounting policies: Fair Value of Financial Instruments Fair value is defined as the price that would be received for sale of an asset or paid for transfer of a liability, in an orderly transaction between market participants at the measurement date. GAAP establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). These tiers include: · Level 1, defined as observable inputs such as quoted prices (unadjusted) for identical instruments in active markets; · Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable such as quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active; and · Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions, such as valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable. In some circumstances, the inputs used to measure fair value might be categorized within different levels of the fair value hierarchy. In those instances, the fair value measurement is categorized in its entirety in the fair value hierarchy based on the lowest level input that is significant to the fair value measurement. As of December 31, 2019 and 2018, the carrying values of cash, accounts payable, accrued expenses, franchise tax payable and income tax payable approximate their fair values due to the short-term nature of the instruments. Our investments held in Trust Account is comprised of investments in U.S. Treasury securities with an original maturity of 180 days or less and are recognized at fair value. The fair value of investments held in Trust Account is determined using quoted prices in active markets. The warrant liability is recognized at fair value. Common Stock Subject to Possible Redemption All of the 24,376,512 public shares may be redeemed under certain circumstances. Redemption provisions not solely within our control require the security to be classified outside of permanent equity, excluding ordinary liquidation events, which involve the redemption and liquidation of all of the entity’s equity instruments. Although we did not specify a maximum redemption threshold, the second amended and restated certificate of incorporation provides that in no event will we redeem our public shares in an amount that would cause our net tangible assets (stockholders’ equity) to be less than $5,000,001. We recognize changes in redemption value immediately as they occur and adjusts the carrying value of the security at the end of each reporting period. Increases or decreases in the carrying amount of redeemable common stock shall be affected by charges against additional paid-in capital. Accordingly, at December 31, 2019 and December 31, 2018, 21,182,947 and 22,576,796 public shares were classified outside of permanent equity, respectively. Net Income (Loss) Per Common Share Net income (loss) per share is computed by dividing net income (loss) by the weighted-average number of common stock outstanding during the periods. We have not considered the effect of the warrants sold in the initial public offering (including warrants issued in connection with the consummation of the over-allotment) and private placement to purchase an aggregate of 19,263,558 shares of our common stock in the calculation of diluted income per share, since their inclusion would be anti-dilutive under the treasury stock method. Our statements of operations include a presentation of loss per share for common stock subject to redemption in a manner similar to the two-class method of income per share. Net income per share, basic and diluted for Public Share for the year ended December 31, 2019 and for the period from June 26, 2018 (inception) through December 31, 2018 are calculated by dividing the investment income earned on the Trust Account, net of applicable taxes and funds available to be withdrawn from the Trust Account, resulting in a total of approximately $4.1 million and $808,000, respectively, by the weighted average number of Public Shares outstanding for the periods. Net loss per share, basic and diluted for founder shares is calculated by dividing the net income, less income attributable to public shares, resulted in a net loss of approximately $17.9 million and a net income of approximately $3.3 million for the year ended December 31, 2019 and for the period from June 26, 2018 (inception) through December 31, 2018, respectively, by the weighted average number of founder shares outstanding for the period. Recent Accounting Pronouncements In December 2019, the FASB issued ASU No. 2019-12, “Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes” (“ASU 2019-12”), which is intended to simplify various aspects related to accounting for income taxes. ASU 2019-12 removes certain exceptions to the general principles in Topic 740 and also clarifies and amends existing guidance to improve consistent application. This guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2020, with early adoption permitted. We are currently evaluating the impact of this standard on our financial statements and related disclosures. Management does not believe that any other recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations. JOBS Act The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We will qualify as an “emerging growth company” and under the JOBS Act will be allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As such, our financial statements may not be comparable to companies that comply with public company effective dates.

<s>[INST] Overview We are a blank check company incorporated in Delaware on June 26, 2018 and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses that the Company has not yet identified (a “business combination”). We are not limited to a particular industry or sector for purposes of consummating a business combination. Our sponsor is Graf Acquisition LLC, a Delaware limited liability company (the “sponsor”). Our registration statement on Form S1 for the initial public offering (the “initial public offering”) was declared effective on October 15, 2018. On October 18, 2018, we consummated the initial public offering of 22,500,000 units (the “units” and, with respect to the shares of common stock included in the units offered, the “public shares”), generating gross proceeds of $225 million and incurring underwriting commissions of $4.5 million. On October 25, 2018, we consummated the closing of the sale of 1,876,512 additional units upon receiving notice of the underwriters’ election to partially exercise their overallotment option (the “overallotment”), generating additional gross proceeds of approximately $18.8 million, and incurring $0.4 million in underwriting commissions. Each unit consists of one share of common stock and one redeemable warrant (a “public warrant”). Each public warrant entitled the holder to purchase onehalf of one share of common stock at a price of $11.50 per share, provided, that if we have not consummated a business combination within 15 months from the closing of the initial public offering, each public warrant will entitle the holder thereof to purchase threequarters of one share of common stock at a price of $11.50 per share (such adjustment from onehalf of one share to threequarters of one share, the “warrant adjustment provision”), subject to adjustment in either case. Simultaneously with the closing of the initial public offering and the overallotment, we consummated the private placement (“private placement”) of 14,150,605 warrants (the “private placement warrants”) at a price of $0.50 per private placement warrant, with our sponsor, generating gross proceeds of approximately $7.08 million. Each private placement warrant has the same terms as the public warrants. We currently have outstanding warrants to purchase as aggregate of 19,263,558 shares of our common stock. As of December 31, 2019, our management had deemed that it was probable that the warrant adjustment provision would come into effect. The shares of common stock underlying our outstanding warrants increased by 9,631,779 shares on January 18, 2020, totaling 28,895,338. Upon the closing of the initial public offering, the overallotment and the private placement, approximately $243.8 million ($10.00 per Unit) of the net proceeds of the sale of the units in the initial public offering and the private placement warrants in the private placement was placed in a U.S.based trust account at J.P. Morgan Chase Bank, N.A. maintained by Continental Stock Transfer & Trust Company, acting as trustee (the “trust account”). The proceeds held in the trust account were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act 1940, as amended (the “Investment Company Act”), with a maturity of 180 days or less or in any open ended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (d)(2), (d)(3) and (d)(4) of Rule 2a7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a business combination, (ii) the redemption of any public shares properly submitted in connection with a stockholder vote to amend our second amended and restated certificate of [/INST] Negative. </s>

Mimecast Ltd

2018-05-29

2018-03-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of our operations should be read in conjunction with Item 6. “Selected Financial Data,” our audited consolidated financial statements and related notes and other financial information included elsewhere in this Annual Report on Form 10-K. In addition to historical consolidated financial information, this discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of numerous factors, including, but not limited to, the risks discussed in Item 1A, “Risk Factors.” Our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K are prepared in accordance with accounting principles generally accepted in the United States. Overview We are a leading global provider of next generation cloud security and risk management services for corporate information and email. Our fully-integrated suite of proprietary cloud services protects customers of all sizes from the significant business and data security risks to which their email system exposes them. We protect customers from today’s rapidly changing threat landscape where email has become a powerful attack vector and data leak concern. We also mitigate the significant business disruption that email failure or downtime causes. In addition, our archiving services secure, store and manage critical corporate communications and information to address growing compliance, regulatory and e-discovery requirements and enable customers to use this increasing archive of information to improve employee productivity. We operate our business on a SaaS model with renewable annual subscriptions. Customers enter into annual and multi-year contracts to utilize various components of our services. Our subscription fee includes the use of the selected service and technical support. We believe our technology, subscription-based model, and customer support have led to our high revenue retention rate, which has helped us drive our strong revenue growth. We have historically experienced significant revenue growth from our existing customer base as they renew our services and purchase additional products. We market and sell our services to organizations of all sizes across a broad range of industries. As of March 31, 2018, we provided our services to approximately 30,400 customers and protected millions of their employees across the world. We generate sales through our network of channel partners as well as through our direct sales force. Our growth and future success depends on our ability to expand our customer base and to sell additional services to our existing customers. In the fiscal year ended March 31, 2018, we generated 51% of our revenue outside of the United States, with 31% generated from the United Kingdom, 15% from South Africa and 5% from the rest of the world. In the fiscal year ended March 31, 2017, we generated 51% of our revenue outside of the United States, with 33% generated from the United Kingdom, 15% from South Africa and 3% from the rest of the world. Our most significant growth market is the United States. We also believe that there is significant opportunity in our other existing markets. We intend to make significant investments in sales and marketing to continue expanding our customer base in our target markets. We were founded in 2003 with a mission to make email safer and better, and to transform the way organizations protect, store and access their email and corporate information. Our first service, Mimecast Email Security, which we launched in late 2003, was quickly followed by Mimecast Email Continuity. In 2004, we added Mimecast Enterprise Information Archiving. These three services generate a large proportion of our revenue today. In 2006, we started the development of our proprietary cloud architecture, which we refer to as Mime | OS™. We believed early on that investing in the development of our own cloud operating system was a strategic requirement that would enable us to integrate and scale our services. Mimecast Large File Send was released in 2013 and was followed by Mimecast Targeted Threat Protection in 2014, our advanced persistent threat protection service. In 2014, we also released comprehensive risk mitigation technologies specifically for Microsoft Office 365®, and in 2015, we released Mimecast Secure Messaging. In 2016 and 2017, we announced the newest aspects of our Targeted Threat Protection service, Impersonation Protect and Internal Email Protect, respectively. Additionally, in 2017, we acquired technology from iSheriff, Inc. to provide our customers additional real-time email threat intelligence and detection expertise complementing our existing portfolio of email security, continuity and archiving solutions. In fiscal 2018, we announced Sync & Recover, a service to enable fast mailbox recovery in the event omnipresent attackers are successful in penetrating an organization. Key Factors Affecting Our Performance We believe that the growth of our business and our future success are dependent upon a number of key factors, including the following: Acquisition of new customers. We employ a sales strategy that focuses on acquiring new customers through our direct sales force and network of channel partners, and selling additional products to existing customers. Acquiring new customers is a key element of our continued success, growth opportunity and future revenue. We have invested in and intend to continue to invest in our direct sales force and channel partners. During the year ended March 31, 2018, our customer base increased by approximately 4,000 organizations. Further penetration of existing customers. Our direct sales force, together with our channel partners and dedicated customer experience team seek to generate additional revenue from our existing customers by adding more employees and selling additional services. We continue to believe a significant opportunity exists for us to sell additional services to current customers as they experience the benefits of our services and we address additional business use cases. Investment in growth. We are expanding our operations, increasing our headcount and developing software to both enhance our current offerings and build new features. We expect our total operating expenses to increase, particularly as we continue to expand our sales operations, marketing activities and research and development team. We intend to continue to invest in our sales, marketing and customer experience organizations to drive additional revenue and support the growth of our customer base. Investments we make in our sales and marketing and research and development organizations will occur in advance of experiencing any benefits from such investments. For the year ending March 31, 2019, we plan to continue increasing the size of our sales force and to invest in the development of additional marketing content. We have increased and plan to continue to increase the size of our research and development team. Currency fluctuations. We conduct business in the United States and in other countries in North America, the United Kingdom and other countries in Europe, South Africa and other countries in Africa, and also Australia. As a result, we are exposed to risks associated with fluctuations in currency exchange rates, particularly between the U.S. dollar, the British pound and the South African rand. In the year ended March 31, 2018, 51% of our revenue was denominated in U.S. dollars, 29% in British pounds, 15% in South African rand and 5% in other currencies. Given that our functional currency and the functional currency of our subsidiaries is the local currency of each entity but our reporting currency is the U.S. dollar, devaluations of the British pound, South African rand and other currencies relative to the U.S. dollar impacts our profitability. Key Performance Indicators In addition to traditional financial metrics, such as revenue and revenue growth trends, we monitor several other key performance indicators to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. The key performance indicators that we monitor are as follows: (1) Adjusted EBITDA and revenue constant currency growth rates are non-GAAP financial measures. For a reconciliation of Adjusted EBITDA and revenue constant currency growth rates to the nearest comparable GAAP measures, see Item 6. “Selected Financial Data.” (2) Reflects the customer count on the last day of the period rounded to the nearest hundred customers. Revenue constant currency growth rate. We believe revenue constant currency growth rate is a key indicator of our operating results. We calculate revenue constant currency growth rate by translating revenue from entities reporting in foreign currencies into U.S. dollars using the comparable foreign currency exchange rates from the prior fiscal period. For further explanation of the uses and limitations of this measure and a reconciliation of our revenue constant currency growth rate to revenue, as reported, the most directly comparable GAAP measure, see Item 6. “Selected Financial Data.” Our revenue constant currency growth rate in fiscal 2018 was relatively consistent with fiscal 2017. As our total revenue grows, we expect our constant currency growth rate will decline as the incremental growth from period to period is expected to represent a smaller percentage of total revenue as compared to the prior period. Revenue retention rate. We believe that our ability to retain customers is an indicator of the stability of our revenue base and the long-term value of our customer relationships. Our revenue retention rate is driven by our customer renewals and upsells. For each of the fiscal years ended March 31, 2018, 2017 and 2016, our customer retention rate has been consistently greater than 90%. We calculate our revenue retention rate by annualizing constant currency revenue recorded on the last day of the measurement period for only those customers in place throughout the entire measurement period. We include add-on, or upsell, revenue from additional employees and services purchased by existing customers. We divide the result by revenue on a constant currency basis on the first day of the measurement period for all customers in place at the beginning of the measurement period. The measurement period is the trailing twelve months. The revenue on a constant currency basis is based on the average exchange rates in effect during the respective period. Our revenue retention rate in fiscal 2018 was relatively consistent with fiscal 2017. We expect our revenue retention rate to remain relatively consistent for fiscal 2019. Total customers. We believe the total number of customers is a key indicator of our financial success and future revenue potential. We define a customer as an entity with an active subscription contract as of the measurement date. A customer is typically a parent company or, in a few cases, a significant subsidiary that works with us directly. We expect to continue to grow our customer base through the addition of new customers in each of our markets. Gross profit percentage. Gross profit percentage is calculated as gross profit divided by revenue. Our gross profit percentage has been relatively consistent over the past three years, however has fluctuated on a quarterly basis due to timing of the addition of hardware and employees to serve our growing customer base. We provide our services in each of the regions in which we operate. Costs related to supporting and hosting our product offerings and delivering our services are incurred in the region in which the related revenue is recognized. As a result, our gross profit percentage in actual terms is consistent with gross profit on a constant currency basis. Adjusted EBITDA. We believe that Adjusted EBITDA is a key indicator of our operating results. We define Adjusted EBITDA as net (loss) income, adjusted to exclude: depreciation, amortization, disposals and impairments of long-lived assets, share-based compensation expense, restructuring expense, interest income and interest expense, provision for income taxes and foreign exchange (expense) income and includes rent paid in the period related to locations that are accounted for as build-to-suit facilities. For further explanation of the uses and limitations of this measure and a reconciliation of our Adjusted EBITDA to the most directly comparable GAAP measure, net (loss) income, see Item 6. “Selected Financial Data.” We expect that our Adjusted EBITDA will continue to increase; however, we expect that our operating expenses will also increase in absolute dollars as we focus on expanding our sales and marketing teams and growing our research and development capabilities. Components of Consolidated Statements of Operations Revenue We generate substantially all of our revenue from subscription fees paid by customers accessing our cloud services and by customers purchasing additional support beyond the standard support that is included in our basic subscription fees. A small portion of our revenue consists of related professional services and other revenue, which consists primarily of set-up fees, ingestion fees and training fees. We generally license our services on a price per employee basis under annual contracts. Some services, such as ingestion services, are invoiced upfront and recognized on a straight-line basis over the longer of the contract term or the average customer life. We serve approximately 30,400 customers in multiple industries, and our revenue is not concentrated with any single customer or industry. For each of the years ended March 31, 2018, 2017 and 2016, no single customer accounted for more than 1% of our revenue, and our largest ten customers accounted for less than 10% of our revenue in aggregate. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. As of March 31, 2018, deferred revenue was $141.1 million. We estimate the future recognition of deferred revenue as of March 31, 2018 to be $123.1 million in 2019, $8.0 million in 2020, $5.3 million in 2021, $2.6 million in 2022 and $2.1 million thereafter. We have continued to expand our customer base, and have recently signed on more customers with monthly, instead of annual, billing terms. The proportion of aggregate contract value reflected on our balance sheet as deferred revenue may decrease if this trend continues. We recognize revenue ratably on a straight-line basis over the subscription term, which is typically one year in duration, provided that an enforceable contract has been signed by both parties, we have given the customer access to our SaaS solutions, collection of the fee is probable, and the fee is fixed or determinable. Our subscription service arrangements do not contain refund-type provisions. Our professional services contracts are on a time and material basis. When these services are not combined with subscription revenues as a single unit of accounting, as discussed in the section below entitled “-Critical Accounting Policies and Estimates,” these revenues are recognized as the services are rendered. Cost of revenue Cost of revenue primarily consists of expenses related to supporting and hosting our product offerings and delivering our professional services. These costs consist primarily of personnel and related costs including salaries, benefits, bonuses and share-based compensation expense related to the management of our data centers, our customer support team and our professional services team. In addition to these expenses, we incur third-party service provider costs such as data center and networking expenses, allocated overhead costs, depreciation expense and amortization expense related to intangible assets. We allocate overhead costs, such as rent and facility costs, information technology costs and employee benefit costs to all departments based on headcount. As such, general overhead expenses are reflected in cost of revenue and each operating expense category. We expect our cost of revenue to increase in absolute dollars due to expenditures related to the purchase of hardware, expansion and support of our data center operations and customer support teams. We also expect that cost of revenue as a percentage of revenue will decrease over time as we are able to achieve economies of scale in our business, although it may fluctuate from period to period depending on the timing of significant expenditures. To the extent that our customer base grows, we intend to continue to invest additional resources in expanding the delivery capability of our products and other services. The timing of these additional expenses could affect our cost of revenue, both in terms of absolute dollars and as a percentage of revenue in any particular quarterly or annual period. Research and development expenses Research and development expenses consist primarily of personnel and related costs, including salaries, benefits, bonuses, share-based compensation expense, costs of server usage by our developers and allocated overhead costs. We expense all research and development costs as they are incurred. We have focused our efforts on developing new versions of our SaaS technology with expanded features. Our technology is constantly being refined and, as such, we do not capitalize development costs. We believe that continued investment in our technology is important for our future growth. As a result, we expect research and development expenses to increase in absolute dollars as we make further substantial investments in developing our Mime | OS™ platform, improving our existing services and creating new features that will increase the functionality of our new and existing products. Research and development expenses as a percentage of total revenue may fluctuate on a quarterly basis but we expect it to increase in the coming fiscal year as a result of the expected investments noted above. Sales and marketing expenses Sales and marketing expenses consist primarily of personnel and related costs, including salaries, benefits, bonuses, commissions and share-based compensation expense. In addition to these expenses, we incur costs related to marketing and promotional events, online marketing, product marketing and allocated overhead costs. We expense all costs as they are incurred, including sales commissions. Sales and marketing expenses increased substantially in fiscal 2018 as we continued to expand our sales and marketing efforts globally, particularly in the United States. We expect that our sales and marketing expenses will continue to increase substantially in the year ending March 31, 2019. New sales personnel require training and may take several months or more to achieve productivity; as such, the costs we incur in connection with the hiring of new sales personnel in a given period are not typically offset by increased revenue in that period and may not result in new revenue if these sales personnel fail to become productive. We expect to increase our investment in sales and marketing as we add new services, which will increase these expenses in absolute dollars. Over the long term, we believe that sales and marketing expenses as a percentage of revenue will decrease, but will vary depending upon the mix of revenue from new and existing customers, as well as changes in the productivity of our sales and marketing programs. General and administrative expenses General and administrative expenses consist primarily of personnel and related expenses for executive, legal, finance, information technology and human resources functions, including salaries, benefits, incentive compensation and share-based compensation expense, in addition to the costs associated with professional fees, insurance premiums, other corporate expenses and allocated overhead costs. We expect general and administrative expenses to increase in absolute dollars as we continue to incur additional personnel and professional services costs in order to support business growth as well as meeting the compliance requirements of operating as a public company, including those costs incurred in connection with Section 404 of the Sarbanes-Oxley Act, costs associated with the loss of our status as a foreign private issuer, and costs associated with the adoption of new accounting standards, including ASC 606, Revenue Recognition, and ASU 2016-02, Leases, among others. Over the long term, we believe that general and administrative expenses as a percentage of revenue will decrease. Impairments of long-lived assets In the fourth quarter of fiscal 2018, upon the exit of our Watertown, Massachusetts corporate office space, we recorded a non-cash impairment charge of $1.7 million primarily related to leasehold improvements. Restructuring In the fourth quarter of fiscal 2018, upon the exit of our Watertown, Massachusetts corporate office space, we recorded a restructuring charge in the amount of $0.8 million for the remaining non-cancelable rent and estimated operating expenses, net of sublease rentals, for the vacated premises, in accordance with ASC 840-20, Leases. Other income (expense) Other income (expense) is comprised of the following items: Interest income Interest income includes interest income earned on our cash, cash equivalents and investments balances. We expect interest income to vary each reporting period depending on our average cash, cash equivalents and investments balances during the period and market interest rates. We expect interest income to increase in the fiscal year ending March 31, 2019 due to higher yields on cash deposits and investments. Interest expense Interest expense consists primarily of interest expense associated with our construction financing lease obligations, capital leases and our long-term debt, which was fully repaid in fiscal 2018. Foreign exchange income Foreign exchange income consists primarily of foreign exchange fluctuations related to short-term intercompany accounts and foreign currency exchange gains and losses related to transactions denominated in currencies other than the functional currency for each of our subsidiaries. We expect our foreign currency exchange gains and losses to continue to fluctuate in the future as foreign currency exchange rates change, however, we expect foreign currency exchange gains and losses could be less significant in the fiscal year ending March 31, 2019 as compared to the fiscal year ended March 31, 2018 due to the capitalization and repayment of certain intercompany balances during fiscal 2018. Provision for income taxes We operate in several tax jurisdictions and are subject to taxes in each country or jurisdiction in which we conduct business. We account for income taxes in accordance with the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases for assets and liabilities using statutory rates. In addition, this method requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Our provision for income taxes for the fiscal years ended March 31, 2018, 2017 and 2016 primarily relates to our South African entity. Operating Results The following table sets forth selected consolidated statements of operations data for each of the periods indicated: The following table sets forth our consolidated statements of operations data as a percentage of revenue for each of the periods indicated: We have operations in jurisdictions other than the United States and generate revenue and incur expenditures in currencies other than the U.S. dollar. The following information shows the effect on certain components of our consolidated statements of operations data for each of the periods indicated based on a 10% increase or decrease in foreign currency exchange rates assuming that all foreign currency exchange rates move in the same directions at the same time: Comparison of Years Ended March 31, 2018 and 2017 Revenue Revenue increased $75.3 million in the year ended March 31, 2018 compared to the year ended March 31, 2017. The increase in revenue was primarily attributable to increases in new customers, including the 4,000 new customers added since March 31, 2017, a full year of revenue related to new customers added during fiscal 2017 and additional revenue from customers that existed as of March 31, 2017. Revenue for the year ended March 31, 2018 compared to the year ended March 31, 2017 was positively impacted by approximately $4.7 million primarily as a result of the weakening of the U.S. dollar relative to the South African rand and to a lesser extent the British pound. Cost of revenue Cost of revenue increased $19.4 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to increases in personnel-related costs of $5.8 million, data center costs of $5.4 million, depreciation expense of $3.9 million, information technology and facility costs of $1.9 million, amortization of intangibles of $1.4 million and professional services costs of $0.8 million. Cost of revenue for the year ended March 31, 2018 compared to the year ended March 31, 2017 was negatively impacted by approximately $1.1 million primarily as a result of the weakening of the U.S. dollar relative to the South African rand and British pound. Personnel-related cost increased primarily as a result of salaries and benefits associated with increased headcount, data center costs increased as a result of the increase in our customer base, and depreciation increased primarily as a result of increased capital expenditures in support of our expanding infrastructure. In addition, the increase in information technology and facility costs is primarily a result of increased headcount and the increase in amortization of intangibles is primarily as a result of amortization of capitalized software. As a result of changes in foreign exchange rates, gross profit increased in absolute dollars by approximately $3.6 million for the year ended March 31, 2018 as compared to the year ended March 31, 2017. Operating expenses nm-not meaningful Research and development expenses Research and development expenses increased $15.8 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to increases in personnel-related costs of $10.1 million, information technology and facility costs of $2.3 million, professional services costs of $0.9 million, share-based compensation expense of $0.7 million, travel and other costs of $0.5 million and data center costs of $0.5 million. Research and development expenses for the year ended March 31, 2018 as compared to the year ended March 31, 2017 were negatively impacted by approximately $0.5 million primarily as a result of the weakening of the U.S. dollar relative to the British pound. Personnel-related cost increased primarily as a result of salaries and benefits associated with increased headcount throughout the year, information technology and facility costs increased primarily as a result of increased headcount, professional services costs increased primarily as a result of the use of research and development contractors and share-based compensation expense increased primarily as a result of share option grants since the prior year. Sales and marketing expenses Sales and marketing expenses increased $25.1 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to increases in personnel-related costs of $13.5 million, marketing costs of $4.7 million, information technology and facilities costs of $3.6 million, travel and other costs of $2.3 million and professional services of $0.8 million. Sales and marketing expenses for the year ended March 31, 2018 as compared to the year ended March 31, 2017 were negatively impacted by approximately $1.4 million primarily as a result of the weakening of the U.S. dollar relative to the South African rand and British pound. Personnel-related costs increased primarily as a result of salaries and benefits associated with increased headcount. Information technology and facility costs and travel and other costs increased primarily as a result of increased headcount. General and administrative expenses General and administrative expenses increased $9.1 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to increases in personnel-related costs of $5.0 million, share-based compensation expense of $1.2 million, information technology and facilities costs of $1.0 million and professional services costs and material supplies of $0.6 million each. General and administrative expenses for the year ended March 31, 2018 as compared to the year ended March 31, 2017 were negatively impacted by approximately $0.3 million primarily as a result of the weakening of the U.S. dollar against the British pound and South African rand. Personnel-related costs increased primarily as a result of salaries and benefits associated with increased headcount. Share-based compensation expense increased primarily as a result of share option grants since the prior year. Information technology and facility and material supplies costs increased primarily as a result of increased headcount. Restructuring and Impairment of long-lived assets In the fourth quarter of fiscal 2018, upon the exit of our Watertown, Massachusetts corporate office space, we recorded a restructuring charge of $0.8 million for remaining non-cancelable rent and estimated operating expenses for the vacated premises, net of sublease rentals, and a non-cash impairment charge of $1.7 million primarily related to leasehold improvements. Other income (expense) nm-not meaningful Other income (expense) changed $9.9 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to a change of $10.4 million in foreign exchange expense which was primarily attributable to the re-measurement of short-term intercompany balances denominated in currencies other than the functional currency of our operating units. The increase in interest income is primarily due to interest on investments. Provision for income taxes Provision for income taxes increased $0.5 million in the year ended March 31, 2018 compared to the year ended March 31, 2017. The provision for income taxes in each period was primarily attributable to taxes related to our South African entity. The increase in the provision for income taxes from the prior period was primarily attributable to withholding taxes accrued by our Australian entity combined with an increase in the earnings in South Africa. Comparison of Years Ended March 31, 2017 and 2016 Revenue Revenue increased $44.7 million in the year ended March 31, 2017 compared to the year ended March 31, 2016. The increase in revenue was primarily attributable to increases in new customers, including the 8,400 new customers added during fiscal 2017, a full year of revenue related to new customers added in fiscal 2016 and additional revenue from customers that existed as of March 31, 2016. Revenue for the year ended March 31, 2017 compared to the year ended March 31, 2016 was negatively impacted by approximately $9.9 million primarily as a result of the strengthening of the U.S. dollar relative to the British pound and to a lesser extent the South African rand. Cost of revenue Cost of revenue increased $8.5 million in the year ended March 31, 2017 compared to the year ended March 31, 2016, which was primarily attributable to increases in data center costs of $3.9 million, personnel-related costs of $2.7 million, depreciation expense of $1.0 million and share-based compensation expense of $0.7 million. Cost of revenue for the year ended March 31, 2017 compared to the year ended March 31, 2016 was positively impacted by approximately $3.2 million primarily as a result of the strengthening of the U.S. dollar relative to the British pound. Data center costs increased as a result of the increase in our customer base, personnel-related cost increased primarily as a result of salaries and benefits associated with increased headcount, depreciation increased primarily as a result of increased capital expenditures in support of our expanding infrastructure and share-based compensation expense increased primarily as a result of an increase in share option modification charges. As a result of changes in foreign exchange rates, gross profit decreased in absolute dollars by approximately $6.7 million for the year ended March 31, 2017 as compared to the year ended March 31, 2016. Excluding the impact of changes in foreign currency exchange rates, gross profit as a percentage of revenue remained consistent as costs related to supporting and hosting our product offerings and delivering our services are incurred in the region in which the related revenue is recognized. Operating expenses nm-not meaningful Research and development expenses Research and development expenses increased $4.9 million in the year ended March 31, 2017 compared to the year ended March 31, 2016, which was primarily attributable to increases in personnel-related costs of $3.5 million, information technology and facility costs of $0.5 million, travel and other costs of $0.3 million, professional services costs of $0.2 million and share-based compensation expense of $0.2 million. Research and development expenses for the year ended March 31, 2017 as compared to the year ended March 31, 2016 were positively impacted by approximately $2.8 million primarily as a result of the strengthening of the U.S. dollar relative to the British pound. Personnel-related cost increased primarily as a result of salaries and benefits associated with increased headcount throughout the year and professional services costs increased primarily as a result of the use of research and development contractors. Sales and marketing expenses Sales and marketing expenses increased $31.0 million in the year ended March 31, 2017 compared to the year ended March 31, 2016, which was primarily attributable to increases in personnel-related costs of $17.3 million, marketing costs of $7.4 million, travel and other costs of $2.0 million, share-based compensation expense of $1.5 million, professional services of $1.3 million and information technology and facilities costs of $1.1 million. Sales and marketing expenses for the year ended March 31, 2017 as compared to the year ended March 31, 2016 were positively impacted by approximately $3.9 million primarily as a result of the strengthening of the U.S. dollar relative to the British pound. Personnel-related costs increased primarily as a result of salaries, benefits and commissions associated with increased headcount. Marketing costs increased primarily as a result of increased lead generation, online marketing, brand development costs and advertising. General and administrative expenses General and administrative expenses increased $8.1 million in the year ended March 31, 2017 compared to the year ended March 31, 2016, which was primarily attributable to increases in personnel-related costs of $4.3 million, professional services costs of $2.9 million and information technology and facilities costs of $0.3 million. General and administrative expenses for the year ended March 31, 2017 as compared to the year ended March 31, 2016 were positively impacted by approximately $1.0 million primarily as a result of the strengthening of the U.S. dollar against the British pound. Personnel-related costs increased primarily as a result of salaries and benefits associated with increased headcount. Professional service costs increased primarily due to accounting, consulting and legal services associated with operating as a public company. In addition, we incurred $0.6 million of expenses related to the October 2016 secondary offering and $0.7 million in transaction costs related to the iSheriff transaction. Other income (expense) nm-not meaningful Other income (expense) increased $6.9 million in the year ended March 31, 2017 compared to the year ended March 31, 2016, which was primarily attributable to a $6.1 million increase in foreign exchange income associated with the re-measurement of short-term intercompany balances as well as working capital balances denominated in currencies other than the functional currency of our operating units. The increase in foreign exchange income is a result of the British pound weakening compared to the foreign currencies in which we operate to a greater extent in fiscal 2017 as compared to fiscal 2016. The increase in interest income is primarily due to higher weighted-average cash and investment balances after our initial public offering, or IPO. The decrease in interest expense is primarily due to a decrease in weighted-average debt balances. Provision for income taxes Provision for income taxes increased $1.3 million in the year ended March 31, 2017 compared to the year ended March 31, 2016. The provision for income taxes in each period was primarily attributable to taxes related to our South African entity and the increase in the provision for income taxes from the prior period was primarily due to increased net pre-tax income in that entity. Liquidity and Capital Resources Our principal sources of liquidity are cash and cash equivalents, investments and accounts receivable. The following table shows net cash provided by operating activities, net cash used in investing activities, and net cash provided by (used in) financing activities for the years ended March 31, 2018, 2017 and 2016: In November 2015, we raised net proceeds of $68.3 million in our IPO, after deducting underwriting discounts and commissions and offering expenses paid by us. Prior to our IPO in November 2015, we financed our operations primarily through private placements of equity and borrowings from our primary bank lender. In the years ended March 31, 2018 and 2017, we incurred operating losses of $7.0 million and $10.4 million, respectively. While we expect to generate an operating loss in the year ending March 31, 2019, we expect to continue to generate positive cash flows from operating activities. In the year ending March 31, 2019, we plan to continue to invest in the development and expansion of our Mime | OS™ platform to improve on our existing solutions in order to provide more capabilities to our customers. Investments in capital expenditures in the year ended March 31, 2018 were $34.5 million of which $24.5 million related to the expansion of our grid architecture. We expect that with the exception of the $3.8 million we invested in the development of our German data centers, that this level of investment will be consistent in the year ending March 31, 2019. As of March 31, 2018 and 2017, we had cash, cash equivalents and investments of $137.2 million and $111.7 million, respectively. Based on our current operating plan, we believe that our current cash and cash equivalents, investments and operating cash flows will be sufficient to fund our operations for at least the next twelve months. Our future capital requirements may vary materially from those planned and will depend on certain factors, such as our growth and our operating results. If we require additional capital resources to grow our business or to acquire complementary technologies and businesses in the future, we may seek to sell additional equity or raise funds through debt financing or other sources. We may also seek to invest in or acquire complementary businesses, applications or technologies, any of which could also require us to seek additional equity or debt financing. We cannot provide assurance that additional financing will be available at all or on terms favorable to us. We had no material commitments for capital expenditures as of March 31, 2018 or 2017. Borrowings Since January 2012, we have entered into various term loan borrowings with Silicon Valley Bank. The term loans had fixed interest rates of 4.5% and principal repayment periods of 36 equal monthly installments maturing in January 2018. As of March 31, 2017, the aggregate principal balance of the term loans was $1.7 million, all of which was paid in the year ended March 31, 2018. As of March 31, 2018 and March 31, 2017, there were no amounts available for future borrowings under the term loans. We were in compliance with all covenants under the agreement through March 31, 2018. Operating activities For the year ended March 31, 2018, cash provided by operating activities was $46.4 million. The primary factors affecting our operating cash flows during the period were our net loss of $12.4 million, adjusted for non-cash items of $19.0 million for depreciation and amortization of our property, equipment and intangible assets, $11.7 million of share-based compensation expense, and $3.0 million in unrealized foreign currency gains on foreign denominated transactions primarily, intercompany balances and $1.7 million of long-lived asset impairments. The drivers of the changes in operating assets and liabilities were a $39.0 million increase in deferred revenue and $7.1 million increase in accrued expenses and other current liabilities and a $0.1 million increase in accounts payable, partially offset by an $18.1 million increase in accounts receivable and a $5.0 million increase in prepaid expenses and other current assets. For the year ended March 31, 2017, cash provided by operating activities was $32.5 million. The primary factors affecting our operating cash flows during the period were our net loss of $5.4 million, adjusted for non-cash items of $11.9 million for depreciation and amortization of our property and equipment and intangible assets, $10.3 million of share-based compensation expense, and $6.5 million in unrealized foreign currency gains on foreign denominated transactions primarily, intercompany balances. The drivers of the changes in operating assets and liabilities were a $29.1 million increase in deferred revenue, a $4.9 million increase in accrued expenses and other liabilities, a $1.9 million decrease in other assets and a $0.8 million increase in accounts payable, partially offset by a $11.8 million increase in accounts receivable and a $2.8 million increase in prepaid expenses and other current assets. For the year ended March 31, 2016, cash provided by operating activities was $24.6 million. The primary factors affecting our operating cash flows during the period were our net loss of $3.2 million, adjusted for non-cash items of $10.5 million for depreciation and amortization of our property and equipment, $7.9 million of share-based compensation expense, and $1.0 million in net foreign currency gains. The drivers of the changes in operating assets and liabilities were an $18.6 million increase in deferred revenue and a $4.7 million increase in accrued expenses and other liabilities, partially offset by a $9.8 million increase in accounts receivable, a $2.2 million increase in prepaid expenses and other current assets, a $0.5 million decrease in accounts payable and a $0.4 million increase in other assets. Investing activities Cash used in investing activities of $35.0 million for the year ended March 31, 2018 consisted primarily of $34.5 million in capital expenditures and $1.4 million in payments related to the iSheriff and other acquisitions, partially offset by net purchase and maturity activity on investments of $0.9 million. Cash used in investing activities of $84.6 million for the year ended March 31, 2017 consisted of $67.6 million in purchases of investments, $18.5 million in capital expenditures and $5.6 million in payments related to the iSheriff acquisition partially offset by $7.0 million in maturities of investments. Cash used in investing activities of $14.2 million for the year ended March 31, 2016 was due to capital expenditures. Our capital expenditures were associated primarily with computer equipment purchased in support of our expanding infrastructure and to a lesser extent leasehold improvements and office equipment associated with increased headcount. Financing activities Cash provided by financing activities of $13.2 million for the year ended March 31, 2018 was primarily due to $17.0 million of proceeds from issuance of ordinary shares from share option exercises and our employee stock purchase plan, partially offset by payments on debt of $1.8 million, payments on capital lease obligations of $1.0 million and payments on construction financing lease obligation of $1.0 million. Cash used in financing activities of $0.3 million for the year ended March 31, 2017 was primarily due to payments on debt of $4.6 million and payments on capital lease obligations of $0.2 million, partially offset by $4.5 million of proceeds from exercises of share options. Cash provided by financing activities of $63.8 million for the year ended March 31, 2016 was due primarily to $68.3 million in proceeds from our IPO, net of issuance costs, and $0.9 million of proceeds from exercises of share options, partially offset by payments on debt of $5.4 million. Net operating loss carryforwards As of March 31, 2018, we had U.K. net operating loss carryforwards of approximately $52.6 million that do not expire. As of March 31, 2018, we had U.S. federal net operating loss carryforwards of approximately $56.4 million. U.S. federal net operating loss carryforwards generated through March 31, 2017 of approximately $31.5 million expire at various dates through 2037, and U.S. federal net operating loss carryforwards generated during the year ended March 31, 2018 of approximately $24.9 million do not expire. As of March 31, 2018, we had U.S. state net operating loss carryforwards of approximately $39.5 million that expire at various dates through 2038. As of March 31, 2018, we had Australian net operating loss carryforwards of approximately $17.3 million that do not expire. As of March 31, 2018, the Company had Germany net operating loss carryforwards of approximately $2.4 million that do not expire. As of March 31, 2018, the Company had a U.K. income tax credit carryforward of $1.2 million that does not expire. On April 1, 2017, we adopted ASU No. 2016-09, Compensation - Stock Compensation (ASU 2016-09). In connection with the adoption, we are required to recognize all excess tax benefits and tax deficiencies attributable to share-based compensation as either income tax expense or tax benefit in the income statement in the period when the awards vest or are settled. We applied this amendment prospectively to excess tax benefits and tax deficiencies arising from vesting or settlement after the adoption date. ASU 2016-09 also requires excess tax benefits to be recognized, regardless as to whether the benefit reduces taxes payable in the current period. We adopted this guidance using a modified retrospective transition method and recorded a cumulative-effect adjustment for certain off-balance sheet net operating loss carryforwards to retained earnings and deferred tax assets with an equal offsetting adjustment to our valuation allowance of approximately $7.4 million. In assessing our ability to realize our net deferred tax assets, we considered various factors including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations, to determine whether it is more likely than not that some portion or all of our net deferred tax assets will not be realized. Based upon these factors, we have determined that the uncertainty regarding the realization of these assets is sufficient to warrant the need for a full valuation allowance against our net deferred tax assets. Off-balance sheet arrangements Up to and including the fiscal year ended March 31, 2018, we have not had any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As a result, we are not exposed to related financing, liquidity, market or credit risks that could arise if we had engaged in those types of arrangements. Contractual obligations and commitments The following table represents our contractual obligations as of March 31, 2018, aggregated by type: We lease our facilities under non-cancelable operating leases with various expiration dates through January 2028. We have outstanding letters of credit of $3.8 million related to certain operating leases. Recently issued and adopted accounting pronouncements For information on recent accounting pronouncements, see Note 2. “Summary of Significant Accounting Policies” in the notes to the consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K. Critical accounting policies and estimates Our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Changes in accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from our estimates. We evaluate our estimates and assumptions on an ongoing basis. To the extent that there are material differences between our estimates and our actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that of our significant accounting policies, which are described in Note 2 to the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of our operations. Revenue Recognition We derive our revenue from two sources: (1) subscription revenues, which are comprised of subscription fees from customers accessing our cloud services and from customers purchasing additional support beyond the standard support that is included in the basic subscription fees; and (2) related professional services and other revenue, which consists primarily of set-up and ingestion fees as well as training fees. We recognize revenue when all of the following conditions are satisfied: • there is persuasive evidence of an arrangement; • the service has been or is being provided to the customer; • the collection of the fees is probable; and • the amount of fees to be paid by the customer is fixed or determinable. Our subscription arrangements provide customers the right to access our hosted software applications. Customers do not have the right to take possession of our software during the hosting arrangement. Accordingly, we recognize revenue in accordance with ASC 605, Revenue Recognition, and Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. We sell our products and services directly through our sales force and also indirectly through third-party resellers. In accordance with the provisions of ASC 605, we have considered certain factors in determining whether the end-user or the third-party reseller is our customer in arrangements involving resellers. We concluded that in the majority of transactions with resellers, the reseller is our customer. In these arrangements, we considered that it is the reseller, and not us, that has the relationship with the end-user. Specifically, the reseller has the ability to set pricing with the end-user and the credit risk with the end-user is borne by the reseller. Further, the reseller is not obligated to report its transaction price with the end-user to us, and in the majority of transactions, we are unable to determine the amount paid by the end-user customer to the reseller in these transactions. As a result of such considerations, revenue for these transactions is presented in the accompanying consolidated statements of operations based upon the amount billed to the reseller. For transactions where we have determined that the end-user is the ultimate customer, revenue is presented in the accompanying consolidated statements of operations based on the transaction price with the end-user. We recognize subscription and support revenue ratably over the term of the contract, typically one year in duration, beginning on the commencement date of each contract. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. Our professional services contracts are on a time and material basis. When these services are not combined with subscription revenues as a single unit of accounting, as discussed below, we recognize these revenues as the services are rendered. Revenue is presented net of any taxes collected from customers. We may enter into arrangements with multiple-deliverables that generally include multiple subscriptions, premium support and professional services. For arrangements with multiple deliverables, we evaluate each deliverable to determine whether it represents a separate unit of accounting based on the following criteria: (a) whether the delivered item has value to the customer on a stand-alone basis; and (b) if the contract includes a general right of return relative to the delivered item, whether delivery or performance of the undelivered items is considered probable and substantially within our control. If the deliverables are determined to qualify as separate units of accounting, consideration is allocated to each unit of accounting based on the units’ relative selling prices. We determine the relative selling price for a deliverable based on its vendor-specific objective evidence of fair value, or VSOE, if available, or its best estimate of selling price, if VSOE is not available. We have determined that third-party evidence of selling price is not a practical alternative due to differences in our service offerings compared to other parties and the availability of relevant third-party pricing information. The amount of revenue allocated to delivered items is limited by contingent revenue, if any. Subscription services have standalone value as such services are often sold separately. In determining whether professional services sold together with the subscription services have standalone value, we consider the following factors for each professional services agreement: availability of the services from other vendors, the nature of the professional services, the determination that customers cannot resell the services that we provide, the timing of when the professional services contract was signed in comparison to the subscription service start date and the contractual dependence of the subscription service on the customer’s satisfaction with the professional services work. Professional services sold at the time of the multiple-element subscription arrangement typically include customer set-up and ingestion services. To date, we have concluded that all of these professional services included in executed multiple-deliverable arrangements do not have standalone value and are therefore not considered separate units of accounting. These professional services are purchased by customers only in contemplation of, or in concert with, purchasing one of our hosted subscription solutions and, therefore, are not considered a substantive service, such that the provision of such service does not reflect the culmination of the earnings process. We do not sell these services without the related underlying primary subscription as there would be no practical interest or need on the behalf of a customer to buy these services without the underlying subscription. We do not have any knowledge of other vendors selling these services on a stand-alone basis and there is no way for an end-user to resell the deliverable. Accordingly, the deliverables within the arrangement including both subscription services and other professional services are accounted for as a single unit of accounting. On these occasions, revenue for the professional services deliverables in the arrangement is recognized on a straight-line basis over the contractual term or the average customer life, as further described below. Deferred revenue primarily consists of billings or payments received in advance of revenue recognition from subscription services described above and is recognized as the revenue recognition criteria are met. In addition, deferred revenue consists of amounts paid by customers related to upfront set-up or ingestion fees. Revenue related to such services is recognized over the contractual term or the average customer life, whichever is longer. The estimated customer life has been determined to be six years. Deferred revenue that is expected to be recognized during the succeeding twelve-month period is recorded as current deferred revenue and the remaining portion is recorded as non-current in the accompanying consolidated balance sheets. Income taxes We are subject to income tax in the United Kingdom, the United States and other international jurisdictions, and we use estimates in determining our provision for income taxes. We account for income taxes in accordance with ASC 740, Income Taxes. ASC 740 is an asset and liability approach that requires recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the carrying amounts of assets and liabilities for financial reporting purposes and their respective tax basis, and for net operating loss and tax credit carryforwards. ASC 740 requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. In making such determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance. We recognize the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained on examination by the tax authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such position are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. As of March 31, 2018 and 2017, we did not have any uncertain tax positions that would impact our net tax provision if recognized. Accounting for share-based compensation awards We account for share-based compensation awards in accordance with the provisions of ASC 718, Compensation-Stock Compensation, which requires the recognition of expense related to the fair value of share-based compensation awards in the statements of operations. For service-based awards, we recognize share-based compensation expense on a straight-line basis over the requisite service period of the award. In connection with the adoption of ASU 2016-09 on April 1, 2017, we changed our accounting policy to record actual forfeitures as they occur, rather than estimating forfeitures by applying a forfeiture rate. This change has been applied on a modified retrospective basis, resulting in a cumulative effect adjustment on the date of adoption, which increased accumulated deficit and additional paid-in-capital by $0.1 million. For additional information, see Note 2 to the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Share Options We estimate the fair value of employee share options on the date of grant using the Black-Scholes option-pricing model, which requires the use of highly subjective estimates and assumptions. We estimate the expected term of share options for service-based awards utilizing the “Simplified Method,” as we do not have sufficient historical share option exercise information on which to base our estimate. The Simplified Method is based on the average of the vesting tranches and the contractual life of each grant. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the share option. Since there was no public market for our ordinary shares prior to the IPO and as our shares have been publicly traded for a limited time, we determined the expected volatility for options granted based on an analysis of reported data for a peer group of companies that issue options with substantially similar terms. The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies. We use an expected dividend rate of zero as we currently have no history or expectation of paying dividends on our ordinary shares. The grant date fair value of our ordinary shares at the time of each share option grant is based on the closing market value on the date of grant. Employee Stock Purchase Plan (ESPP) We estimate the fair value of ESPP share options on the date of grant using the Black-Scholes option-pricing model, which requires the use of highly subjective estimates and assumptions. We estimate the expected term of ESPP share options based on the length of each offering period, which is six months. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the ESPP share option. Expected volatility is based on our historical volatility. We use an expected dividend rate of zero as we currently have no history or expectation of paying dividends on our ordinary shares. The grant date fair value per ordinary share is based on the closing market value on the first day of each ESPP offering period. Restricted Share Units (RSUs) For restricted share units issued under our share-based compensation plans, the fair value of each grant is calculated based on the closing market value of our ordinary shares on the date of grant.

<s>[INST] Overview We are a leading global provider of next generation cloud security and risk management services for corporate information and email. Our fullyintegrated suite of proprietary cloud services protects customers of all sizes from the significant business and data security risks to which their email system exposes them. We protect customers from today’s rapidly changing threat landscape where email has become a powerful attack vector and data leak concern. We also mitigate the significant business disruption that email failure or downtime causes. In addition, our archiving services secure, store and manage critical corporate communications and information to address growing compliance, regulatory and ediscovery requirements and enable customers to use this increasing archive of information to improve employee productivity. We operate our business on a SaaS model with renewable annual subscriptions. Customers enter into annual and multiyear contracts to utilize various components of our services. Our subscription fee includes the use of the selected service and technical support. We believe our technology, subscriptionbased model, and customer support have led to our high revenue retention rate, which has helped us drive our strong revenue growth. We have historically experienced significant revenue growth from our existing customer base as they renew our services and purchase additional products. We market and sell our services to organizations of all sizes across a broad range of industries. As of March 31, 2018, we provided our services to approximately 30,400 customers and protected millions of their employees across the world. We generate sales through our network of channel partners as well as through our direct sales force. Our growth and future success depends on our ability to expand our customer base and to sell additional services to our existing customers. In the fiscal year ended March 31, 2018, we generated 51% of our revenue outside of the United States, with 31% generated from the United Kingdom, 15% from South Africa and 5% from the rest of the world. In the fiscal year ended March 31, 2017, we generated 51% of our revenue outside of the United States, with 33% generated from the United Kingdom, 15% from South Africa and 3% from the rest of the world. Our most significant growth market is the United States. We also believe that there is significant opportunity in our other existing markets. We intend to make significant investments in sales and marketing to continue expanding our customer base in our target markets. We were founded in 2003 with a mission to make email safer and better, and to transform the way organizations protect, store and access their email and corporate information. Our first service, Mimecast Email Security, which we launched in late 2003, was quickly followed by Mimecast Email Continuity. In 2004, we added Mimecast Enterprise Information Archiving. These three services generate a large proportion of our revenue today. In 2006, we started the development of our proprietary cloud architecture, which we refer to as Mime | OS™. We believed early on that investing in the development of our own cloud operating system was a strategic requirement that would enable us to integrate and scale our services. Mimecast Large File Send was released in 2013 and was followed by Mimecast Targeted Threat Protection in 2014, our advanced persistent threat protection service. In 2014, we also released comprehensive risk mitigation technologies specifically for Microsoft Office 365®, and in 2015, we released Mimecast Secure Messaging. In 2016 and 2017, we announced the newest aspects of our Targeted Threat Protection service, Impersonation Protect and Internal Email Protect, respectively. Additionally, in 2017, we acquired technology from iSheriff, Inc. to provide our customers additional realtime email threat intelligence and detection expertise complementing our existing portfolio of email security, continuity and archiving solutions. In fiscal 2018, we announced Sync & Recover, a service to enable fast mailbox recovery in the event omnipresent attackers are successful in penetrating an organization. Key Factors Affecting Our Performance We believe that the growth of our business and our future success are dependent upon a number of key factors, including the following: Acquisition of new customers. We employ a sales strategy that focuses on acquiring new customers through our direct sales force and network of channel partners, and selling additional products to existing customers. Acquiring new customers is a key element of our [/INST] Positive. </s>

Mimecast Ltd

2019-05-29

2019-03-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of our operations should be read in conjunction with Item 6. “Selected Financial Data,” our audited consolidated financial statements and related notes and other financial information included elsewhere in this Annual Report on Form 10-K. In addition to historical consolidated financial information, this discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of numerous factors, including, but not limited to, the risks discussed in Item 1A, “Risk Factors.” Our audited consolidated financial statements included elsewhere in this Annual Report on Form 10-K are prepared in accordance with accounting principles generally accepted in the United States. Overview We are a leading global provider of next generation cloud security and risk management services for corporate information and email. Our fully-integrated suite of proprietary cloud services protects customers of all sizes from the significant business and data security risks to which their email system exposes them. We protect customers from today’s rapidly changing threat landscape where email has become a powerful attack vector and data leak concern. We also mitigate the significant business disruption that email failure or downtime causes. In addition, our archiving services secure, store and manage critical corporate communications and information to address growing compliance, regulatory and e-discovery requirements and enable customers to use this increasing archive of valuable information to improve employee productivity. In fiscal 2019, we launched our awareness training product to help our customers train their employees as employee errors are one of the leading causes of cyber security incidents. During the year, we also introduced our web security product that protects our customers against malicious web activity initiated by employees and provides customers with the ability to block inappropriate websites. Web is the second highest threat vector for cyberattacks. We operate our business on a software-as-a-service, or SaaS, model with renewable annual subscriptions. Customers enter into annual and multi-year contracts to utilize various components of our services. Our subscription fee includes the use of the selected service and technical support. We believe our technology, subscription-based model, and customer support have led to our high revenue retention rate, which has helped us drive our strong revenue growth. We have historically experienced significant revenue growth from our existing customer base as they renew our services and purchase additional products. We market and sell our services to organizations of all sizes across a broad range of industries. As of March 31, 2019, we provided our services to approximately 34,400 customers and protected millions of their employees across the world. We generate sales through our network of channel partners as well as through our direct sales force. Our growth and future success depends on our ability to expand our customer base and to sell additional services to our existing customers. In the fiscal year ended March 31, 2019, we generated 50% of our revenue outside of the United States, with 31% generated from the United Kingdom, 14% from South Africa and 5% from the rest of the world. In the fiscal year ended March 31, 2018, we generated 51% of our revenue outside of the United States, with 31% generated from the United Kingdom, 15% from South Africa and 5% from the rest of the world. In the fiscal year ended March 31, 2017, we generated 51% of our revenue outside of the United States, with 33% generated from the United Kingdom, 15% from South Africa and 3% from the rest of the world. Our most significant growth market is the United States. We also believe that there is a large opportunity in our other existing markets. We intend to make significant investments in sales and marketing to continue expanding our customer base in our target markets. We were founded in 2003 in the U.K. with a mission to make email safer and better, and to transform the way organizations protect, store and access their email and corporate information. Our first service, Mimecast Email Security, which we launched in late 2003, was quickly followed by Mimecast Email Continuity. In 2004, we added Mimecast Enterprise Information Archiving. These three services generate a large proportion of our revenue today. In 2006, we started the development of our proprietary cloud architecture, which we refer to as Mime | OS™. Mimecast Large File Send was released in 2013 and was followed by Mimecast Targeted Threat Protection in 2014, our advanced persistent threat protection service. In 2014, we also released comprehensive risk mitigation technologies specifically for Microsoft Office 365®, and in 2015, we released Mimecast Secure Messaging. In 2016 and 2017, we announced the newest aspects of our Targeted Threat Protection service, Impersonation Protect and Internal Email Protect, respectively. Additionally, in 2017, we acquired technology from iSheriff, Inc. to provide our customers additional real-time email threat intelligence and detection expertise complementing our existing portfolio of email security, continuity and archiving solutions. In 2018, we announced Sync & Recover, a service to enable fast mailbox recovery in the event omnipresent attackers are successful in penetrating an organization. In 2019, we opened an early adopter program for new web security services that provide an easy to deploy and use Domain Name System, or DNS, solution alongside Mimecast’s core email offerings. Additionally, in 2019, with our acquisitions of Ataata and Solebit, we entered the security awareness training market and added leading threat detection technology, respectively. In 2019, we also acquired Simply Migrate, a provider of archive data migration technology. Key Factors Affecting Our Performance We believe that the growth of our business and our future success are dependent upon a number of key factors, including the following: Acquisition of new customers. We employ a sales strategy that focuses on acquiring new customers, through our direct sales force and network of channel partners, and selling additional products to existing customers. Acquiring new customers is a key element of our continued success, growth opportunity and future revenue. We have invested in and intend to continue to invest in our direct sales force and channel partners. During the year ended March 31, 2019, our customer base increased by approximately 4,000 organizations. Further penetration of existing customers. Our direct sales force, together with our channel partners and dedicated customer experience team seek to generate additional revenue from our existing customers by adding more of their employees to our services and selling additional services. We continue to believe a significant opportunity exists for us to sell additional services to current customers as they experience the benefits of our services and we address additional business use cases. Investment in growth. We are expanding our operations, increasing our headcount and developing software to both enhance our current offerings and build new features and products. We expect our total operating expenses to increase, particularly as we continue to expand our sales operations, marketing activities and research and development team. We intend to continue to invest in our sales, marketing and customer experience organizations to drive additional revenue and support the growth of our customer base. Investments we make in our sales and marketing and research and development organizations will occur in advance of experiencing any benefits from such investments. For the year ending March 31, 2020, we plan to continue increasing the size of our sales force, investing in the development of additional marketing content and increasing the size of our research and development team. Currency fluctuations. We conduct business in the United States and in other countries in North America, the United Kingdom and other countries in Europe, South Africa and other countries in Africa, Australia and UAE. As a result, we are exposed to risks associated with fluctuations in currency exchange rates, particularly between the U.S. dollar, the British pound and the South African rand. In the year ended March 31, 2019, 52% of our revenue was denominated in U.S. dollars, 28% in British pounds, 14% in South African rand and 6% in other currencies. Given that the functional currency of our subsidiaries is generally the local currency of each entity but our reporting currency is the U.S. dollar, devaluations of the British pound, South African rand and other currencies relative to the U.S. dollar impacts our profitability. Key Performance Indicators In addition to traditional financial metrics, such as revenue and revenue growth trends, we monitor several other key performance indicators to help us evaluate growth trends, establish budgets, measure the effectiveness of our sales and marketing efforts and assess operational efficiencies. The key performance indicators that we monitor are as follows: (1) Adjusted EBITDA and revenue constant currency growth rate are non-GAAP financial measures. For a reconciliation of Adjusted EBITDA and revenue constant currency growth rate to the nearest comparable GAAP measures, see Item 6. “Selected Financial Data.” (2) Reflects the customer count on the last day of the period rounded to the nearest hundred customers. Revenue constant currency growth rate. We believe revenue constant currency growth rate is a key indicator of our operating results. We calculate revenue constant currency growth rate by translating revenue from entities reporting in foreign currencies into U.S. dollars using the comparable foreign currency exchange rates from the prior fiscal periods. For further explanation of the uses and limitations of this non-GAAP measure and a reconciliation of our revenue constant currency growth rate to revenue, as reported, the most directly comparable U.S. GAAP measure, see Item 6. “Selected Financial Data.” As our total revenue grew over the past three years, our revenue constant currency growth rate has decreased over the same period, as the incremental growth from period to period represented a smaller percentage of total revenue as compared to the prior period. As our total revenue grows, we expect our constant currency growth rate will decline as the incremental growth from period to period is expected to represent a smaller percentage of total revenue as compared to the prior period. Revenue retention rate. We believe that our ability to retain customers is an indicator of the stability of our revenue base and the long-term value of our customer relationships. Our revenue retention rate is driven by our customer renewals and upsells. We calculate our revenue retention rate by annualizing constant currency revenue recorded on the last day of the measurement period for only those customers in place throughout the entire measurement period. We include add-on, or upsell, revenue from additional employees and services purchased by existing customers. We divide the result by revenue on a constant currency basis on the first day of the measurement period for all customers in place at the beginning of the measurement period. The measurement period is the trailing twelve months. The revenue on a constant currency basis is based on the average exchange rates in effect during the respective period. Our revenue retention rate in fiscal 2019 was relatively consistent with fiscal 2018. We expect our revenue retention rate to remain relatively consistent for fiscal 2020. Total customers. We believe the total number of customers is a key indicator of our financial success and future revenue potential. We define a customer as an entity with an active subscription contract as of the measurement date. A customer is typically a parent company or, in a few cases, a significant subsidiary that works with us directly. We expect to continue to grow our customer base through the addition of new customers in each of our markets. Gross profit percentage. Gross profit percentage is calculated as gross profit divided by revenue. Our gross profit percentage has been relatively consistent over the past three years; however, it has fluctuated and will continue to fluctuate on a quarterly basis due to timing of the addition of hardware and employees to serve our growing customer base. More recently, gross profit has also included amortization of intangible assets related to acquired businesses. We provide our services in each of the regions in which we operate. Costs related to supporting and hosting our product offerings and delivering our services are incurred in the region in which the related revenue is recognized. As a result, our gross profit percentage in actual terms is consistent with gross profit on a constant currency basis. Adjusted EBITDA. We believe that Adjusted EBITDA is a key indicator of our operating results. We define Adjusted EBITDA as net (loss) income, adjusted to exclude: depreciation, amortization, disposals and impairment of long-lived assets, acquisition-related gains and expenses, litigation-related expenses, share-based compensation expense, restructuring expense, interest income and interest expense, the provision for income taxes and foreign exchange income (expense). Adjusted EBITDA also includes rent paid in the period related to locations that are accounted for as build-to-suit facilities. For further explanation of the uses and limitations of this non-GAAP measure and a reconciliation of our Adjusted EBITDA to the most directly comparable U.S. GAAP measure, net (loss) income, see Item 6. “Selected Financial Data.” We expect that our Adjusted EBITDA will continue to increase; however, we expect that our operating expenses will also increase in absolute dollars as we focus on expanding our sales and marketing teams and growing our research and development capabilities. Components of Consolidated Statements of Operations Revenue We generate substantially all of our revenue from subscription fees paid by customers accessing our cloud services and by customers purchasing additional support beyond the standard support that is included in our basic subscription fees. A small portion of our revenue consists of related professional services and other revenue, which consists primarily of performance obligations related to set-up, ingestion and training fees. We generally license our services on a price per employee basis under annual contracts. In some instances, we receive upfront payments, which are determined to be material rights to a discount upon renewal. In these instances, we recognize revenue related to the upfront payment over the estimated customer benefit period, which has been determined to be six years. We serve approximately 34,400 customers in multiple industries, and our revenue is not concentrated with any single customer or industry. For each of the years ended March 31, 2019, 2018 and 2017, no single customer accounted for more than 1% of our revenue, and our largest ten customers accounted for less than 10% of our revenue in aggregate. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. As of March 31, 2019, deferred revenue was $175.6 million. We estimate the future recognition of deferred revenue as of March 31, 2019 to be $163.1 million in 2020, $6.7 million in 2021, $3.2 million in 2022, $1.3 million in 2023 and $1.3 million thereafter. We recognize revenue ratably on a straight-line basis over the subscription term, which begins when we have given the customer access to our SaaS solutions. Our subscription contracts are typically one year in duration and do not contain refund-type provisions. Our professional services contracts are recognized based on out-put measures of performance. Cost of revenue Cost of revenue primarily consists of expenses related to supporting and hosting our product offerings and delivering our professional services. These costs consist primarily of personnel and related costs including salaries, benefits, bonuses and share-based compensation expense related to the management of our data centers, our customer support team and our professional services team. In addition to these expenses, we incur third-party service provider costs such as data center and networking expenses, allocated overhead costs, depreciation expense and amortization expense related to capitalized software and acquired intangible assets. We allocate overhead costs, such as rent and facility costs, information technology costs and employee benefit costs to all departments based on headcount. As such, general overhead expenses are reflected in cost of revenue and each operating expense category. We expect our cost of revenue to increase in absolute dollars due to expenditures related to the purchase of hardware, expansion and support of our data center operations and customer support teams. We also expect that cost of revenue as a percentage of revenue will decrease over time as we are able to achieve economies of scale in our business, although it may fluctuate from period to period depending on the timing of significant expenditures. To the extent that our customer base grows, we intend to continue to invest additional resources in expanding the delivery capability of our products and other services. The timing of these additional expenses could affect our cost of revenue, both in terms of absolute dollars and as a percentage of revenue in any particular quarterly or annual period. Research and development expenses Research and development expenses consist primarily of personnel and related costs, including salaries, benefits, bonuses, share-based compensation expense, costs of server usage by our developers and allocated overhead costs. We expense all research and development costs as they are incurred. We have focused our efforts on developing new versions of our SaaS technology with expanded features. Our technology is constantly being refined and, as such, we do not capitalize development costs. We believe that continued investment in our technology is important for our future growth. As a result, we expect research and development expenses to increase in absolute dollars as we make further substantial investments in developing our Mime | OS™ platform, improving our existing services and creating new features and products. Research and development expenses as a percentage of total revenue may fluctuate on a quarterly basis but we expect it to increase in the coming fiscal year as a result of the expected investments noted above. Sales and marketing expenses Sales and marketing expenses consist primarily of personnel and related costs, including salaries, benefits, bonuses, commissions and share-based compensation expense. In addition to these expenses, we incur costs related to marketing and promotional events, online marketing, product marketing and allocated overhead costs. We expense all costs as they are incurred, excluding sales commissions identified as incremental costs to obtain a contract, which are capitalized and amortized over the life of our customers, which we estimate to be six years. Sales and marketing expenses increased in fiscal 2019 as we continued to expand our sales and marketing efforts globally, and particularly in the United States. We expect that our sales and marketing expenses will continue to increase in absolute dollars in the year ending March 31, 2020, but remain relatively consistent as a percentage of revenue with fiscal 2019. New sales personnel require training and may take several months or more to achieve productivity; as such, the costs we incur in connection with the hiring of new sales personnel in a given period are not typically offset by increased revenue in that period and may not result in new revenue if these sales personnel fail to become productive. We expect to increase our investment in sales and marketing as we add new services, which will increase these expenses in absolute dollars. Over the long term, we believe that sales and marketing expenses as a percentage of revenue will decrease, but will vary depending upon the mix of revenue from new and existing customers, as well as changes in the productivity of our sales and marketing programs. General and administrative expenses General and administrative expenses consist primarily of personnel and related expenses for executive, legal, finance, information technology and human resources functions, including salaries, benefits, incentive compensation, litigation-related expenses and share-based compensation expense, in addition to the costs associated with professional fees, insurance premiums, other corporate expenses and allocated overhead costs. We expect general and administrative expenses to increase in absolute dollars as we continue to incur additional personnel and professional services costs in order to support business growth as well as meeting the compliance requirements of operating as a public company, including those costs incurred in connection with Section 404 of the Sarbanes-Oxley Act, costs associated with acquisitions, legal fees and litigation-related expenses, funding transactions, the adoption of new accounting standards, including Accounting Standards Update (ASU) 2016-02, Leases, and others. Over the long term, we believe that general and administrative expenses as a percentage of revenue will decrease. Impairments of long-lived assets In the fourth quarter of fiscal 2018, upon the exit of our Watertown, Massachusetts corporate office space, we recorded a non-cash impairment charge of $1.7 million primarily related to leasehold improvements. Restructuring In the second quarter of fiscal 2019, we recorded a revision to restructuring expense of $0.2 million related to the exit of our Watertown, Massachusetts corporate office space. In the fourth quarter of fiscal 2018, upon the exit of our Watertown, Massachusetts corporate office space, we recorded a restructuring charge in the amount of $0.8 million for the remaining non-cancelable rent and estimated operating expenses, net of sublease rentals, for the vacated premises, in accordance with ASC 840-20, Leases. Other income (expense) Other income (expense) is comprised of the following items: Interest income Interest income includes interest income earned on our cash, cash equivalents and investments balances. We expect interest income to vary each reporting period depending on our average cash, cash equivalents and investments balances during the period and market interest rates. Interest expense Interest expense consists primarily of interest expense associated with our long-term debt, our financing lease obligation in connection with the construction of our Lexington, MA - U.S. headquarters and our capital leases. We expect interest expense to increase in fiscal 2020 primarily due to the senior secured term loan entered into in July 2018. Foreign exchange (expense) income and other, net Foreign exchange (expense) income and other, net consists primarily of foreign exchange fluctuations related to short-term intercompany accounts, foreign currency exchange gains and losses related to transactions denominated in currencies other than the functional currency for each of our subsidiaries and other non-operating items including sublease income and other income. We expect our foreign currency exchange gains and losses to continue to fluctuate in the future as foreign currency exchange rates change. The foreign currency exchange gains and losses were less significant in the fiscal year ending March 31, 2019 as compared to the fiscal year ended March 31, 2018 due to the capitalization and repayment of certain intercompany balances during fiscal 2018. Provision for income taxes We operate in several tax jurisdictions and are subject to tax in each country or jurisdiction in which we conduct business. We account for income taxes in accordance with the asset and liability method. Under this method, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases for assets and liabilities using statutory rates. In addition, this method requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Our provision for income taxes for the fiscal year ended March 31, 2019 is primarily attributable to the tax provision recorded on the earnings of our South African entity. This is partially offset by the tax benefit attributable to the operating loss on our Israeli entity, and the tax benefit for the release of a portion of our pre-existing U.S. and U.K. valuation allowances as a result of the Ataata and Simply Migrate business combinations. Our provision for income taxes for the fiscal years ending 2018 and 2017 primarily relates to the tax provision on the earnings of our South African entity. Operating Results The following table sets forth selected consolidated statements of operations data for each of the periods indicated: The following table sets forth our consolidated statements of operations data as a percentage of revenue for each of the periods indicated: We have operations in jurisdictions other than the United States and generate revenue and incur expenditures in currencies other than the U.S. dollar. The following information shows the effect on certain components of our consolidated statements of operations data for each of the periods indicated based on a 10% increase or decrease in foreign currency exchange rates assuming that all foreign currency exchange rates move in the same directions at the same time: Comparison of Years Ended March 31, 2019 and 2018 Revenue Revenue increased $78.5 million in the year ended March 31, 2019 compared to the year ended March 31, 2018. The increase in revenue was primarily attributable to increases in new customers, including the 4,000 new customers added since March 31, 2018, a full year of revenue related to new customers added during fiscal 2018 and additional revenue from customers that existed as of March 31, 2018. Revenue for the year ended March 31, 2019 compared to the year ended March 31, 2018 was negatively impacted by approximately $4.8 million primarily as a result of the strengthening of the U.S. dollar relative to the South African rand and to a lesser extent relative to the Australian dollar and British pound. Cost of revenue Cost of revenue increased $21.2 million in the year ended March 31, 2019 compared to the year ended March 31, 2018, which was primarily attributable to increases in personnel-related costs of $6.3 million, data center costs of $4.8 million, depreciation expense of $3.5 million, information technology and facility costs of $3.0 million, amortization of acquisition-related intangible assets of $1.3 million and professional services costs of $1.0 million. Cost of revenue for the year ended March 31, 2019 compared to the year ended March 31, 2018 was positively impacted by approximately $1.4 million primarily as a result of the strengthening of the U.S. dollar relative to the South African rand, Australian dollar and British pound. Personnel-related cost increased primarily as a result of salaries and benefits associated with increased headcount, data center costs increased as a result of the increase in our customer base, and depreciation expense increased primarily as a result of increased capital expenditures in support of our expanding infrastructure. In addition, the increase in information technology and facility costs is primarily a result of increased headcount and the increase in amortization of acquisition-related intangible assets is primarily attributable to the Solebit acquisition. As a result of changes in foreign currency exchange rates, gross profit decreased in absolute dollars by approximately $3.4 million for the year ended March 31, 2019 as compared to the year ended March 31, 2018. Excluding the impact of changes in foreign currency exchange rates, gross profit as a percentage of revenue remained consistent as costs related to supporting and hosting our product offerings and delivering our services are primarily incurred in the region in which the related revenue is recognized. Operating expenses nm-not meaningful Research and development expenses Research and development expenses increased $19.6 million in the year ended March 31, 2019 compared to the year ended March 31, 2018, which was primarily attributable to increases in personnel-related costs of $11.8 million, share-based compensation expense of $3.6 million and information technology and facility costs of $1.6 million. Research and development expenses for the year ended March 31, 2019 as compared to the year ended March 31, 2018 were positively impacted by approximately $0.5 million primarily as a result of the strengthening of the U.S. dollar relative to the British pound. Personnel-related cost increased primarily as a result of salaries and benefits associated with increased headcount throughout the year, share-based compensation expense increased primarily as a result of share option grants since the prior year and information technology and facility costs increased primarily as a result of increased headcount. Sales and marketing expenses Sales and marketing expenses increased $17.9 million in the year ended March 31, 2019 compared to the year ended March 31, 2018, which was primarily attributable to increases in information technology and facilities costs of $5.3 million, personnel-related costs of $4.0 million, share-based compensation expense of $3.4 million, professional services of $2.7 million, travel and other costs of $1.2 million and marketing costs of $1.1 million. Sales and marketing expenses for the year ended March 31, 2019 as compared to the year ended March 31, 2018 were positively impacted by approximately $1.5 million primarily as a result of the strengthening of the U.S. dollar relative to the Australian dollar, South African rand and British pound. Information technology and facilities costs and travel and other costs increased primarily as a result of increased headcount. Personnel-related costs increased primarily as a result of salaries and benefits associated with increased headcount and commissions, partially offset by the impact of adopting ASC 606, which resulted in capitalizing $13.8 million of commissions that would have been expensed under the prior accounting rules. Share-based compensation expense increased primarily as a result of share option grants since the prior year. Professional services costs increased primarily due to increased consulting fees. General and administrative expenses General and administrative expenses increased $16.8 million in the year ended March 31, 2019 compared to the year ended March 31, 2018, which was primarily attributable to increases in personnel-related costs of $6.3 million, share-based compensation expense of $5.8 million, information technology and facilities costs of $1.9 million, professional services costs of $1.2 million and litigation-related expenses of $1.0 million. Personnel-related costs increased primarily as a result of salaries and benefits associated with increased headcount. Share-based compensation expense increased primarily as a result of share option grants since the prior year and to a lesser extent the impact of share option modifications. Information technology and facility costs increased primarily as a result of increased headcount. Professional services costs increased primarily due to acquisition-related expenses. Restructuring and Impairment of long-lived assets In the second quarter of fiscal 2019, we recorded a revision to restructuring expense of $0.2 million related to the exit of our Watertown, Massachusetts corporate office space. In the fourth quarter of fiscal 2018, upon the exit of our Watertown, Massachusetts corporate office space, we recorded a restructuring charge of $0.8 million for the remaining non-cancelable rent and estimated operating expenses for the vacated premises, net of sublease rentals and we recorded a non-cash impairment charge of $1.7 million primarily related to leasehold improvements. Other income (expense) nm-not meaningful Interest income increased $1.2 million primarily as a result of higher weighted-average balances of cash, cash equivalents and investments and higher yields on investments. Interest expense increased $5.3 million primarily as a result of interest expense of $3.3 million associated with our long-term debt and our financing lease obligation of $2.0 million in connection with the construction of our Lexington, MA - U.S. headquarters. Foreign exchange expense and other, net decreased by $3.1 million primarily as a result of a decrease in foreign exchange expense of $1.9 million, sublease income of $0.9 million and a gain on a previously held asset related to the Solebit acquisition of $0.3 million. Provision for income taxes Provision for income taxes decreased $0.7 million in the year ended March 31, 2019 compared to the year ended March 31, 2018, which is primarily attributable to the tax benefit provided on the loss of our Israeli entity, and the tax benefit for the release of a portion of pre-existing U.S. and U.K. valuation allowances as a result of the Ataata and Simply Migrate business combinations, partially offset by an increase in income tax provision due to the earnings of our South African entity. Comparison of Years Ended March 31, 2018 and 2017 Revenue Revenue increased $75.3 million in the year ended March 31, 2018 compared to the year ended March 31, 2017. The increase in revenue was primarily attributable to increases in new customers, including approximately 4,000 new customers added since March 31, 2017, a full year of revenue related to new customers added during fiscal 2017 and additional revenue from customers that existed as of March 31, 2017. Revenue for the year ended March 31, 2018 compared to the year ended March 31, 2017 was positively impacted by approximately $4.7 million primarily as a result of the weakening of the U.S. dollar relative to the South African rand and to a lesser extent the British pound. Cost of revenue Cost of revenue increased $19.4 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to increases in personnel-related costs of $5.8 million, data center costs of $5.4 million, depreciation expense of $3.9 million, information technology and facility costs of $1.9 million, amortization of intangibles of $1.4 million and professional services costs of $0.8 million. Cost of revenue for the year ended March 31, 2018 compared to the year ended March 31, 2017 was negatively impacted by approximately $1.1 million primarily as a result of the weakening of the U.S. dollar relative to the South African rand and British pound. Personnel-related cost increased primarily as a result of salaries and benefits associated with increased headcount, data center costs increased as a result of the increase in our customer base, and depreciation increased primarily as a result of increased capital expenditures in support of our expanding infrastructure. In addition, the increase in information technology and facility costs is primarily a result of increased headcount and the increase in amortization of intangibles is primarily as a result of amortization of capitalized software. As a result of changes in foreign exchange rates, gross profit increased in absolute dollars by approximately $3.6 million for the year ended March 31, 2018 as compared to the year ended March 31, 2017. Excluding the impact of changes in foreign currency exchange rates, gross profit as a percentage of revenue remained consistent as costs related to supporting and hosting our product offerings and delivering our services are primarily incurred in the region in which the related revenue is recognized. Operating expenses nm-not meaningful Research and development expenses Research and development expenses increased $15.8 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to increases in personnel-related costs of $10.1 million, information technology and facility costs of $2.3 million, professional services costs of $0.9 million, share-based compensation expense of $0.7 million, travel and other costs of $0.5 million and data center costs of $0.5 million. Research and development expenses for the year ended March 31, 2018 as compared to the year ended March 31, 2017 were negatively impacted by approximately $0.5 million primarily as a result of the weakening of the U.S. dollar relative to the British pound. Personnel-related cost increased primarily as a result of salaries and benefits associated with increased headcount throughout the year, information technology and facility costs increased primarily as a result of increased headcount, professional services costs increased primarily as a result of the use of research and development contractors and share-based compensation expense increased primarily as a result of share option grants since the prior year. Sales and marketing expenses Sales and marketing expenses increased $25.1 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to increases in personnel-related costs of $13.5 million, marketing costs of $4.7 million, information technology and facilities costs of $3.6 million, travel and other costs of $2.3 million and professional services of $0.8 million. Sales and marketing expenses for the year ended March 31, 2018 as compared to the year ended March 31, 2017 were negatively impacted by approximately $1.4 million primarily as a result of the weakening of the U.S. dollar relative to the South African rand and British pound. Personnel-related costs increased primarily as a result of salaries and benefits associated with increased headcount. Information technology and facility costs and travel and other costs increased primarily as a result of increased headcount. General and administrative expenses General and administrative expenses increased $9.1 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to increases in personnel-related costs of $5.0 million, share-based compensation expense of $1.2 million, information technology and facilities costs of $1.0 million and professional services costs and material supplies of $0.6 million each. General and administrative expenses for the year ended March 31, 2018 as compared to the year ended March 31, 2017 were negatively impacted by approximately $0.3 million primarily as a result of the weakening of the U.S. dollar against the British pound and South African rand. Personnel-related costs increased primarily as a result of salaries and benefits associated with increased headcount. Share-based compensation expense increased primarily as a result of share option grants since the prior year. Information technology and facility and material supplies costs increased primarily as a result of increased headcount. Restructuring and Impairment of long-lived assets In the fourth quarter of fiscal 2018, upon the exit of our Watertown, Massachusetts corporate office space, we recorded a restructuring charge of $0.8 million for remaining non-cancelable rent and estimated operating expenses for the vacated premises, net of sublease rentals, and a non-cash impairment charge of $1.7 million primarily related to leasehold improvements. Other income (expense) nm-not meaningful Other income (expense), net changed $9.9 million in the year ended March 31, 2018 compared to the year ended March 31, 2017, which was primarily attributable to a change of $10.4 million in foreign exchange expense which was primarily attributable to the re-measurement of short-term intercompany balances denominated in currencies other than the functional currency of our operating units. The increase in interest income is primarily due to interest on investments. Provision for income taxes Provision for income taxes increased $0.5 million in the year ended March 31, 2018 compared to the year ended March 31, 2017. The provision for income taxes in each period was primarily attributable to taxes related to our South African entity. The increase in the provision for income taxes from the prior period was primarily attributable to withholding taxes accrued by our Australian entity combined with an increase in the earnings in South Africa. Liquidity and Capital Resources Our principal sources of liquidity are cash and cash equivalents, investments and accounts receivable. The following table shows net cash provided by operating activities, net cash used in investing activities, and net cash provided by (used in) financing activities for the years ended March 31, 2019, 2018 and 2017: In November 2015, we raised net proceeds of $68.3 million in our initial public offering after deducting underwriting discounts and commissions and offering expenses paid by us. In the years ended March 31, 2019, 2018 and 2017, we incurred operating losses of $1.2 million, $7.0 million and $10.4 million, respectively. While we expect to generate an operating loss in the year ending March 31, 2020, we expect to continue to generate positive cash flows from operating activities. In the year ending March 31, 2020, we plan to continue to invest in the development and expansion of our Mime | OS™ platform to improve on our existing solutions in order to provide more capabilities to our customers. Investments in capital expenditures in the year ended March 31, 2019 were $28.8 million of which $25.8 million related to the expansion of our grid architecture. We expect fiscal year 2020 capital expenditures to increase significantly as we expect to incur one-time costs related to the build out and expansion of facilities in the U.K. and other locations and additional data center expansion primarily in the U.S. As of March 31, 2019 and 2018, we had cash, cash equivalents and investments of $173.5 million and $137.2 million, respectively. Based on our current operating plan, we believe that our current cash and cash equivalents, investments and operating cash flows will be sufficient to fund our operations for at least the next twelve months. Our future capital requirements may vary materially from those planned and will depend on certain factors, such as our growth and our operating results. If we require additional capital resources to grow our business or to acquire complementary technologies and businesses in the future, we may seek to sell additional equity or raise funds through debt financing or other sources. We may also seek to invest in or acquire complementary businesses, applications or technologies, any of which could also require us to seek additional equity or debt financing. We cannot provide assurance that additional financing will be available at all or on terms favorable to us. We had no material commitments for capital expenditures as of March 31, 2019 or 2018. Borrowings and Credit Facility In July 23, 2018, we entered into that certain Credit Agreement, or the Credit Agreement, by and among us, certain of our subsidiaries party thereto, as guarantors, certain financial institutions party thereto from time to time, as lenders, and JPMorgan Chase Bank, N.A., as administrative agent, or the Administrative Agent. The Credit Agreement provided the Company with a $100.0 million senior secured term loan, or the Term Loan, and a $50.0 million senior secured revolving credit facility, or the Revolving Facility, and together with the Term Loan, the Credit Facility, which shall be available to fund working capital and for other corporate purposes, including to finance permitted acquisitions and investments. Total availability under the Revolving Facility is reduced by outstanding letters of credit of $3.9 million. As of March 31, 2019, total availability under the Revolving Facility was $46.1 million. Interest under the Credit Facility accrues at a rate between LIBOR plus 1.375% and LIBOR plus 1.875%, based on our ratio of indebtedness to earnings before interest, taxes, depreciation, amortization and certain other adjustments, or Consolidated EBITDA. Based on this ratio, the current interest rate as of March 31, 2019 under the Credit Facility is LIBOR plus 1.625%. The term of the Credit Facility is five years, maturing on July 23, 2023. At the time we entered into the Credit Agreement, we had no existing debt. The Credit Facility has financial covenants that require us to maintain a Consolidated Secured Leverage Ratio (as described below), commencing on September 30, 2018, of not more than 3.00 to 1.00 for the four consecutive fiscal quarter period ending on the last day of each fiscal quarter, or the Reference Period, with a step-up to 3.50 to 1.00 for any four-quarter period in which we consummate a permitted acquisition having an aggregate purchase price in excess of $25.0 million. We must also maintain a Consolidated Interest Expense Ratio of 3.00 to 1.00 commencing on September 30, 2018 and for each Reference Period thereafter. For purposes of the covenants, “Consolidated Secured Leverage Ratio” generally refers to the ratio of Consolidated Funded Debt that is secured by a lien on assets of us or our subsidiaries to Consolidated EBITDA. “Consolidated Funded Debt” generally refers to borrowed money, debt instruments, capital leases, deferred purchase price of property or services (excluding accounts payable in the ordinary course of business), and earn outs that are due and payable. “Consolidated Interest Expense Ratio” generally refers to the ratio of Consolidated EBITDA to cash interest expense with respect to indebtedness, with certain exclusions. The Company was in compliance with all covenants as of March 31, 2019 and management reasonably believes it will be in compliance over next 12 months. The Credit Agreement contains customary affirmative covenants for transactions of this type and other affirmative covenants agreed to by the parties, including, among others, the provision of annual and quarterly financial statements and compliance certificates, maintenance of property, insurance, compliance with laws and environmental matters. The Credit Agreement contains customary negative covenants, including, among others, restrictions on the incurrence of certain indebtedness, granting of liens, making investments and acquisitions, mergers and consolidations, paying dividends, entering into affiliate transactions and asset sales. The Credit Agreement also provides for a number of customary events of default, including, among others, payment, bankruptcy, covenant, representation and warranty, default under material indebtedness (other than the Credit Agreement), change of control and judgment defaults. All obligations under the Credit Agreement are unconditionally guaranteed by all of our material direct and indirect subsidiaries organized under the laws of the United States, the United Kingdom, the Bailiwick of Jersey, and other jurisdictions agreed to us and the Administrative Agent, with certain exceptions. These guarantees are secured by substantially all of the present and future property and assets of the guarantors, with certain exclusions. The foregoing summary (and any reference to the Credit Facility contained in this Annual Report on Form 10-K) does not purport to be complete and is qualified in its entirety by reference to the Credit Agreement and the related agreements, which are filed as Exhibits 10.22, 10.23, 10.24, 10.25, 10.26, 10.27, 10.28, 10.29, and 10.30 to this Annual Report on Form10-K incorporated herein by reference. Operating activities For the year ended March 31, 2019, cash provided by operating activities was $66.2 million. The primary factors affecting our operating cash flows during the period were our net loss of $7.0 million, adjusted for non-cash items of $30.0 million for depreciation and amortization of our property, equipment and intangible assets, $26.0 million of share-based compensation expense, and $6.4 million in amortization of deferred contract costs. The drivers of the changes in operating assets and liabilities were a $45.9 million increase in deferred revenue and $5.2 million increase in accrued expenses and other current liabilities and a $2.1 million increase in accounts payable, partially offset by a $20.2 million increase in deferred contract costs, $18.8 million increase in accounts receivable, $2.0 million increase in prepaid expenses and other current assets and a $2.0 million increase in other assets. For the year ended March 31, 2018, cash provided by operating activities was $46.4 million. The primary factors affecting our operating cash flows during the period were our net loss of $12.4 million, adjusted for non-cash items of $19.0 million for depreciation and amortization of our property, equipment and intangible assets, $11.7 million of share-based compensation expense, and $3.0 million in unrealized foreign currency gains on foreign denominated transactions, primarily intercompany balances, and $1.7 million of long-lived asset impairments. The primary drivers of the changes in operating assets and liabilities were a $39.0 million increase in deferred revenue and $7.1 million increase in accrued expenses and other current liabilities, partially offset by a $17.9 million increase in accounts receivable and a $5.0 million increase in prepaid expenses and other current assets. For the year ended March 31, 2017, cash provided by operating activities was $32.5 million. The primary factors affecting our operating cash flows during the period were our net loss of $5.4 million, adjusted for non-cash items of $11.9 million for depreciation and amortization of our property and equipment and intangible assets, $10.3 million of share-based compensation expense, and $6.5 million in unrealized foreign currency gains on foreign denominated transactions, primarily intercompany balances. The drivers of the changes in operating assets and liabilities were a $29.1 million increase in deferred revenue, a $4.9 million increase in accrued expenses and other liabilities, a $1.9 million decrease in other assets and a $0.8 million increase in accounts payable, partially offset by a $11.7 million increase in accounts receivable and a $2.8 million increase in prepaid expenses and other current assets. Investing activities Cash used in investing activities of $121.3 million for the year ended March 31, 2019 consisted primarily of $115.7 million in payments for the Solebit, Ataata and Simply Migrate acquisitions, $28.8 million in purchases of property, equipment and capitalized software and $42.9 million in purchases of investments, partially offset by $66.0 million in maturities of investments. Cash used in investing activities of $35.0 million for the year ended March 31, 2018 consisted primarily of $34.5 million in capital expenditures and $1.4 million in payments related to the iSheriff and other acquisitions, partially offset by net purchase and maturity activity on investments of $0.9 million. Cash used in investing activities of $84.6 million for the year ended March 31, 2017 consisted of $67.6 million in purchases of investments, $18.5 million in capital expenditures and $5.6 million in payments related to the iSheriff acquisition partially offset by $7.0 million in maturities of investments. Our capital expenditures were associated primarily with computer equipment purchased in support of our expanding infrastructure and to a lesser extent leasehold improvements and office equipment associated with increased headcount. Financing activities Cash provided by financing activities of $117.0 million for the year ended March 31, 2019 was primarily due to proceeds from issuance of debt, net of issuance costs, of $97.7 million and proceeds from issuance of ordinary shares under our equity plans of $24.7 million, partially offset by payments on construction financing lease obligations of $2.3 million, payments on debt of $1.9 million and payments on capital lease obligations of $1.3 million. Cash provided by financing activities of $13.2 million for the year ended March 31, 2018 was primarily due to $17.0 million of proceeds from issuance of ordinary shares from share option exercises and our employee stock purchase plan, partially offset by payments on debt of $1.8 million, payments on capital lease obligations of $1.0 million and payments on construction financing lease obligation of $1.0 million. Cash used in financing activities of $0.3 million for the year ended March 31, 2017 was primarily due to payments on debt of $4.6 million and payments on capital lease obligations of $0.2 million, partially offset by $4.5 million of proceeds from exercises of share options. Net operating loss carryforwards and income tax credits As of March 31, 2019, we had U.K. net operating loss carryforwards of approximately $57.4 million that do not expire. As of March 31, 2019, we had U.S. federal net operating loss carryforwards of approximately $78.6 million. U.S. federal net operating loss carryforwards generated through March 31, 2017 of approximately $32.5 million expire at various dates through 2037, and U.S. federal net operating loss carryforwards generated in tax years beginning after March 31, 2017 of approximately $46.1 million do not expire. As of March 31, 2019, we had U.S. state net operating loss carryforwards of approximately $54.6 million that expire at various dates through 2039. As of March 31, 2019, we had Australian net operating loss carryforwards of approximately $23.9 million that do not expire. As of March 31, 2019, we had German net operating loss carryforwards of approximately $9.9 million that do not expire. As of March 31, 2019, we had Israeli net operating loss carryforwards of approximately $3.3 million that do not expire. As of March 31, 2019, we had a U.K. income tax credit carryforward of $1.1 million that does not expire. As of March 31, 2019, we had an Israeli income tax credit carryforward of $0.6 million that expires in 2023 and 2024. In assessing our ability to realize our net deferred tax assets, we considered various factors including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations, to determine whether it is more likely than not that some portion or all of our net deferred tax assets will not be realized. Based upon these factors, we have determined that the uncertainty regarding the realization of these assets is sufficient to warrant the need for a full valuation allowance against our net deferred tax assets. Off-balance sheet arrangements Up to and including the fiscal year ended March 31, 2019, we have not had any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As a result, we are not exposed to related financing, liquidity, market or credit risks that could arise if we had engaged in those types of arrangements. Contractual obligations and commitments The following table represents our contractual obligations as of March 31, 2019, aggregated by type: We lease our facilities under non-cancelable operating leases with various expiration dates through March 2029. We have outstanding letters of credit of $3.9 million related to certain operating leases. Recently issued and adopted accounting pronouncements For information on recent accounting pronouncements, see Note 2. “Summary of Significant Accounting Policies” in the notes to the consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K. Critical accounting policies and estimates Our consolidated financial statements and the related notes included elsewhere in this Annual Report on Form 10-K are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Changes in accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ significantly from our estimates. We evaluate our estimates and assumptions on an ongoing basis. To the extent that there are material differences between our estimates and our actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected. We believe that of our significant accounting policies, which are described in Note 2 to the notes to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of our operations. Revenue Recognition Adoption of ASC 606 Effective April 1, 2018, we adopted the requirements of ASC 606 under the modified retrospective method of transition, which was applied to all customer contracts that were not completed on the effective date of ASC 606. We implemented internal controls and key system functionality to enable the preparation of financial information on adoption. The adoption of ASC 606 resulted in changes to our accounting policies for revenue recognition previously recognized under ASC 605, Revenue Recognition (Legacy GAAP), as detailed below. Revenue Recognition Policy Under ASC 606, we recognize revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. To achieve the core principle of ASC 606, we perform the following steps: 1) Identify the contract(s) with a customer; 2) Identify the performance obligations in the contract; 3) Determine the transaction price; 4) Allocate the transaction price to the performance obligations in the contract; and 5) Recognize revenue when (or as) we satisfy a performance obligation. We derive our revenue from two sources: (1) subscription revenues, which are comprised of subscription fees from customers accessing our cloud services and from customers purchasing additional support beyond the standard support that is included in the basic subscription fees; and (2) related professional services and other revenue, which consists primarily of certain performance obligations related to set-up, ingestion, consulting and training fees. In the years ended March 31, 2019, 2018 and 2017, subscription revenue made up the substantial majority of our revenue and professional services and other revenue made up less than 5% of our revenue. Our subscription arrangements provide customers the right to access our hosted software applications. Customers do not have the right to take possession of our software during the hosting arrangement. We sell our products and services directly through our sales force and also indirectly through third-party resellers. In accordance with the provisions of ASC 606, we have considered certain factors in determining whether the end-user or the third-party reseller is the customer in arrangements involving resellers. We concluded that in the majority of transactions with resellers, the reseller is the customer. In these arrangements, we consider that it is the reseller, and not us, that has the relationship with the end-user. Specifically, the reseller has the ability to set pricing with the end-user and the credit risk with the end-user is borne by the reseller. Further, the reseller is not obligated to report its transaction price with the end-user to us, and in the majority of transactions, we are unable to determine the amount paid by the end-user customer to the reseller in these transactions. As a result of such considerations, revenue for these transactions is presented in the accompanying consolidated statements of operations based upon the amount billed to the reseller. For transactions where we have determined that the end-user is the ultimate customer, revenue is presented in the accompanying consolidated statements of operations based on the transaction price with the end-user. We recognize subscription and support revenue ratably over the term of the contract, typically one year in duration, beginning on the date the customer is provided access to our service. For performance obligations related to set-up and ingestion, including implementation assistance and data migration services, respectively, we recognize revenue using output measures of performance that reflect the transfer of promised services to the customer consistent with progress to completion. We consider training, consulting, and other professional services contracts as separate performance obligations and recognize revenue using output measures of performance as services are completed. Amounts that have been invoiced are recorded in accounts receivable and in deferred revenue or revenue, depending on whether the revenue recognition criteria have been met. We primarily bill and collect payments from customers for our services in advance on a monthly and annual basis. In some instances, we receive non-refundable upfront payments for activities that do not constitute a promise to transfer a service and therefore are considered administrative tasks, not separate performance obligations. The upfront payments are evaluated to determine whether a material right to a discount upon renewal of the subscription exists. When we conclude a material right does not exist, we recognize revenue related to the upfront payment over the initial contract term. When we conclude a material right does exist, we recognize revenue related to the upfront payment, under the look-through method, over the estimated customer benefit period, which has been determined to be six years. All of our performance obligations, and associated revenue, are generally transferred to customers over time, with the exception of training, consulting and other professional services, which are generally transferred to the customer at a point in time. Revenue is presented net of any taxes collected from customers. Some of our contracts with customers contain multiple performance obligations. For these contracts, we account for individual performance obligations separately if they are distinct. The transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. We determine the standalone selling prices based on our overall pricing objectives, taking into consideration market conditions and other factors, including the value of our contracts, the products sold, customer demographics, our sales channel, and the number and size of users within our contracts. Deferred revenue primarily consists of billings or payments received in advance of revenue recognition from subscription and other services described above and is recognized as the revenue recognition criteria are met. Deferred revenue that is expected to be recognized during the succeeding twelve-month period is recorded as current deferred revenue and the remaining portion is recorded as non-current in the accompanying consolidated balance sheets. Deferred Cost Policy As part of our adoption of ASC 606, we capitalize incremental costs of obtaining revenue contracts, which primarily consist of commissions paid to our sales representatives. We amortize these commissions over six years on a systematic basis, consistent with the pattern of transfer of the goods or services to which the asset relates. Six years represents the estimated benefit period of the customer relationship taking into account factors such as peer estimates of technology lives and customer lives as well as our own historical data. No commissions are paid related to contract renewals. The current and noncurrent portions of deferred commissions are included in deferred contract costs, net, and deferred contract costs, net of current portion, respectively, in the accompanying consolidated balance sheets. Amortization of capitalized costs to obtain revenue contracts is included in sales and marketing expense in the accompanying consolidated statements of operations. See Note 2 of the notes to our consolidated financial statements, included elsewhere in this Annual Report on Form 10-K for costs capitalized as of March 31, 2019. Goodwill and long-lived asset impairment assessments Goodwill is not amortized, but is evaluated for impairment annually, or whenever events or changes in circumstances indicate that the carrying value may not be recoverable. We have determined that there is a single reporting unit for the purpose of conducting this goodwill impairment assessment. For purposes of assessing potential impairment, we estimate the fair value of the reporting unit, based on our market capitalization, and compare this amount to the carrying value of the reporting unit. If we determine that the carrying value of the reporting unit exceeds its fair value, an impairment charge would be required. The annual goodwill impairment test is performed as of January 1st of each year. To date, we have not identified any impairment to goodwill. Intangible assets acquired in a business combination are recorded at their estimated fair values at the date of acquisition. We amortize acquired definite-lived intangible assets over their estimated useful lives based on the pattern of consumption of the economic benefits or, if that pattern cannot be readily determined, on a straight-line basis. We review long-lived assets, including property and equipment and definite-lived intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. During this review, we re-evaluate the significant assumptions used in determining the original cost and estimated lives of long-lived assets. Although the assumptions may vary from asset to asset, they generally include operating results, changes in the use of the asset, cash flows, and other indicators of value. We then determine whether the remaining useful life continues to be appropriate, or whether there has been an impairment of long-lived assets based primarily upon whether expected future undiscounted cash flows are sufficient to support the recoverability of these assets. Recoverability of these assets is measured by comparison of the carrying amount of the asset to the future undiscounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset. Income taxes We are subject to income tax in the United Kingdom, the United States and other international jurisdictions, and we use estimates in determining our provision for income taxes. We account for income taxes in accordance with ASC 740, Income Taxes. ASC 740 is an asset and liability approach that requires recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the carrying amounts of assets and liabilities for financial reporting purposes and their respective tax basis, and for net operating loss and tax credit carryforwards. ASC 740 requires a valuation allowance against net deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. In making such determination, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent financial operations. Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance. We recognize the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained on examination by the tax authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such position are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. As of March 31, 2019 and 2018, we maintained tax reserves for uncertain tax positions, however none of these amounts would impact our tax provision if recognized. Share-based compensation We account for share-based compensation awards in accordance with the provisions of ASC 718, Compensation-Stock Compensation, which requires the recognition of expense related to the fair value of share-based compensation awards in the statements of operations. For service-based awards, we recognize share-based compensation expense on a straight-line basis over the requisite service period of the award with actual forfeitures recognized as they occur. Share Options We estimate the fair value of employee share options on the date of grant using the Black-Scholes option-pricing model, which requires the use of highly subjective estimates and assumptions. We estimate the expected term of share options for service-based awards utilizing the “Simplified Method,” as we do not have sufficient historical share option exercise information on which to base our estimate. The Simplified Method is based on the average of the vesting tranches and the contractual life of each grant. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the share option. Since there was no public market for our ordinary shares prior to the IPO and as our shares have been publicly traded for a limited time, we determined the expected volatility for options granted based on an analysis of reported data for a peer group of companies that issue options with substantially similar terms. The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies. We use an expected dividend rate of zero as we currently have no history or expectation of paying dividends on our ordinary shares. The grant date fair value of our ordinary shares at the time of each share option grant is based on the closing market value of our ordinary shares on the grant date. Employee Stock Purchase Plan, or ESPP We estimate the fair value of ESPP share options on the date of grant using the Black-Scholes option-pricing model, which requires the use of highly subjective estimates and assumptions. We estimate the expected term of ESPP share options based on the length of each offering period, which is six months. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the ESPP share option. Expected volatility is based on our historical volatility. We use an expected dividend rate of zero as we currently have no history or expectation of paying dividends on our ordinary shares. The grant date fair value per ordinary share is based on the closing market value of our ordinary shares on the first day of each ESPP offering period. Restricted Share Units, or RSUs For RSUs issued under our share-based compensation plans, the fair value of each grant is calculated based on the closing market value of our ordinary shares on the grant date.

<s>[INST] Overview We are a leading global provider of next generation cloud security and risk management services for corporate information and email. Our fullyintegrated suite of proprietary cloud services protects customers of all sizes from the significant business and data security risks to which their email system exposes them. We protect customers from today’s rapidly changing threat landscape where email has become a powerful attack vector and data leak concern. We also mitigate the significant business disruption that email failure or downtime causes. In addition, our archiving services secure, store and manage critical corporate communications and information to address growing compliance, regulatory and ediscovery requirements and enable customers to use this increasing archive of valuable information to improve employee productivity. In fiscal 2019, we launched our awareness training product to help our customers train their employees as employee errors are one of the leading causes of cyber security incidents. During the year, we also introduced our web security product that protects our customers against malicious web activity initiated by employees and provides customers with the ability to block inappropriate websites. Web is the second highest threat vector for cyberattacks. We operate our business on a softwareasaservice, or SaaS, model with renewable annual subscriptions. Customers enter into annual and multiyear contracts to utilize various components of our services. Our subscription fee includes the use of the selected service and technical support. We believe our technology, subscriptionbased model, and customer support have led to our high revenue retention rate, which has helped us drive our strong revenue growth. We have historically experienced significant revenue growth from our existing customer base as they renew our services and purchase additional products. We market and sell our services to organizations of all sizes across a broad range of industries. As of March 31, 2019, we provided our services to approximately 34,400 customers and protected millions of their employees across the world. We generate sales through our network of channel partners as well as through our direct sales force. Our growth and future success depends on our ability to expand our customer base and to sell additional services to our existing customers. In the fiscal year ended March 31, 2019, we generated 50% of our revenue outside of the United States, with 31% generated from the United Kingdom, 14% from South Africa and 5% from the rest of the world. In the fiscal year ended March 31, 2018, we generated 51% of our revenue outside of the United States, with 31% generated from the United Kingdom, 15% from South Africa and 5% from the rest of the world. In the fiscal year ended March 31, 2017, we generated 51% of our revenue outside of the United States, with 33% generated from the United Kingdom, 15% from South Africa and 3% from the rest of the world. Our most significant growth market is the United States. We also believe that there is a large opportunity in our other existing markets. We intend to make significant investments in sales and marketing to continue expanding our customer base in our target markets. We were founded in 2003 in the U.K. with a mission to make email safer and better, and to transform the way organizations protect, store and access their email and corporate information. Our first service, Mimecast Email Security, which we launched in late 2003, was quickly followed by Mimecast Email Continuity. In 2004, we added Mimecast Enterprise Information Archiving. These three services generate a large proportion of our revenue today. In 2006, we started the development of our proprietary cloud architecture, which we refer to as Mime | OS™. Mimecast Large File Send was released in 2013 and was followed by Mimecast Targeted Threat Protection in 2014, our advanced persistent threat protection service. In 2014, we also released comprehensive risk mitigation technologies specifically for Microsoft Office 365®, and in 2015, we released Mimecast Secure Messaging. In 2016 and 2017, we announced the newest aspects of our Targeted Threat Protection service, Impersonation Protect and Internal Email Protect, respectively. Additionally, in 2017, we acquired technology from iSheriff, Inc. to provide our customers additional realtime email threat intelligence and detection expertise complementing our existing portfolio of email [/INST] Positive. </s>

Cloudera, Inc.

2018-04-04

2018-01-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes thereto included elsewhere in this Annual Report on From 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” included elsewhere in this Annual Report on From 10-K. Our fiscal year end is January 31, and references throughout this Annual Report to a given fiscal year are to the twelve months ended on that date. Overview Cloudera empowers organizations to become data-driven enterprises. We have developed the modern platform for machine learning and analytics, optimized for the cloud. We collaborate extensively with the global open source community, continuously innovate in data management technologies and leverage the latest advances in infrastructure including the public cloud for “big data” applications. Our pioneering hybrid open source software (HOSS) model incorporates the best of open source with our robust proprietary software to form an enterprise-grade platform. This platform delivers an integrated suite of capabilities for data management, machine learning and advanced analytics, affording customers an agile, scalable and cost-effective solution for transforming their businesses. Our platform enables organizations to use vast amounts of data from a variety of sources, including the Internet of Things (IoT), to better serve and market to their customers, design connected products and services and reduce risk through greater insight from data. We generate revenue primarily from sales of our term-based subscriptions of our platform generally on a per node basis, whether deployed on-premises or in the cloud. We also offer consumption-based pricing for cloud-based deployments. In addition, we generate revenue from professional services and training. We market and sell our platform to a broad range of organizations, although we focus our selling efforts on the largest enterprises globally. We target these organizations because they capture and manage the vast majority of the world’s data and operate highly complex IT environments. We market our platform primarily through a direct sales force while benefiting from business driven by our ecosystem of technology partners, resellers, OEMs, MSPs, independent software vendors and systems integrators. Our total number of Global 8000 customers grew to 698 as of January 31, 2018 from 566 as of January 31, 2017. We compile our Global 8000 list based upon the FORBES Global 2000 ranking of the top 2000 global enterprises as determined by FORBES. The remainder of our Global 8000 list is based on entities listed in Data.com as having the highest annual revenue, excluding those that are already listed in the FORBES Global 2000. For purposes of customer count, we define a customer as an entity with a unique FORBES Global 2000 or Data.com identifier and quarterly subscription revenue as of the measurement date. We update our list of Global 8000 customers periodically. Our customer count is subject to adjustments for acquisitions, spin-offs and other market activity or other factors and previously disclosed numbers of customers are updated to allow for comparability. While we do not typically count multiple entities within a given Global 8000 customer as a new customer, we do make exceptions for holding companies and other organizations for which the FORBES Global 2000 or Data.com identifier in our judgment does not accurately represent the Cloudera customer. The FORBES Global 2000 list is updated annually in the second quarter of the calendar year and we have since updated our previously disclosed numbers of customers to allow for comparability. We have a broad customer base that spans industries and geographies. For the year ended January 31, 2018, 2017 and 2016, no customer accounted for more than 10% of our total revenue. We have significant revenue in the banking and financial services, technology, business services, telecommunications, public sector, consumer and retail, and healthcare and life sciences verticals, and continue to expand our penetration across many other data-intensive industries. Sales outside of the United States represented approximately 28%, 25% and 21% of our total revenue for the years ended January 31, 2018, 2017 and 2016, respectively. Our business model is based on a “land and expand” strategy designed to use the initial sale as a foothold to increase revenue per customer by increasing the amount of data and number of use cases each customer runs through our platform. After an initial purchase of our platform, we work with our customers to identify new use cases that can be developed on or moved to our platform, ultimately increasing the amount of data managed on our platform as well as the number and size of our platform deployments. Our quarterly net subscription revenue expansion rate equals: • the subscription revenue in a given quarter from end user customers that had subscription revenue in the same quarter of the prior year, divided by • the subscription revenue attributable to that same group of customers in that prior quarter. Our net expansion rate equals the simple arithmetic average of our quarterly net subscription revenue expansion rate for the four quarters ending with the most recently completed fiscal quarter. We have excluded Intel Corporation from our calculation of net expansion rate, as it is a related party. Our net expansion rate for the years ended January 31, 2018, 2017 and 2016 was 136%, 142% and 130%, respectively. Components of Results of Operations Revenue We generate revenue primarily from the sale of subscriptions for our platform that our customers deploy either on-premises or in the cloud, as well as the sale of services. Subscription revenue primarily relates to term (or time-based) subscriptions to our platform, which includes both open source and proprietary software. Our subscription arrangements are typically one to three years in length and we recognize subscription revenue ratably over the term of the subscription period. Our subscription includes internet, email and phone support, bug fixes and the right to receive unspecified software updates and upgrades released when and if available during the subscription term. Services revenue relates to professional services for the implementation and use of our subscriptions, machine learning expertise and consultation, customer training and education services, and related reimbursable travel costs. Cost of Revenue Cost of revenue for subscriptions primarily consists of personnel costs including salaries, bonuses, travel costs, benefits and stock-based compensation for employees providing technical support for our subscription customers, allocated shared costs (including rent and information technology) and amortization of acquired intangible assets from business combinations. Cost of revenue for services primarily consists of personnel costs including salaries, bonuses, benefits and stock-based compensation, fees to subcontractors associated with service contracts, travel costs and allocated shared costs (including rent and information technology). We expect cost of revenue to increase in absolute dollars for the foreseeable future as we continue to obtain new customers and expand our relationship with existing customers. As discussed in detail below, see “-Significant Impacts of Stock-based Compensation Expense,” during fiscal 2018 our initial public offering was declared effective and the performance-based condition for the RSUs was either achieved or probable of being achieved. As such we recognized a cumulative catch-up of stock-based compensation expense attributable to service prior to such effective date for RSUs. Operating Expenses Research and Development. Research and development expenses primarily consist of personnel costs including salaries, bonuses, travel costs, benefits and stock-based compensation for our research and development employees, contractor fees, allocated shared costs (including rent and information technology), supplies, and depreciation of equipment associated with the continued development of our platform prior to establishment of technological feasibility and the related maintenance of the existing technology. We expect our research and development expenses to increase in absolute dollars for the foreseeable future as we continue to enhance and add new technologies, features and functionality to our subscriptions. We also expect allocated shared costs to increase in the periods following the commencement of the leases for our new headquarters in Palo Alto in July 2017 and our new office in San Francisco in December 2017. As discussed in detail below, see “-Significant Impacts of Stock-based Compensation Expense,” during fiscal 2018 our initial public offering was declared effective and the performance-based condition for the RSUs was either achieved or probable of being achieved. As a result, we recognized a cumulative catch-up of stock-based compensation expense attributable to service prior to such effective date for RSUs. Sales and Marketing. Sales and marketing expenses primarily consist of personnel costs including salaries, bonuses, travel costs, sales-based incentives, benefits and stock-based compensation for our sales and marketing employees. In addition, sales and marketing expenses also includes costs for advertising, promotional events, corporate communications, product marketing and other brand-building activities, allocated shared costs (including rent and information technology) and amortization of acquired intangible assets from business combinations. Sales-based incentives are expensed as incurred. We expect our sales and marketing expenses to increase in absolute dollars as we continue to invest in selling and marketing activities to attract new customers and expand our relationship with existing customers. We also expect allocated shared costs to increase in the periods following the commencement of the leases for our new headquarters in Palo Alto in July 2017 and our new office in San Francisco in December 2017. As discussed in detail below, see “-Significant Impacts of Stock-based Compensation Expense,” during fiscal 2018 our initial public offering was declared effective and the performance-based condition for the RSUs was either achieved or probable of being achieved. As a result, we recognized a cumulative catch-up of stock-based compensation expense attributable to service prior to such effective date for RSUs. General and Administrative. General and administrative expenses primarily consist of personnel costs including salaries, bonuses, travel costs, benefits and stock-based compensation for our executive, finance, legal, human resources, information technology and other administrative employees. In addition, general and administrative expenses include fees for third-party professional services, including consulting, legal and accounting services and other corporate expenses, and allocated shared costs (including rent and information technology). We expect our general and administrative expenses to increase in absolute dollars due to the anticipated growth of our business and related infrastructure as well as legal, accounting, insurance, investor relations and other costs associated with becoming a public company. We also expect allocated shared costs to increase in the periods following the commencement of the lease for our new headquarters in Palo Alto in July 2017. As discussed in detail below, see “-Significant Impacts of Stock-based Compensation Expense,” during fiscal 2018 our initial public offering was declared effective and the performance-based condition for the RSUs was either achieved or probable of being achieved. As a result, we recognized a cumulative catch-up of stock-based compensation expense attributable to service prior to such effective date for RSUs. Interest Income, net Interest income primarily relates to amounts earned on our cash and cash equivalents and marketable securities. Other Income (Expense), net Other income (expense), net primarily relates to foreign currency transactions, realized gains and losses on our marketable securities, and other non-operating gains or losses. Provision for Income Taxes Provision for income taxes primarily consists of federal, state and foreign income taxes. Due to cumulative losses, we maintain a valuation allowance against our deferred tax assets. We consider all available evidence, both positive and negative, in assessing the extent to which a valuation allowance should be applied against our U.S. deferred tax assets. Significant Impacts of Stock-based Compensation Expense We have granted RSUs to our employees and members of our board of directors under our 2008 Equity Incentive Plan, or the 2008 Plan, and our 2017 Equity Incentive Plan, or the 2017 Plan. Prior to our IPO in May 2017, the employee RSUs vest upon the satisfaction of both a service-based condition and a liquidity event-related performance condition. The service-based vesting condition for these awards is generally satisfied pro-rata over four years. The liquidity event-related performance condition was achieved for the majority of our RSUs and probable of being achieved for the remaining RSUs on April 27, 2017, the effective date of our initial public offering. We recognized stock-based compensation expense using the accelerated attribution method with a cumulative catch-up of stock-based compensation expense in the amount of $181.5 million during fiscal 2018, attributable to service prior to such effective date. The total stock-based compensation expense recorded on the effective date of our initial public offering associated with the achievement of the liquidity event-related performance condition was as follows (in thousands): Tender Offer In May 2015, an unrelated third party initiated a cash tender offer which was completed in July 2015 for the purchase of our common stock from specified categories of current and former employees which had a significant impact on our stock-based compensation expense for the year ended January 31, 2016. Sellers participating in the tender offer sold a total of 4,079,131 shares of common stock to the unrelated third party. The purchase price per share in the tender offer was in excess of the fair value of our outstanding common stock at the time of the transaction and accordingly, upon the completion of the transaction, we recorded $16.6 million as stock-based compensation expense related to the excess of the selling price per share of common stock paid to our employees over the fair value of the tendered shares. Additionally, the completion of the tender offer was a qualifying liquidity event, such that the performance-based vesting requirement was satisfied for those RSUs that had met the service-based condition at this date. Upon the completion of the transaction, we recorded $19.7 million of stock-based compensation expense for the RSUs for which both the service-based condition and the qualifying liquidity event had been achieved. The total stock-based compensation expense related to the tender offer impacted our fiscal 2016 as follows (in thousands): Results of Operations The following table sets forth our results of operations for the periods indicated: (1) Amounts include stock-based compensation expense as follows: (2) Amounts include amortization of acquired intangible assets as follows: (3) In January 2017, we donated 1,175,063 shares of common stock to the Cloudera Foundation. We recorded a non-cash charge of $21.6 million for the fair value of the donated shares, which was recognized in general and administrative expense for the year ended January 31, 2017, see Note 10 to our consolidated financial statements for further discussion. The following table sets forth selected consolidated statements of operations data for each of the periods indicated as a percentage of total revenue: (1) Amounts include stock-based compensation expense as a percentage of total revenue as follows: (2) Amounts include amortization of acquired intangible assets as a percentage of total revenue as follows: (3) As a percentage of revenue, the non-cash expense recognized for the donation of common stock to the Cloudera Foundation for the year ended January 31, 2017 was 8%. Year Ended January 31, 2018 and 2017 Revenue The increase in subscription revenue during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily attributable to volume driven increases in subscription sales to new and existing customers. Our net expansion rate for the period ended January 31, 2018 was 136%. During the year ended January 31, 2018 as compared to the year ended January 31, 2017, our services revenue increased at a lower rate compared to the increase in our subscription revenue primarily due to our existing customers increasing experience with the technology and our efforts to develop relationships with partners and other system integrators, resulting in a shift of the provision of such services to these partners. Cost of Revenue, Gross Profit and Gross Margin The increase in cost of revenue for subscription during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $23.4 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $6.5 million in salaries and benefits related to growth in employee headcount to support our overall expansion in customers and an increase of $2.2 million in allocated shared costs. Subscription gross margin declined from 81% to 76% in the year ended January 31, 2018 as compared to the same period a year ago due to the recording of stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO. The increase in cost of revenue for services during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $30.0 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $7.5 million in salaries and benefits related to growth in employee headcount and an increase of $0.9 million in allocated shared costs. Services gross margin declined from 21% to negative 31% in the year ended January 31, 2018 as compared to the same period a year ago due to the recording of stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO. Operating Expenses Research and Development The increase in research and development expenses during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $94.5 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $12.9 million in employee-related costs including salaries, benefits and travel costs associated with the growth in employee headcount and an increase of $6.6 million in allocated shared costs, offset by a decrease of $1.9 million in costs for services from external vendors. Sales and Marketing The increase in sales and marketing expenses during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $84.7 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $8.1 million in employee-related costs including salaries, incentive-based compensation and benefits and travel costs associated with the growth in employee headcount to support our overall sales activities and an increase of $2.6 million in allocated shared costs, offset by a decrease of $0.2 million in advertising costs. General and Administrative The increase in general and administrative expenses during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $35.7 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $8.4 million in employee-related costs including salaries, benefits and travel costs associated with the growth in employee headcount to support our overall expansion, a cash donation of $2.4 million, or 1% of the net proceeds from the IPO, to fund the Cloudera Foundation and an increase of $0.9 million in costs for services from external vendors, offset by a decrease of a $21.6 million non-cash charge related to the donation of 1,175,063 shares of our common stock to the Cloudera Foundation in fiscal 2017. Interest Income, net Interest income, net increased primarily due to an increase in our cash balance obtained from the net proceeds of the IPO during the year ended January 31, 2018 as compared to the same period a year ago. Other Income (Expense), net Other income (expense), net increased primarily due to an increase of $1.9 million from foreign exchange gains during the year ended January 31, 2018 as compared to the same period a year ago. Provision for Income Taxes Provision for income taxes decreased primarily due to an income tax benefit of $0.8 million resulting from an acquisition, offset by increases in foreign income taxes and tax withholding from increases on foreign sales, during the year ended January 31, 2018 as compared to the same period a year ago. Year Ended January 31, 2017 and 2016 Revenue The increase in subscription revenue during the year ended January 31, 2017 compared to the year ended January 31, 2016 was primarily attributable to volume driven increases in subscription sales to new and existing customers. Our net expansion rate for the period ended January 31, 2017 was 142%. During the year ended January 31, 2017 as compared to the year ended January 31, 2016, our services revenue increased at a lower rate compared to the increase in our subscription revenue primarily due to our existing customers increasing experience with the technology and our efforts to develop relationships with partners and other system integrators, resulting in a shift of the provision of such services to these partners. Cost of Revenue, Gross Profit and Gross Margin The increase in cost of revenue for subscription during the year ended January 31, 2017 compared to the year ended January 31, 2016 was primarily due to an increase of $8.0 million in salaries and benefits related to growth in employee headcount to support our overall expansion in customers and an increase of $1.1 million in allocated shared costs, partially offset by a decrease of $1.9 million in stock-based compensation expense mainly due to the tender offer in July 2015, which was not repeated in fiscal 2017. Subscription gross margin improved from 74% to 81% in fiscal 2017 as compared to fiscal 2016. The increase in cost of revenue for services during the year ended January 31, 2017 compared to the year ended January 31, 2016 was primarily due to an increase of $4.1 million in salaries and benefits related to growth in employee headcount and an increase of $1.3 million in fees to subcontractors as a result of higher demand of services by our customers, offset by a decrease of $2.5 million in stock-based compensation expense mainly due to the tender offer in July 2015, which was not repeated in fiscal 2017. Services gross margin improved from 5% to 21% in fiscal 2017 as compared to fiscal 2016. Operating Expenses Research and Development The increase in research and development expenses during the year ended January 31, 2017 compared to the year ended January 31, 2016 was primarily due to an increase of $15.8 million in employee-related costs including salaries, benefits and travel costs associated with the growth in employee headcount, an increase of $0.9 million in depreciation expense of equipment to support our research and development activities and an increase of $1.7 million in allocated shared costs, partially offset by a decrease of $17.4 million in stock-based compensation expense mainly due to the tender offer in July 2015 which was not repeated in fiscal 2017. Sales and Marketing The increase in sales and marketing expenses during the year ended January 31, 2017 compared to the year ended January 31, 2016 was primarily due to an increase of $46.5 million in employee-related costs including salaries, incentive-based compensation, benefits and travel costs associated with the growth in employee headcount to support our overall sales activities and an increase of $2.9 million in allocated shared costs, offset by a decrease of $13.4 million in stock-based compensation expense mainly due to the tender offer in July 2015 which was not repeated in fiscal 2017. General and Administrative The increase in general and administrative expenses during the year ended January 31, 2017 compared to the year ended January 31, 2016 was primarily due to a $21.6 million non-cash charge related to the donation of 1,175,063 shares of common stock to the Cloudera Foundation in the fourth quarter of fiscal 2017 and an increase of $8.6 million in employee-related costs including salaries, benefits and travel costs associated with the growth in employee headcount to support our overall expansion, offset by a decrease of $6.6 million in stock-based compensation expense mainly due to the tender offer in July 2015 which was not repeated in fiscal 2017 and decreases in third party consulting and professional service costs. Interest Income, net Interest income, net increased primarily as a result of higher interest rates obtained from investing more of our cash and cash equivalents in marketable securities during the year ended January 31, 2017 as compared to the same period a year ago. Other Income (Expense), net Other income (expense), net decreased primarily as a result of an escrow claim adjustment in fiscal 2016 of $0.8 million related to a fiscal 2015 acquisition outside of the measurement period during the year ended January 31, 2017 as compared to the same period a year ago. Provision for Income Taxes Provision for income taxes increased primarily due to an increase in pre-tax income in our foreign locations driven by our continued international expansion into new countries during the year ended January 31, 2017 as compared to the same period a year ago. Seasonality We have seasonal and end-of-quarter concentration of our sales, which impacts our ability to plan and manage cash flows and margins. Our sales vary by season with the fourth quarter typically being our strongest sales quarter, and the first quarter typically being our largest collections and operating cash flow quarter. In addition, within each quarter, most sales occur in the last month of that quarter. See “Risk Factors-Our sales cycles can be long, unpredictable and vary seasonally, particularly with respect to large subscriptions, and our sales efforts require considerable time and expense.” Liquidity and Capital Resources As of January 31, 2018, our principal sources of liquidity were cash, cash equivalents and marketable securities totaling $442.7 million which are held for working capital purposes. Our cash equivalents are comprised primarily of money market funds and our marketable securities are comprised of U.S. agency obligations, asset-backed securities, corporate notes and obligations, commercial paper, municipal securities, certificates of deposit and U.S. treasury securities. To date, our principal sources of liquidity have been payments received from customers for our subscriptions and services, the net proceeds we received through the sale of our common stock in our IPO in May 2017, our follow-on offering in October 2017 and private sales of equity securities. We believe our existing liquidity will be sufficient to meet our working capital and capital expenditure needs for at least the next twelve months. Our future capital requirements may vary materially from those currently planned and will depend on many factors, including our net expansion rate, the timing and extent of spending on research and development efforts, the expansion of sales and marketing activities, the continuing market acceptance of our subscriptions and services and ongoing investments to support the growth of our business. We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies and intellectual property rights. From time to time, we may explore additional financing sources which could include equity, equity-linked and debt financing arrangements. We cannot assure you that any additional financing will be available on terms favorable to us, or at all. If adequate funds are not available on acceptable terms, or at all, we may not be able to adequately fund our business plans and it could have a negative effect on our operating cash flows and financial condition. The following table summarizes our cash flows for the periods indicated: Cash Used in Operating Activities During the year ended January 31, 2018, cash used in operating activities was $42.3 million which was due to a net loss of $385.8 million partially offset by non-cash adjustments of $301.7 million and an increase from net change in operating assets and liabilities of $41.8 million. Non-cash adjustments primarily consisted of $12.1 million of depreciation and amortization and $290.0 million of stock-based compensation. The net change in operating assets and liabilities was due to an increase in deferred revenue of $74.2 million due to the timing of amounts billed to customers compared to revenue recognized during the same period, a net increase in accounts payable and accrued expenses and other liabilities of $7.4 million due to timing of payments to vendors, an increase in accrued compensation of $5.2 million due to the timing of bonus and incentive-based compensation payments, offset by an increase in accounts receivable of $28.8 million due to the timing of invoicing compared to the receipt of cash from customers and an increase in prepaid expenses and other assets of $16.2 million. During the year ended January 31, 2017, cash used in operating activities was $116.6 million which was due to a net loss of $187.3 million partially offset by non-cash adjustments of $56.3 million and an increase from net change in operating assets and liabilities of $14.5 million. Non-cash adjustments consisted of $10.1 million of depreciation and amortization, $21.7 million of stock-based compensation, $21.6 million of expense for the donation of common stock to the Cloudera Foundation and $2.9 million in accretion and amortization of marketable securities. The net change in operating assets and liabilities was due to an increase in deferred revenue of $59.2 million due to the timing of amounts billed to customers compared to revenue recognized during the same period, an increase in accrued compensation of $11.2 million due to the timing of bonus and incentive-based compensation payments, partially offset by an increase in accounts receivable of $52.1 million due to the timing of invoicing compared to the receipt of cash from customers, an increase of $3.3 million in prepaid expenses and other assets and a decrease in accounts payable and accrued expenses and other liabilities of $0.6 million due to the timing of payments to vendors. During the year ended January 31, 2016, cash used in operating activities was $90.5 million which was due to a net loss of $203.1 million partially offset by non-cash adjustments of $75.8 million and an increase from net change in operating assets and liabilities of $36.9 million. Non-cash adjustments consisted of $8.6 million of depreciation and amortization, $63.6 million of stock-based compensation and $3.6 million in accretion and amortization of marketable securities. The net change in operating assets and liabilities was due to an increase in deferred revenue of $42.1 million due to the timing of amounts billed to customers compared to revenue recognized during the same period, an increase in accrued compensation of $9.4 million due to the timing of bonus and incentive-based compensation payments, an increase in accounts payable and accrued expenses and other liabilities of $6.2 million due to the timing of payments to vendors, partially offset by an increase in accounts receivable of $19.0 million due to the timing of invoicing compared to the receipt of cash from customers and an increase of $1.8 million in prepaid expenses. Cash Provided by (Used in) Investing Activities During the year ended January 31, 2018, cash used in investing activities was $234.5 million which was due to purchases of marketable securities of $620.3 million, partially offset by sales and maturities of marketable securities of $400.6 million, capital expenditures for the purchase of property and equipment of $13.0 million and cash used in business combinations, net of cash acquired, of $1.9 million. During the year ended January 31, 2017, cash provided by investing activities was $168.6 million which was due to sales and maturities of marketable securities of $282.4 million, partially offset by purchases of marketable securities of $103.8 million, cash used in business combinations, net of cash acquired, of $2.7 million and purchases of property and equipment of $7.4 million. During the year ended January 31, 2016, cash used in investing activities was $242.7 million which was due to purchases of marketable securities of $411.5 million, cash used in business combinations, net of cash acquired, of $8.9 million, purchases of property and equipment of $5.5 million, offset by sales and maturities of marketable securities of $183.3 million. Cash Provided by Financing Activities During the year ended January 31, 2018, cash provided by financing activities was $247.3 million which was due to the net proceeds from the issuance of common stock in the IPO of $237.4 million, the net proceeds from the follow-on offering of $46.0 million and proceeds from the exercise of stock options and withholdings under our 2017 Employee Stock Purchase Plan (ESPP) of $23.7 million, offset by shares withheld related to net settlement of restricted stock units of $59.8 million. During the year ended January 31, 2017, cash provided by financing activities was $1.5 million which was due to proceeds from the exercise of stock options of $3.6 million, offset by payment of deferred offering costs of $2.1 million. During the year ended January 31, 2016, cash provided by financing activities was $9.7 million which was due to proceeds from the exercise of stock options of $10.9 million, offset by shares withheld related to net settlement of restricted stock units of $1.2 million. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Contractual Obligations and Commitments The following table summarizes our non-cancelable contractual obligations as of January 31, 2018: (1) We lease our facilities under long-term operating leases, which expire at various dates through 2027. The lease agreements frequently include provisions which require us to pay taxes, insurance, or maintenance costs. In June 2017, we entered into a new non-cancelable operating lease agreement to rent office space in San Francisco, California. The lease has an 87-month term, commenced in December 2017 and ends in April 2025 with an option to renew for an additional 60 months. Total minimum lease payments under the lease agreement, included in the table above, are $34.5 million, of which $0.4 million was required to be prepaid upon execution of the lease agreement. Deferred Revenue and Unbilled Deferred Revenue Our deferred revenue consists of amounts that have been invoiced but that have not yet been recognized as revenue as of the end of a reporting period. Unbilled deferred revenue represents future non-cancelable customer commitments under our subscription agreements that have not been invoiced and, accordingly, are not recorded in deferred revenue. For our annual or multiple-year subscription contracts we typically invoice an initial annual amount at contract signing followed by subsequent annual invoices over the contract term. Until these amounts are invoiced, they are not recorded in revenue, deferred revenue, accounts receivable or elsewhere in our consolidated financial statements, and are considered by us to be unbilled deferred revenue. We expect unbilled deferred revenue to fluctuate from period to period for several reasons, including the timing and duration of customer contracts, varying billing cycles and the timing and duration of customer renewals. Unbilled deferred revenue does not include minimum revenue commitments from resellers as we recognize revenue and deferred revenue upon sell-through to an end user customer. Our total deferred revenue and unbilled deferred subscription revenue was $494.4 million and $378.3 million as of January 31, 2018 and 2017, respectively. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (GAAP). The preparation of these financial statements requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these judgments and estimates under different assumptions or conditions and any such differences may be material. We believe that our significant accounting policies, which are discussed in Note 2 to our consolidated financial statements, and the accounting policies discussed below, involve a greater degree of complexity, involving management’s judgments and estimates. Accordingly, these are the policies we believe are critical to understanding our financial condition and historical and future results of operations. Revenue Recognition We generate revenue from subscriptions and services. Subscription arrangements are typically one to three years in length but may be up to seven years in limited cases. Arrangements with our customers typically do not include general rights of return. Incremental direct costs incurred related to the acquisition or origination of a customer contract are expensed as incurred. Revenue recognition commences when all of the following criteria are met: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred; (iii) the fee is fixed or determinable; and (iv) collection is probable. Subscription revenue Subscription revenue primarily relates to term (or time-based) subscription agreements for both open source and proprietary software. Subscriptions include internet, email and phone support, bug fixes, and the right to receive unspecified software updates and upgrades released when and if available during the subscription term. Revenue for subscription arrangements is recognized ratably over the contractual term of the arrangement beginning on the date access to the subscription is made available to the customer. Services revenue Services revenue relates to professional services for the implementation and use of our subscriptions, machine learning expertise and consultation, training and education services and related reimbursable travel costs. For time and materials and fixed fee arrangements, revenue is recognized as the services are performed or upon acceptance, if applicable. For milestone-based arrangements, revenue is recognized upon acceptance or subsequent to completion and upon the lapse of any acceptance period. Revenue for training and education services is recognized upon delivery except for On-Demand Training, which is recognized ratably over the contractual term. Multiple-element arrangements Arrangements with our customers generally include multiple elements (e.g., subscription and services). We allocate revenue to each element of the arrangement based on vendor-specific objective evidence of each element’s fair value (VSOE) when we can demonstrate sufficient evidence of the fair value. VSOE for elements of an arrangement is based upon the normal pricing and discounting practices for those elements when sold separately on a stand-alone basis. We have established VSOE for some of our services. If VSOE for one or more undelivered elements does not exist, revenue recognition does not commence until delivery of both the subscription and services have commenced, or when VSOE of the undelivered elements has been established. Once revenue recognition commences, revenue for the arrangement is recognized ratably over the longest service period in the arrangement. Reseller arrangements We also recognize subscription revenue for sales through resellers or other indirect sales channels. Subscription revenue from these sales is generally recognized upon sell-through to an end user customer. Subscription revenue from these sales does not commence until cash is collected where payments to us are believed to be contingent upon payment by the end user to the reseller. Deferred revenue Deferred revenue consists of amounts billed to or collected from customers under a binding agreement provided delivery of the related subscription or services has commenced. Business Combinations, Goodwill and Intangible Assets We allocate the fair value of purchase consideration in a business combination to tangible assets, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is allocated to goodwill. The allocation of the purchase consideration requires management to make significant estimates and assumptions, especially with respect to intangible assets. These estimates can include, but are not limited to, future expected cash flows from acquired customers and acquired technology from a market participant perspective, useful lives and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable but which are inherently uncertain and unpredictable, and, as a result, actual results may differ from estimates. During the measurement period, which is up to one year from the acquisition date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings. We assess goodwill for impairment at least annually and whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. We test goodwill using the two-step process. In the first step, we compare the carrying amount of the reporting unit to the fair value based on the fair value of our common stock. If the fair value of the reporting unit exceeds the carrying value, goodwill is not considered impaired and no further testing is required. If the carrying value of the reporting unit exceeds the fair value, goodwill is potentially impaired and the second step of the impairment test must be performed. In the second step, we would compare the implied fair value of the goodwill to its carrying amount to determine the amount of impairment loss, if any. Acquired finite-lived intangible assets are amortized over their estimated useful lives. We evaluate the recoverability of our intangible assets for possible impairment whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of these assets is measured by a comparison of the carrying amounts to the future undiscounted cash flows the intangible assets are expected to generate. If such review indicates that the carrying amount of our intangible assets is not recoverable, the carrying amount of such assets is reduced to fair value. We have not recorded any such impairment charge during the periods presented. Stock-based Compensation We recognize stock-based compensation expense for all stock-based payments. Employee stock-based compensation cost is estimated at the grant date based on the fair value of the equity for financial reporting purposes and is recognized as expense, over the requisite service period. Prior to our IPO, fair value of our common stock for financial reporting purposes was determined considering objective and subjective factors and required judgment to determine the fair value of common stock for financial reporting purposes as of the date of each equity grant or modification. We calculate the fair value of options and purchase rights granted under the ESPP based on the Black-Scholes option-pricing model. The Black-Scholes model requires the use of various assumptions including expected term and expected stock price volatility. We estimate the expected term for stock options using the simplified method due to the lack of historical exercise activity. The simplified method calculates the expected term as the midpoint between the vesting date and the contractual expiration date of the award. The expected term for the ESPP purchase rights is estimated using the offering period, which is typically six months. We estimate volatility for options and ESPP purchase rights using volatilities of a group of public companies in a similar industry, stage of life cycle, and size. The interest rate is derived from government bonds with a similar term to the option or ESPP purchase right granted. We have not declared nor do we expect to declare dividends. Therefore, there is no dividend impact on the valuation of options or ESPP purchase rights. We use the straight-line method for employee expense attribution for stock options and ESPP purchase rights. We have granted RSUs to our employees and members of our board of directors under the 2008 Equity Incentive Plan (2008 Plan) and our 2017 Equity Incentive Plan (2017 Plan). Prior to our IPO in May 2017, the employee RSUs vest upon the satisfaction of both a service-based vesting condition and a liquidity event-related performance vesting condition. RSUs granted subsequent to our IPO vest upon the satisfaction of a service-based vesting condition only. The service-based condition for the majority of these awards is generally satisfied pro-rata over four years. The liquidity event related performance condition is satisfied upon the occurrence of a qualifying liquidity event, such as the effective date of an initial public offering, or six months following the effective date of an initial public offering. During the quarter ended April 30, 2017, the majority of RSUs were modified such that the liquidity event related performance condition is satisfied upon the effective date of an initial public offering, rather than six months following an initial public offering. The modification established a new measurement date for these modified RSUs. The liquidity event related performance condition is viewed as a performance based criterion for which the achievement of such liquidity event is not deemed probable for accounting purposes until the event occurs. The liquidity event related performance condition was achieved for the majority of our RSUs and became probable of being achieved for the remaining RSUs on April 27, 2017, the effective date of our initial public offering. We recognized stock-based compensation expense using the accelerated attribution method with a cumulative catch up of stock-based compensation expense in the amount of $181.5 million in fiscal 2018, attributable to service prior to such effective date. In fiscal 2017 and fiscal 2016, stock-based compensation expense was recorded based on awards that were ultimately expected to vest, and such expense was reduced for estimated forfeitures. When estimating forfeitures, we considered voluntary termination behaviors as well as trends of the actual option forfeitures. Prior to our IPO, we also recorded stock-based compensation expense when a holder of an economic interest in our company purchased shares from an employee for an amount in excess of the fair value of the common stock at the time of the purchase. We recognized any excess value transferred in these transactions as stock-based compensation expense in the statement of operations. We estimate the fair value of options and other equity awards granted to non-employees using the Black-Scholes method. These awards are subject to periodic re-measurement over the period during which services are rendered. Stock-based compensation expense is recognized over the vesting period on a straight-line basis. JOBS Act Accounting Election We are an emerging growth company, as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We have elected to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. Recent Accounting Pronouncements Recently Adopted Accounting Standards In March 2016, the Financial Accounting Standards Board (FASB) issued ASU No. 2016-09, Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting, or ASU 2016-09, which simplifies the accounting and reporting of share-based payment transactions, including adjustments to how excess tax benefits and payments for tax withholdings should be classified and provides the election to eliminate the estimate for forfeitures. For public entities, this standard is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. For all other entities, this standard is effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. Early adoption is permitted for any entity in any interim or annual period for which financial statements have not been issued or made available for issuance. We have early adopted this standard in the first quarter of fiscal 2018. As a result of this adoption, we have elected to account for forfeitures as they occur. The adoption of this standard did not have a material impact on our consolidated financial statements. Recently Issued Accounting Standards In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), or ASU 2014-09, which amended the existing FASB Accounting Standards Codification. ASU 2014-09 establishes a principle for recognizing revenue upon the transfer of promised goods or services to customers, in an amount that reflects the expected consideration to be received in exchange for those goods or services and also provides guidance on the recognition of costs related to obtaining and fulfilling customer contracts. For public entities, this standard is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. For all other entities, this standard is effective for annual reporting periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019. We are currently in the process of assessing the adoption methodology, which allows ASU 2014-09 to be applied either retrospectively to each prior period presented or with the cumulative effect recognized as of the date of initial application. Our final determination will depend on a number of factors, such as the significance of the impact of the new standard on our financial results, system readiness, including that of software procured from third-party providers, and our ability to accumulate and analyze the information necessary to assess the impact on prior period financial statements, as necessary. We are also currently evaluating the impact ASU 2014-09 will have on our consolidated financial statements and our accounting policies, processes, and system requirements. We have assigned internal resources in addition to engaging third party service providers to assist in the evaluation. While we continue to assess all potential impacts under ASU 2014-09, there is the potential for significant impacts to the timing of our revenue recognition and contract acquisition costs, such as sales commissions. Accounting for sales commissions under ASU 2014-09 is different than our current accounting policy which is to expense sales commissions as incurred whereas such costs will be deferred and amortized under ASU 2014-09. Additionally, we preliminarily believe that the amortization period for such deferred commission costs will be longer than the contract term of the subscription agreement, as ASU 2014-09 requires entities to determine whether the costs relate to specific anticipated contracts. While we continue to assess the potential impacts of ASU 2014-09, including the areas described above, and anticipate ASU 2014-09 could have a material impact on our consolidated financial statements, we do not know or cannot reasonably estimate the quantitative impact on our financial statements at this time. In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), or ASU 2016-02, which requires lessees to record most leases on their balance sheets but recognize the expenses on their income statements in a manner similar to current practice. ASU 2016-02 states that a lessee would recognize a lease liability for the obligation to make lease payments and a right-to-use asset for the right to use the underlying asset for the lease term. For public entities, this standard is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. For all other entities, this standard is effective for annual reporting periods beginning after December 15, 2019, and interim periods within annual periods beginning after December 15, 2020. Early adoption is permitted. We are currently evaluating the impact that this standard will have on our consolidated financial statements. In June 2016 the FASB issued ASU No. 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, or ASU 2016-13. ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. For public entities, this standard is effective for annual reporting periods beginning after December 15, 2019, including interim periods within that reporting period. For all other entities, this standard is effective for annual reporting periods beginning after December 15, 2020, including interim periods within that reporting period. Earlier adoption is permitted in our first interim period in fiscal 2020. We are currently evaluating the impact that this standard will have on our consolidated financial statements. In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, or ASU 2016-15. ASU 2016-15 identifies how certain cash receipts and cash payments are presented and classified in the Statement of Cash Flows. For public entities, this standard is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. For all other entities, this standard is effective for annual reporting periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019. This standard should be applied retrospectively and early adoption is permitted, including adoption in an interim period. We are currently evaluating the impact that this standard will have on our consolidated financial statements. In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory, or ASU 2016-16. ASU 2016-16 requires entities to recognize the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. For public entities, this standard is effective for annual reporting periods beginning after December 15, 2017. For all other entities, this standard is effective for annual reporting periods beginning after December 15, 2018. Early adoption is permitted as of the beginning of an annual period. We are currently evaluating the impact that this standard will have on our consolidated financial statements. In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business (ASU 2017-01), which changes the definition of a business to assist entities with evaluating when a set of transferred assets and activities is a business. If substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set of transferred assets and activities is not a business. For public entities, this standard is effective for annual reporting periods beginning after December 15, 2017, including interim periods within those years. For all other entities, it is effective for annual reporting periods beginning after December 15, 2018, and interim periods within annual periods beginning after December 15, 2019. Early adoption is permitted. We are currently evaluating the impact that this standard will have on our consolidated financial statements. In January 2017, the FASB issued ASU No. 2017-04, Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, or ASU 2017-04. ASU 2017-04 simplifies how an entity is required to test goodwill for impairment by eliminating Step 2 from the goodwill impairment test. For public entities, this standard is effective for annual reporting periods beginning after December 15, 2019, including interim periods within that reporting period. For all other entities, this standard is effective for annual reporting periods beginning after December 15, 2021. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. We are currently evaluating the impact that this standard will have on our consolidated financial statements. In May 2017, the FASB issued ASU No. 2017-09, Compensation - Stock Compensation (Topic 718): Scope of Modification Accounting, or ASU 2017-09, which clarifies when to account for a change to the terms or conditions of a share-based payment award as a modification. Under ASU 2017-09, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. This standard is effective for all entities for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. Early adoption is permitted. We are currently evaluating the impact that this standard will have on our consolidated financial statements.

<s>[INST] Overview Cloudera empowers organizations to become datadriven enterprises. We have developed the modern platform for machine learning and analytics, optimized for the cloud. We collaborate extensively with the global open source community, continuously innovate in data management technologies and leverage the latest advances in infrastructure including the public cloud for “big data” applications. Our pioneering hybrid open source software (HOSS) model incorporates the best of open source with our robust proprietary software to form an enterprisegrade platform. This platform delivers an integrated suite of capabilities for data management, machine learning and advanced analytics, affording customers an agile, scalable and costeffective solution for transforming their businesses. Our platform enables organizations to use vast amounts of data from a variety of sources, including the Internet of Things (IoT), to better serve and market to their customers, design connected products and services and reduce risk through greater insight from data. We generate revenue primarily from sales of our termbased subscriptions of our platform generally on a per node basis, whether deployed onpremises or in the cloud. We also offer consumptionbased pricing for cloudbased deployments. In addition, we generate revenue from professional services and training. We market and sell our platform to a broad range of organizations, although we focus our selling efforts on the largest enterprises globally. We target these organizations because they capture and manage the vast majority of the world’s data and operate highly complex IT environments. We market our platform primarily through a direct sales force while benefiting from business driven by our ecosystem of technology partners, resellers, OEMs, MSPs, independent software vendors and systems integrators. Our total number of Global 8000 customers grew to 698 as of January 31, 2018 from 566 as of January 31, 2017. We compile our Global 8000 list based upon the FORBES Global 2000 ranking of the top 2000 global enterprises as determined by FORBES. The remainder of our Global 8000 list is based on entities listed in Data.com as having the highest annual revenue, excluding those that are already listed in the FORBES Global 2000. For purposes of customer count, we define a customer as an entity with a unique FORBES Global 2000 or Data.com identifier and quarterly subscription revenue as of the measurement date. We update our list of Global 8000 customers periodically. Our customer count is subject to adjustments for acquisitions, spinoffs and other market activity or other factors and previously disclosed numbers of customers are updated to allow for comparability. While we do not typically count multiple entities within a given Global 8000 customer as a new customer, we do make exceptions for holding companies and other organizations for which the FORBES Global 2000 or Data.com identifier in our judgment does not accurately represent the Cloudera customer. The FORBES Global 2000 list is updated annually in the second quarter of the calendar year and we have since updated our previously disclosed numbers of customers to allow for comparability. We have a broad customer base that spans industries and geographies. For the year ended January 31, 2018, 2017 and 2016, no customer accounted for more than 10% of our total revenue. We have significant revenue in the banking and financial services, technology, business services, telecommunications, public sector, consumer and retail, and healthcare and life sciences verticals, and continue to expand our penetration across many other dataintensive industries. Sales outside of the United States represented approximately 28%, 25% and 21% of our total revenue for the years ended January 31, 2018, 2017 and 2016, respectively. Our business model is based on a “land and expand” strategy designed to use the initial sale as a foothold to increase revenue per customer by increasing the amount of data and number of use cases each customer runs through our platform. After an initial purchase of our platform, we work with our customers to identify new use cases that can be developed on or moved to our platform, ultimately increasing the amount of data managed on our platform as well as the number and size of our platform deployments. Our quarterly net subscription revenue expansion rate equals: the subscription revenue in a given quarter from end user customers [/INST] Negative. </s>

Cloudera, Inc.

2019-03-29

2019-01-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” included elsewhere in this Annual Report on Form 10-K. Our fiscal year end is January 31, and references throughout this Annual Report to a given fiscal year are to the twelve months ended on that date. Overview Cloudera is the enterprise data cloud company. We empower people to transform data into clear and actionable insights through an integrated suite of data analytics and management products from the Edge to artificial intelligence (AI). Our portable, multi-cloud platform with common security, governance and data management functions underpins products that include streaming analytics at the edge, data engineering, data warehousing, real-time operational analytics, exploratory data science and machine learning offerings. Today these products are implemented in private and co-location datacenters, multiple public clouds and hybrid cloud environments with common data analytics and management capabilities across all workloads and architectures. Our offerings are based predominantly on open source software, utilizing data stored natively in public cloud object stores as well as in various open source data stores. Using our software, organizations are able to capitalize on vast amounts of data from a variety of sources to better serve and market to their customers, design connected products and services and protect their enterprises. In January 2019, as more fully described in Note 3 to our consolidated financial statements, we completed the merger of Hortonworks, Inc. (Hortonworks), a publicly-held company headquartered in Santa Clara, California (Hortonworks merger). The combined company operates under the Cloudera name. Our results of operations for the year ended January 31, 2019 includes the results of operations of Hortonworks from January 3, 2019 to January 31, 2019. We generate revenue from subscriptions and services. Subscription revenue relates to term (or time-based) subscription agreements for both open source and propriety software including support. Services revenue relates to professional services for the implementation and use of our subscriptions, machine learning expertise and consultation, training and education services and related reimbursable travel costs. We price our subscription offerings based on the number of servers in a cluster, or nodes, core or edge devices, data under management and/or the scope of support provided. During the year ended January 31, 2019, we adopted Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606) (ASC 606), the new accounting standard related to revenue recognition. Prior period information presented has been adjusted to reflect the adoption of this new standard. See Note 2 to consolidated financial statements for details. We market and sell our platform to a broad range of organizations, although we focus our selling efforts on the largest enterprises globally. We target these organizations because they capture and manage the vast majority of the world’s data and operate highly complex IT environments. We market our platform primarily through a direct sales force while benefiting from business driven by our ecosystem of technology partners, resellers, OEMs, MSPs, independent software vendors and systems integrators. As of January 31, 2019, we had more than 2,000 customers. We have a broad customer base that spans industries and geographies. For the years ended January 31, 2019, 2018 and 2017, no customer accounted for more than 10% of our total revenue. We have significant revenue in the banking and financial services, manufacturing, technology, business services, telecommunications, public sector, consumer and retail, and healthcare and life sciences verticals, and continue to expand our penetration across many other data-intensive industries. Sales outside of the United States represented approximately 34%, 30% and 27% of our total revenue for the years ended January 31, 2019, 2018 and 2017, respectively. Our business model is based on a “land and expand” strategy designed to use the initial sale as a foothold to increase revenue per customer by increasing the amount of data and number of use cases each customer runs through our platform. After an initial purchase of our platform, we work with our customers to identify new use cases that can be developed on or moved to our platform, ultimately increasing the amount of data managed on our platform as well as the number and size of our platform deployments. Components of Results of Operations As a result of Hortonworks merger, our results of operations for fiscal 2019 includes Hortonworks’ results of operations from January 3 to January 31, 2019. During fiscal 2018, our IPO was declared effective and the performance-based condition for the RSUs was either achieved or probable of being achieved (see “-Significant Impacts of Stock-based Compensation Expense”). As such we recognized a cumulative catch-up of stock-based compensation expense attributable to service prior to such effective date for RSUs. Revenue We generate revenue from subscriptions and services. Subscription revenue relates to term (or time-based) subscription agreements for both open source and propriety software, including support. Subscription arrangements are typically one to three years in length but may be up to seven years in limited cases. Arrangements with our customers typically do not include general rights of return. Services revenue relates to professional services for the implementation and use of our subscriptions, machine learning expertise and consultation, training and education services and related reimbursable travel costs. We price our subscription offerings based on the number of servers in a cluster, or nodes, core or edge devices, data under management and/or the scope of support provided. Our consulting services are priced primarily on a time and materials basis, and to a lesser extent, a fixed fee basis, and education services are generally priced based on attendance. We expect our revenue to increase in future periods as a result of our continued growth, in addition to increased revenue resulting from the Hortonworks merger in January 2019. Cost of Revenue Cost of revenue for subscriptions primarily consists of personnel costs including salaries, bonuses, travel costs, benefits and stock-based compensation for employees providing technical support for our subscription customers, allocated shared costs (including rent and information technology) and amortization of certain acquired intangible assets from business combinations. Cost of revenue for services primarily consists of personnel costs including salaries, bonuses, benefits and stock-based compensation, fees to subcontractors associated with service contracts, travel costs and allocated shared costs (including rent and information technology). We expect cost of revenue to increase in absolute dollars for the foreseeable future as we continue to obtain new customers and expand our relationship with existing customers, in addition to increased costs resulting from the Hortonworks merger in January 2019. Operating Expenses Research and Development. Research and development expenses primarily consist of personnel costs including salaries, bonuses, travel costs, benefits and stock-based compensation for our research and development employees, contractor fees, allocated shared costs (including rent and information technology), supplies, and depreciation of equipment associated with the continued development of our platform prior to establishment of technological feasibility and the related maintenance of the existing technology. We expect our research and development expenses to increase in absolute dollars for the foreseeable future as we continue to enhance and add new technologies, features and functionality to our subscriptions, in addition to increased costs resulting from the Hortonworks merger in January 2019. Sales and Marketing. Sales and marketing expenses primarily consist of personnel costs including salaries, bonuses, travel costs, sales-based incentives, benefits and stock-based compensation for our sales and marketing employees. In addition, sales and marketing expenses also includes costs for advertising, promotional events, corporate communications, product marketing and other brand-building activities, allocated shared costs (including rent and information technology) and amortization of certain acquired intangible assets from business combinations. Most sales-based incentives are capitalized and expensed over the period of benefit from the underlying contracts. We expect our sales and marketing expenses to increase in absolute dollars as we continue to invest in selling and marketing activities to attract new customers and expand our relationship with existing customers, in addition to increased costs resulting from the Hortonworks merger in January 2019. General and Administrative. General and administrative expenses primarily consist of personnel costs including salaries, bonuses, travel costs, benefits and stock-based compensation for our executive, finance, legal, human resources, information technology and other administrative employees. In addition, general and administrative expenses include fees for third-party professional services, including consulting, legal and accounting services, merger related costs, other corporate expenses, and allocated shared costs (including rent and information technology). We expect our general and administrative expenses to increase in absolute dollars due to the anticipated growth of our business and related infrastructure, in addition to increased costs resulting from the Hortonworks merger in January 2019. Interest Income, net Interest income primarily relates to amounts earned on our cash and cash equivalents and marketable securities. Other Income (Expense), net Other income (expense), net primarily relates to foreign currency transactions, realized gains and losses on our marketable securities, and other non-operating gains or losses. Provision for Income Taxes Provision for income taxes primarily consists of income taxes for certain foreign jurisdictions in which we conduct business. Due to cumulative losses, we maintain a valuation allowance against our U.S and certain foreign deferred tax assets. We consider all available evidence, both positive and negative, in assessing the extent to which a valuation allowance should be applied against our deferred tax assets. Significant Impacts of Stock-based Compensation Expense We have granted RSUs to our employees and members of our board of directors under our 2008 Equity Incentive Plan, or the 2008 Plan, and our 2017 Equity Incentive Plan, or the 2017 Plan. Prior to our IPO in May 2017, the employee RSUs vested upon the satisfaction of both a service-based condition and a liquidity event-related performance condition. The service-based vesting condition for these awards was generally satisfied pro-rata over four years. The liquidity event-related performance condition was achieved for the majority of our RSUs and probable of being achieved for the remaining RSUs on April 27, 2017, the effective date of our IPO. We recognized stock-based compensation expense using the accelerated attribution method with a cumulative catch-up of stock-based compensation expense in the amount of $181.5 million during fiscal 2018, attributable to service prior to such effective date. The total stock-based compensation expense recorded on the effective date of our IPO associated with the achievement of the liquidity event-related performance condition was as follows (in thousands): As a result of the Hortonworks merger, we issued 4,076,157 stock options to purchase shares of our common stock and RSUs for 7,704,004 shares of our common stock to Hortonworks employees in exchange for their outstanding stock options and awards. The total fair value of the stock-based awards assumed is $63.5 million which will be recognized as stock-based compensation expense over a weighted-average period of 1.5 years. Additionally, we recognized $13.1 million of additional stock-based compensation expense during the year ended January 31, 2019 due to the acceleration and modification of certain stock awards assumed as part of the Hortonworks merger. During the year ended January 31, 2019, we incurred $6.2 million of additional stock-based compensation expense related to modifications of stock awards held by certain employees. Results of Operations Our results of operations for the year ended January 31, 2019 includes the results of operations of Hortonworks from January 3, 2019 to January 31, 2019. See Note 3 to our consolidated financial statements. The consolidated statements of operations data for each of the years ended January 31, 2019, 2018 and 2017 set forth in the tables below have been updated to comply with the new standards under Topic 606, including previously reported amounts, which are labeled “as adjusted”. See Note 2 to our consolidated financial statements. The following table sets forth our results of operations for the periods indicated: * As adjusted to reflect the impact of the full retrospective adoption of Topic 606. See Note 2 to our consolidated financial statements for a summary of adjustments. (1) Amounts include stock-based compensation expense as follows: (2) Amounts include amortization of acquired intangible assets as follows: (3) In January 2017, we donated 1,175,063 shares of common stock to the Cloudera Foundation. We recorded a non-cash charge of $21.6 million for the fair value of the donated shares, which was recognized in general and administrative expense for the year ended January 31, 2017, see Note 11 to our consolidated financial statements for further discussion. The following table sets forth selected consolidated statements of operations data for each of the periods indicated as a percentage of total revenue: * As adjusted to reflect the impact of the full retrospective adoption of Topic 606. See Note 2 to our consolidated financial statements for a summary of adjustments. (1) Amounts include stock-based compensation expense as a percentage of total revenue as follows: (2) Amounts include amortization of acquired intangible assets as a percentage of total revenue as follows: (3) As a percentage of revenue, the non-cash expense recognized for the donation of common stock to the Cloudera Foundation for the year ended January 31, 2017 was 8%. Years Ended January 31, 2019 and 2018 Revenue * As adjusted to reflect the impact of the full retrospective adoption of Topic 606. See Note 2 to our consolidated financial statements for a summary of adjustments. The increase in subscription revenue during the year ended January 31, 2019 compared to the year ended January 31, 2018 was primarily attributable to volume driven increases in subscription sales to new and existing customers. Our Hortonworks merger in January 2019 contributed approximately $15.1 million of total subscription revenue. During the year ended January 31, 2019 as compared to the year ended January 31, 2018, the increase in our services revenue was primarily attributable to services revenue associated with Hortonworks, which was approximately $4.4 million. Cost of Revenue, Gross Profit and Gross Margin * As adjusted to reflect the impact of the full retrospective adoption of Topic 606. See Note 2 to our consolidated financial statements for a summary of adjustments. The decrease in cost of revenue for subscription during the year ended January 31, 2019 compared to the year ended January 31, 2018 was primarily due to a decrease of $14.9 million in stock-based compensation expense resulting from the catch-up of stock-based compensation expense following our IPO during the year ended January 31, 2018, partially offset by an increase of $4.1 million in employee-related costs including salaries and benefits, bonuses, severance costs and travel costs, which also includes additional employee- related costs from the Hortonworks merger, an increase of $2.6 million in allocated shared costs and an increase of $1.0 million in amortization of intangible assets due to additional amortization of intangible assets resulting from the Hortonworks merger. The decrease in cost of revenue for services during the year ended January 31, 2019 compared to the year ended January 31, 2018 was primarily due to a decrease of $20.4 million in stock-based compensation expense resulting from the catch-up of stock-based compensation expense following our IPO during the year ended January 31, 2018 and a decrease of $2.5 million in outside consultant fees, partially offset by an increase of $7.0 million in employee-related costs including salaries and benefits, bonuses, severance costs and travel costs, which also includes additional employee- related costs from the Hortonworks merger, and an increase of $1.4 million in allocated shared costs. Subscription gross margin increased from 77% to 84% in the year ended January 31, 2019 as compared to the same period a year ago primarily due to lower stock-based compensation expense. Services gross margin increased from negative 25% to 1% in the year ended January 31, 2019 as compared to the same period a year ago primarily due to lower stock-based compensation expense. Operating Expenses * As adjusted to reflect the impact of the full retrospective adoption of Topic 606. See Note 2 to our consolidated financial statements for a summary of adjustments. Research and Development The decrease in research and development expenses during the year ended January 31, 2019 compared to the year ended January 31, 2018 was primarily due to a decrease of $58.7 million in stock-based compensation expense resulting from the catch-up of stock-based compensation expense following our IPO during the year ended January 31, 2018, partially offset by an increase of $10.5 million in employee-related costs including salaries and benefits, bonuses, severance costs and travel costs, which also includes additional employee- related costs from the Hortonworks merger, and an increase of $5.1 million in allocated shared costs. Sales and Marketing The decrease in sales and marketing expenses during the year ended January 31, 2019 compared to the year ended January 31, 2018 was primarily due to a decrease of $62.5 million in stock-based compensation expense resulting from the catch-up of stock-based compensation expense following our IPO during the year ended January 31, 2018, partially offset by an increase of $18.5 million in employee-related costs including salaries, incentive-based compensation and benefits, severance costs and travel costs, which also includes additional employee- related costs from the Hortonworks merger, an increase of $4.4 million as a result of intangible assets acquired in conjunction from the Hortonworks merger, an increase of $3.4 million in allocated shared costs and an increase of $1.5 million in outside consultant fees. General and Administrative The increase in general and administrative expenses during the year ended January 31, 2019 compared to the year ended January 31, 2018 was primarily due to $22.8 million of merger-related costs, an increase of $9.3 million in employee-related costs including salaries and benefits, bonuses, severance costs and travel costs, which also includes additional employee-related costs from the Hortonworks merger, and an increase of $2.3 million in allocated shared costs, partially offset by a decrease of $16.2 million in stock-based compensation expense resulting from the catch-up of stock-based compensation expense following our IPO during the year ended January 31, 2018. Interest Income, net Interest income, net increased primarily due to higher average investments in marketable securities. Other Income (Expense), net Other expense, net during the year ended January 31, 2019 was primarily due to foreign exchange losses as compared to other income, net during the year ended January 31, 2018 due to foreign exchange gains. Provision for Income Taxes Provision for income taxes increased primarily due to increases in foreign income taxes and tax withholding from increases on foreign sales during the year ended January 31, 2019 as compared to the same period a year ago. Years Ended January 31, 2018 and 2017 Revenue * As adjusted to reflect the impact of the full retrospective adoption of Topic 606. See Note 2 to our consolidated financial statements for a summary of adjustments. The increase in subscription revenue during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily attributable to volume driven increases in subscription sales to new and existing customers. During the year ended January 31, 2018 as compared to the year ended January 31, 2017, our services revenue increased at a lower rate compared to the increase in our subscription revenue primarily due to our existing customers’ increasing experience with the technology as well as our efforts to develop relationships with partners and other system integrators, resulting in a shift of the provision of such services to these partners and system integrators. Cost of Revenue, Gross Profit and Gross Margin * As adjusted to reflect the impact of the full retrospective adoption of Topic 606. See Note 2 to our consolidated financial statements for a summary of adjustments. The increase in cost of revenue for subscription during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $23.4 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $6.5 million in salaries and benefits related to growth in employee headcount to support our overall expansion in customers and an increase of $2.2 million in allocated shared costs. Subscription gross margin declined from 81% to 77% in the year ended January 31, 2018 as compared to the year ended January 31, 2017 due to the recording of stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO. The increase in cost of revenue for services during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $30.0 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $7.5 million in salaries and benefits related to growth in employee headcount and an increase of $0.9 million in allocated shared costs. Services gross margin declined from 25% to negative 25% in the year ended January 31, 2018 as compared to the same period the year ended January 31, 2017 due to the recording of stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO. Operating Expenses * As adjusted to reflect the impact of the full retrospective adoption of Topic 606. See Note 2 to our consolidated financial statements for a summary of adjustments. Research and Development The increase in research and development expenses during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $94.5 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $12.9 million in employee-related costs including salaries, benefits and travel costs associated with the growth in employee headcount and an increase of $6.6 million in allocated shared costs, offset by a decrease of $1.9 million in costs for services from external vendors. Sales and Marketing The increase in sales and marketing expenses during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $84.7 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $14.5 million in employee-related costs including salaries, incentive-based compensation and benefits and travel costs associated with the growth in employee headcount to support our overall sales activities and an increase of $2.8 million in allocated shared costs, offset by a decrease of $0.2 million in advertising costs. General and Administrative The increase in general and administrative expenses during the year ended January 31, 2018 compared to the year ended January 31, 2017 was primarily due to an increase of $35.7 million in stock-based compensation expense resulting from the achievement of the liquidity event-related performance condition on the effective date of the IPO, an increase of $8.4 million in employee-related costs including salaries, benefits and travel costs associated with the growth in employee headcount to support our overall expansion, a cash donation of $2.4 million, or 1% of the net proceeds from the IPO, to fund the Cloudera Foundation and an increase of $0.9 million in costs for services from external vendors, offset by a decrease of a $21.6 million non-cash charge related to the donation of 1,175,063 shares of our common stock to the Cloudera Foundation in fiscal 2017. Interest Income, net Interest income, net increased primarily due to an increase in our cash balance obtained from the net proceeds of the IPO during the year ended January 31, 2018 as compared to the year ended January 31, 2017. Other Income (Expense), net Other income (expense), net increased primarily due to an increase of $1.9 million from foreign exchange gains during the year ended January 31, 2018 as compared to the year ended January 31, 2017. Provision for Income Taxes Provision for income taxes decreased primarily due to an income tax benefit of $0.8 million resulting from an acquisition, offset by increases in foreign income taxes and tax withholding from increases on foreign sales, during the year ended January 31, 2018 as compared to the year ended January 31, 2017. Seasonality We have seasonal and end-of-quarter concentration of our sales, which impacts our ability to plan and manage cash flows and margins. Our sales vary by season with the fourth quarter typically being our strongest sales quarter, and the first quarter typically being our largest collections and operating cash flow quarter. In addition, within each quarter, most sales occur in the last month of that quarter. See “Risk Factors-Our sales cycles can be long, unpredictable and vary seasonally, particularly with respect to large subscriptions, and our sales efforts require considerable time and expense.” Liquidity and Capital Resources As of January 31, 2019, our principal sources of liquidity were cash, cash equivalents and marketable securities totaling $537.2 million which are held for working capital purposes. Our cash equivalents are comprised primarily of money market funds and our marketable securities are comprised of asset-backed securities, corporate notes and obligations, commercial paper, certificates of deposit, U.S. treasury securities and foreign government obligations. To date, our principal sources of liquidity have been payments received from customers for our subscriptions and services, the net proceeds we received through the sale of our common stock in our IPO in May 2017, our follow-on offering in October 2017 and private sales of equity securities. Further, we acquired $49.0 million of cash, cash equivalents and marketable securities as a result of the Hortonworks merger. We believe our existing liquidity will be sufficient to meet our working capital and capital expenditure needs for at least the next twelve months. Our future capital requirements may vary materially from those currently planned and will depend on many factors, including our net expansion rate, the timing and extent of spending on research and development efforts, the expansion of sales and marketing activities, the continuing market acceptance of our subscriptions and services and ongoing investments to support the growth of our business. We may in the future enter into arrangements to acquire or invest in complementary businesses, services and technologies and intellectual property rights. From time to time, we may explore additional financing sources which could include equity, equity-linked and debt financing arrangements. We cannot assure you that any additional financing will be available on terms favorable to us, or at all. If adequate funds are not available on acceptable terms, or at all, we may not be able to adequately fund our business plans and it could have a negative effect on our operating cash flows and financial condition. The following table summarizes our cash flows for the periods indicated: Cash Provided by (Used in) Operating Activities During the year ended January 31, 2019, cash provided by operating activities was $34.3 million which was due to a net loss of $192.6 million offset by non-cash adjustments of $164.0 million and an increase from net change in operating assets and liabilities of $62.9 million. Non-cash adjustments primarily consisted of $117.4 million of stock-based compensation, amortization of deferred costs of $30.6 million and $17.4 million of depreciation and amortization. The net change in operating assets and liabilities, after excluding the impacts from operating assets and liabilities acquired in the business combination with Hortonworks, is as follows: a net decrease in accounts receivable of $54.2 million due to the timing of invoicing compared to the receipt of cash from customers, an increase in deferred revenue of $36.6 million due to the timing of amounts billed to customers compared to revenue recognized during the same period, a decrease in prepaid expenses and other assets of $16.5 million, due to a net increase in other contract liabilities of $5.9 million and a net increase in accounts payable and accrued expenses and other liabilities of $9.2 million due to timing of payments to vendors, offset by a net increase in deferred costs of $39.7 million due to the difference in timing of payment of deferred costs and recognition of these costs and a net decrease in accrued compensation of $18.0 million due to the timing of bonus and incentive-based compensation payments. During the year ended January 31, 2018, cash used in operating activities was $42.3 million which was due to a net loss of $369.7 million partially offset by non-cash adjustments of $325.0 million and an increase from net change in operating assets and liabilities of $2.4 million. Non-cash adjustments primarily consisted of $290.0 million of stock-based compensation, amortization of deferred costs of $23.3 million and $12.1 million of depreciation and amortization. The net change in operating assets and liabilities was due to an increase in deferred revenue of $57.5 million due to the timing of amounts billed to customers compared to revenue recognized during the same period, a net increase in accounts payable and accrued expenses and other liabilities of $7.0 million due to timing of payments to vendors, an increase in accrued compensation of $5.2 million due to the timing of bonus and incentive-based compensation payments, offset by a net increase in deferred costs of $34.6 million due to the difference in timing of payment of costs and recognition of costs, an increase in accounts receivable of $28.8 million due to the timing of invoicing compared to the receipt of cash from customers and an increase in prepaid expenses and other assets of $16.2 million. During the year ended January 31, 2017, cash used in operating activities was $116.6 million which was due to a net loss of $158.4 million partially offset by non-cash adjustments of $73.5 million and an increase from net change in operating assets and liabilities of $31.6 million. Non-cash adjustments consisted of $21.7 million of stock-based compensation, $21.6 million of expense for the donation of common stock to the Cloudera Foundation, amortization of deferred costs of $17.2 million, $10.1 million of depreciation and amortization and $2.9 million in accretion and amortization of marketable securities. The net change in operating assets and liabilities was due to an increase in accounts receivable of $56.7 million due to the timing of invoicing compared to the receipt of cash from customers, a net increase in deferred costs of $34.9 million due to the difference in timing of payment of costs and recognition of costs, an increase of $3.3 million in prepaid expenses and other assets, partially offset by an increase in deferred revenue of $50.4 million due to the timing of amounts billed to customers compared to revenue recognized during the same period, an increase in accrued compensation of $11.2 million due to the timing of bonus and incentive-based compensation payments. Cash Provided by (Used in) Investing Activities During the year ended January 31, 2019, cash provided by investing activities was $62.0 million which was due to sales and maturities of marketable securities of $492.2 million and cash acquired from the business combination with Hortonworks of $42.6 million, partially offset by purchases of marketable securities of $462.7 million and capital expenditures for the purchase of property and equipment of $10.1 million. During the year ended January 31, 2018, cash used in investing activities was $234.5 million which was due to purchases of marketable securities of $620.3 million, partially offset by sales and maturities of marketable securities of $400.6 million, capital expenditures for the purchase of property and equipment of $13.0 million and cash used in business combinations, net of cash acquired, of $1.9 million. During the year ended January 31, 2017, cash provided by investing activities was $168.6 million which was due to sales and maturities of marketable securities of $282.4 million, partially offset by purchases of marketable securities of $103.8 million, cash used in business combinations, net of cash acquired, of $2.7 million and purchases of property and equipment of $7.4 million. Cash Provided by Financing Activities During the year ended January 31, 2019, cash provided by financing activities was $5.6 million which was due to proceeds from the exercise of stock options and withholdings under our 2017 Employee Stock Purchase Plan (ESPP) of $21.8 million, offset by shares withheld related to the net settlement of RSUs of $16.2 million. During the year ended January 31, 2018, cash provided by financing activities was $247.3 million which was due to the net proceeds from the issuance of common stock in the IPO of $237.4 million, the net proceeds from the follow-on offering of $46.0 million and proceeds from the exercise of stock options and withholdings under our ESPP of $23.7 million, offset by shares withheld related to net settlement of RSUs of $59.8 million. During the year ended January 31, 2017, cash provided by financing activities was $1.5 million which was due to proceeds from the exercise of stock options of $3.6 million, offset by payment of deferred offering costs of $2.1 million. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have any holdings in variable interest entities. Contractual Obligations and Commitments The following table summarizes our non-cancelable contractual obligations as of January 31, 2019: (1) We lease our facilities under long-term operating leases, which expire at various dates through 2027. The lease agreements frequently include provisions which require us to pay taxes, insurance, or maintenance costs. The above table also includes the non-cancelable contractual obligations that we assumed as part of the Hortonworks merger. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (GAAP). The preparation of these financial statements requires our management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these judgments and estimates under different assumptions or conditions and any such differences may be material. We believe that our significant accounting policies, which are discussed in Note 2 to our consolidated financial statements, and the accounting policies discussed below, involve a greater degree of complexity, involving management’s judgments and estimates. Accordingly, these are the policies we believe are critical to understanding our financial condition and historical and future results of operations. Revenue Recognition We generate revenue from subscriptions and services. Subscription revenue relates to term (or time-based) subscription agreements for both open source and propriety software including support. Subscription arrangements are typically one to three years in length but may be up to seven years in limited cases. Arrangements with our customers typically do not include general right of returns. Services revenue relates to professional services for the implementation and use of our subscriptions, machine learning expertise and consultation, training and education services and related reimbursable travel costs. We price our subscription offerings based on the number of servers in a cluster, or nodes, core or edge devices, data under management and/or the scope of support provided. Our consulting services are priced primarily on a time and materials basis, and to a lesser extent, a fixed fee basis, and training services are generally priced based on attendance. We determine revenue recognition through the following steps, which are described in more detail below: • Identification of the contract or contracts with a customer • Identification of the performance obligation(s) in the contract • Determination of the transaction price • Allocation of the transaction price to the performance obligation(s) in the contract • Recognition of revenue when, or as, a performance obligation is satisfied Our agreements with customers often include multiple subscriptions and/or professional services elements, and these elements are sometimes included in separate contracts. We consider an entire customer arrangement to determine if separate contracts entered into at or near the same time should be considered combined for the purposes of revenue recognition. We work with partners in various capacities whereby we are typically responsible for providing the actual product or service as a principal. At contract inception, we assess the subscription and services product offerings or bundle of product offerings in our contracts to identify performance obligations that are distinct. A performance obligation is distinct when it is separately identifiable from other items in a bundled package and if a customer can benefit from it on its own or with other resources that are readily available to the customer. To identify our performance obligations, we consider all of the product offerings promised in the contract. We have concluded that our contracts with customers do not contain warranties that give rise to a separate performance obligation. The transaction price is the total amount of consideration we expect to be entitled to in exchange for the product offerings in a contract. Sales, value-added and other taxes we collect from customers concurrent with revenue-producing activities are excluded from revenue. In the instance where our contracts with customers contain variable consideration, we estimate variable consideration primarily using the expected value method. Once we have determined the transaction price, the total transaction price is allocated to each performance obligation in a manner depicting the amount of consideration to which we expect to be entitled in exchange for transferring the product(s) or service(s) to the customer (allocation objective). If the allocation objective is met at contractual prices, no allocations are performed. Otherwise, we allocate the transaction price to each performance obligation identified in the contract on a relative stand-alone selling price basis. In order to determine the stand-alone selling price, we conduct a periodic analysis that requires judgment and considers multiple factors that are reasonably available and maximizes the use of observable inputs that may vary over time depending upon the unique facts and circumstances related to each performance obligation. To have observable inputs, we require that a substantial majority of the stand-alone selling prices for a product offering fall within a pricing range. If a directly observable stand-alone selling price does not exist, we estimate a stand-alone selling price range by reviewing external and internal market factor categories, which may include pricing practices, historical discounting, industry practices, service groups and geographic considerations. There is also no hierarchy for how to estimate or otherwise determine the stand-alone selling price for product offerings that are not sold separately, however, we maximize the use of observable data. We believe that this analysis results in an estimate that approximates the price we would charge for the product offerings if they were sold separately. The following describes the nature of our primary types of revenue and the revenue recognition policies and significant payment terms as they pertain to the types of transactions we enter into with our customers. Subscription Revenue Subscription revenue relates to term (or time-based) subscriptions to our platform, which includes both open source and proprietary software and related support. Subscriptions include internet, email and phone support, bug fixes, and the right to receive unspecified software updates and upgrades released when and if available during the subscription term. Revenue for subscription arrangements is recognized ratably beginning on the later of the date access is made available to the customer or the start of the contractual term of the arrangement. Subscription revenue also includes revenue related to functional intellectual property that is generally recognized on the date access is made available to the customer. As part of a subscription, we stand ready to help customers resolve technical issues related to the installed platform. The subscriptions are designed to assist throughout a customer’s lifecycle from development to proof-of-concept, to quality assurance and testing, to production and development. Subscription is generally offered under renewable, fixed fee contracts where payments are typically due annually in advance and may have a term of one year or multiple years. The contracts generally do not contain refund provisions for fees earned related to services performed. A subscription is viewed as a stand-ready performance obligation comprised of a series of distinct days of service that is satisfied ratably over time as the services are provided. A time-elapsed output method is used to measure progress because our efforts are expended evenly throughout the period given the nature of the promise is a stand-ready service. Unearned subscription revenue is included in deferred revenue and other contract liabilities. On occasion, we may sell engineering services and/or a premium subscription agreement that provides a customer with development input and the opportunity to work more closely with our developers. Services revenue Services revenue is derived primarily from customer fees for consulting services engagements and education services. Our professional services are provided primarily on a time and materials basis and, to a lesser extent, a fixed fee basis, and education services are generally priced based on attendance. Time and material contracts are generally invoiced based upon hours incurred on a monthly basis and fixed fee contracts may be invoiced up-front or as milestones are achieved throughout the project. Services revenue is typically recognized over time as the services are rendered. Depending on the nature of the professional services engagement (e.g., time and materials basis, fixed fee basis, etc.), various measures of progress may be used to recognize revenue. These measures of progress include recognizing revenue in an amount equal to and at the time of invoicing, a measure of time incurred relative to remaining hours expected to be delivered, or other similar measures. These measures depict our efforts to satisfy services contracts and therefore reflect the transfer of control for the services to a customer. Contract Assets Contract assets consist of the right to consideration in exchange for product offerings that we have transferred to a customer when that right is conditional on something other than the passage of time (e.g., performance prior to invoicing on fixed fee service arrangements with substantive acceptance terms). We record unbilled accounts receivable related to revenue recognized in excess of amounts invoiced as we have an unconditional right to invoice and receive payment in the future related to those fulfilled obligations. When we have unconditional rights to consideration, except for the passage of time, a receivable will be recorded on the consolidated balance sheets. We do not typically include extended payment terms in our contracts with customers. Contract Liabilities Contract liabilities represent an obligation to transfer product offerings for which we have received consideration, or for which an amount of consideration is due from the customer (e.g., subscription arrangements where consideration is paid annually in advance). Contract liabilities are comprised of short-term and long-term deferred revenue and other contract liabilities. Deferred revenue consists of amounts invoiced to customers but not yet recognized as revenue. Our contract balances will be reported as net contract assets or liabilities on a contract-by-contract basis at the end of each reporting period. Contract Costs Contract costs, consisting primarily of sales commissions and payroll taxes, that are incremental to obtaining a subscription contract with a customer are capitalized and recorded as deferred costs. We expect to recover deferred contract costs over the period of benefit from the underlying contracts. The amortization period for recovery is consistent with the timing of transfer to the customer of services to which the capitalized costs relate. Contract costs that relate to an underlying transaction are expensed commensurate with the recognition of revenue as performance obligations are satisfied. Contract costs that are incurred in excess of those relating to an underlying transaction are not considered commensurate with recognition of revenue as performance obligations are satisfied, and are amortized on a straight-line basis over the expected benefit period of five years. Commissions for services are treated as a separate class with a contract duration of less than a year and are expensed as incurred. Contract costs were $69.0 million and $60.0 million as of January 31, 2019 and 2018, respectively. For the years ended January 31, 2019, 2018, and 2017, amortization expense for the contract costs were $30.6 million, $23.3 million and $17.2 million, respectively, and there was no impairment loss in relation to the costs capitalized. We do not incur direct fulfillment-related costs of a nature required to be capitalized and amortized. Business Combinations, Goodwill and Intangible Assets We allocate the fair value of purchase consideration in a business combination to tangible assets, liabilities assumed, and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is allocated to goodwill. The allocation of the purchase consideration requires management to make significant estimates and assumptions, especially with respect to intangible assets. These estimates can include, but are not limited to, future expected cash flows from acquired customers and acquired technology from a market participant perspective, useful lives and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable, and, as a result, actual results may differ from estimates. During the measurement period, which is up to one year from the acquisition or merger date, we may record adjustments to the assets acquired and liabilities assumed with the corresponding offset to goodwill. Upon the conclusion of the measurement period, any subsequent adjustments are recorded to earnings. We assess goodwill for impairment at least annually and whenever events or changes in circumstances indicate that the carrying value of the asset may not be recoverable. We test goodwill using the two-step process. In the first step, we compare the carrying amount of the reporting unit to the fair value based on the fair value of our common stock. If the fair value of the reporting unit exceeds the carrying value, goodwill is not considered impaired and no further testing is required. If the carrying value of the reporting unit exceeds the fair value, goodwill is potentially impaired, and the second step of the impairment test must be performed. In the second step, we would compare the implied fair value of the goodwill to its carrying amount to determine the amount of impairment loss, if any. Acquired finite-lived intangible assets are amortized over their estimated useful lives. We evaluate the recoverability of our intangible assets for possible impairment whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of these assets is measured by a comparison of the carrying amounts to the future undiscounted cash flows the intangible assets are expected to generate. If such review indicates that the carrying amount of our intangible assets is not recoverable, the carrying amount of such assets is reduced to fair value. We have not recorded any such impairment charge during the periods presented. Stock-based Compensation We recognize stock-based compensation expense for all stock-based payments. Employee stock-based compensation cost is estimated at the grant date based on the fair value of the equity for financial reporting purposes and is recognized as expense, over the requisite service period. We calculate the fair value of options and purchase rights granted under the ESPP based on the Black-Scholes option-pricing model. The Black-Scholes model requires the use of various assumptions including expected term and expected stock price volatility. We estimate the expected term for stock options using the simplified method due to the lack of historical exercise activity. The simplified method calculates the expected term as the midpoint between the vesting date and the contractual expiration date of the award. The expected term for the ESPP purchase rights is estimated using the offering period, which is typically six months. We estimate volatility for options and ESPP purchase rights using volatilities of a group of public companies in a similar industry, stage of life cycle, and size. The interest rate is derived from government bonds with a similar term to the option or ESPP purchase right granted. We have not declared nor do we expect to declare dividends. Therefore, there is no dividend impact on the valuation of options or ESPP purchase rights. We use the straight-line method for employee expense attribution for stock options and ESPP purchase rights. We have granted RSUs to our employees and members of our board of directors under our 2008 Plan) and our 2017 Plan. Prior to our IPO in May 2017, the employee RSUs vested upon the satisfaction of both a service-based vesting condition and a liquidity event-related performance vesting condition. RSUs granted subsequent to our IPO vest upon the satisfaction of a service-based vesting condition only. The service-based condition for the majority of these awards is generally satisfied pro-rata over four years. In fiscal 2017, stock-based compensation expense was recorded based on awards that were ultimately expected to vest, and such expense was reduced for estimated forfeitures. When estimating forfeitures, we considered voluntary termination behaviors as the trend in actual option forfeitures. We estimate the fair value of options and other equity awards granted to non-employees using the Black-Scholes method. These awards are subject to periodic re-measurement over the period during which services are rendered. Stock-based compensation expense is recognized over the vesting period on a straight-line basis. JOBS Act Accounting Election Under the Jumpstart Our Business Startups Act of 2012, or the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We elected to retain the ability to use this extended transition period for complying with new or revised accounting standards that have different effective dates for public and private companies until the earlier of the date that we (i) are no longer an emerging growth company or (ii) affirmatively and irrevocably opt out of the extended transition period provided in the JOBS Act. We lost our emerging growth company status during the year ended January 31, 2019 as the market value of our common stock held by non-affiliates was greater than $700 million as of July 31, 2018. Recent Accounting Pronouncements See “Recently Adopted Accounting Standards” and “Recently Issued Accounting Standards” in Note 2 to our consolidated financial statements.

<s>[INST] Overview Cloudera is the enterprise data cloud company. We empower people to transform data into clear and actionable insights through an integrated suite of data analytics and management products from the Edge to artificial intelligence (AI). Our portable, multicloud platform with common security, governance and data management functions underpins products that include streaming analytics at the edge, data engineering, data warehousing, realtime operational analytics, exploratory data science and machine learning offerings. Today these products are implemented in private and colocation datacenters, multiple public clouds and hybrid cloud environments with common data analytics and management capabilities across all workloads and architectures. Our offerings are based predominantly on open source software, utilizing data stored natively in public cloud object stores as well as in various open source data stores. Using our software, organizations are able to capitalize on vast amounts of data from a variety of sources to better serve and market to their customers, design connected products and services and protect their enterprises. In January 2019, as more fully described in Note 3 to our consolidated financial statements, we completed the merger of Hortonworks, Inc. (Hortonworks), a publiclyheld company headquartered in Santa Clara, California (Hortonworks merger). The combined company operates under the Cloudera name. Our results of operations for the year ended January 31, 2019 includes the results of operations of Hortonworks from January 3, 2019 to January 31, 2019. We generate revenue from subscriptions and services. Subscription revenue relates to term (or timebased) subscription agreements for both open source and propriety software including support. Services revenue relates to professional services for the implementation and use of our subscriptions, machine learning expertise and consultation, training and education services and related reimbursable travel costs. We price our subscription offerings based on the number of servers in a cluster, or nodes, core or edge devices, data under management and/or the scope of support provided. During the year ended January 31, 2019, we adopted Accounting Standards Update (ASU) 201409, Revenue from Contracts with Customers (Topic 606) (ASC 606), the new accounting standard related to revenue recognition. Prior period information presented has been adjusted to reflect the adoption of this new standard. See Note 2 to consolidated financial statements for details. We market and sell our platform to a broad range of organizations, although we focus our selling efforts on the largest enterprises globally. We target these organizations because they capture and manage the vast majority of the world’s data and operate highly complex IT environments. We market our platform primarily through a direct sales force while benefiting from business driven by our ecosystem of technology partners, resellers, OEMs, MSPs, independent software vendors and systems integrators. As of January 31, 2019, we had more than 2,000 customers. We have a broad customer base that spans industries and geographies. For the years ended January 31, 2019, 2018 and 2017, no customer accounted for more than 10% of our total revenue. We have significant revenue in the banking and financial services, manufacturing, technology, business services, telecommunications, public sector, consumer and retail, and healthcare and life sciences verticals, and continue to expand our penetration across many other dataintensive industries. Sales outside of the United States represented approximately 34%, 30% and 27% of our total revenue for the years ended January 31, 2019, 2018 and 2017, respectively. Our business model is based on a “land and expand” strategy designed to use the initial sale as a foothold to increase revenue per customer by increasing the amount of data and number of use cases each customer runs through our platform. After an initial purchase of our platform, we work with our customers to identify new use cases that can be developed on or moved to our platform, ultimately increasing the amount of data managed on our platform as well as the number and size of our platform deployments. Components of Results of Operations As a result of Hortonworks merger, our results of operations for fiscal 2019 includes Hortonworks’ results of operations from January 3 to January [/INST] Positive. </s>

New Frontier Corp

2019-04-01

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. References to the “Company,” “our,” “us” or “we” refer to New Frontier Corporation. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Form 10-K. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Cautionary Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Form 10-K, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forward-looking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Form 10-K should be read as being applicable to all forward-looking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on March 28, 2018 as a Cayman Islands exempted company formed for the purpose of effecting a business combination. We have reviewed, and continue to review a number of opportunities to enter into a business combination, but we are not able to determine at this time whether we will complete a business combination with any of the target businesses that we have reviewed or with any other target business. We also have neither engaged in any operations nor generated any revenue to date. Based on our business activities, the Company is a “shell company” as defined under the Exchange Act because we have no operations and nominal assets consisting almost entirely of cash. On July 3, 2018, we consummated the initial public offering of 28,750,000 units, including 3,750,000 units issued pursuant to the exercise of the underwriters’ over-allotment option in full. Each unit consists of one Class A ordinary share and one-half of one warrant, with each whole warrant entitling the holder thereof to purchase one Class A ordinary share for $11.50 per share. The units were sold at a price of  $10.00 per unit, generating gross proceeds of  $287.5 million. Simultaneously with the consummation of the initial public offering, we completed the private placement of 7,750,000 private placement warrants to the Sponsor at a purchase price of  $1.00 per private placement warrant, generating gross proceeds to the Company of  $7,750,000. Prior to the consummation of the initial public offering, on April 19, 2018, the Sponsor purchased 10,750,000 founder shares, which issuance was reflected on the register of members of the company on May 29, 2018 in exchange for a capital contribution of $25,000, or approximately $0.002 per share, 5,000,000 of which were issued in connection with the forward purchase agreements. In addition, as an inducement to the anchor investors to enter into with the forward purchase agreements, on June 19, 2018, the Sponsor transferred to the anchor investors an aggregate of 2,262,500 founder shares for no cash consideration. On June 12, 2018, the Sponsor forfeited 475,000 founder shares to us for no consideration. On June 18, 2018, we effected a share capitalization resulting in the Sponsor holding an aggregate of 8,875,000 founder shares after giving effect to the transfer described above. On June 27, 2018, we effected a share capitalization resulting in the Sponsor holding an aggregate of 9,450,000 founder shares. Subsequent to the closing of the initial public offering, the Sponsor transferred an aggregate of 20,000 founder shares to certain of its independent directors (or their designees) in respect of their service on the board of directors. Prior to the initial public offering, we entered into forward purchase agreements pursuant to which the anchor investors agreed to subscribe for an aggregate of 18,100,000 forward purchase shares plus 4,525,000 forward purchase warrants for a purchase price of   $10.00 multiplied by the number of Class A ordinary shares, or $181,000,000 in the aggregate, which aggregate purchase price includes purchases by entities controlled by Antony Leung and Carl Wu, our Chairman and Chief Executive Officer, for an aggregate of   $21,000,000, in a private placement to close concurrently with the closing of our initial business combination. In connection with these agreements, the Sponsor transferred to the anchor investors an aggregate of 2,262,500 founder shares as an inducement to enter into the forward purchase agreements for no cash consideration. Subject to certain exceptions to forfeiture and transfer provisions, the founder shares transferred in connection with these agreements are subject to similar contractual conditions and restrictions as the founder shares issued to the Sponsor in connection with the initial public offering. The forward purchase warrants will have the same terms as our public warrants. Under the terms of the forward purchase agreements, if an anchor investor fails to close on its obligation to purchase forward purchase securities at the time of the initial business combination, such anchor investor will be contractually required to forfeit any and all founder shares transferred to it. We entered into an additional forward purchase agreement as of June 29, 2018, with an accredited investor providing for the purchase of 900,000 forward purchase shares, plus 225,000 forward purchase warrants, for an aggregate purchase price of  $9.0 million, or $10.00 per forward purchase share, in a private placement to close concurrently with the closing of the initial business combination. As an inducement to such accredited investor to enter into the forward purchase agreement, we will issue an aggregate of 112,500 Class B ordinary shares to the accredited investor for nominal cash consideration upon the completion of the initial business combination. The obligations under the forward purchase agreements do not depend on whether any public shareholders redeem their shares and provide us with a minimum funding level for the initial business combination. A total of  $287,500,000, comprised of  $283,550,000 of the proceeds from the initial public offering (which amount includes $5,600,000 of the underwriters’ deferred discount) and $3,950,000 of the proceeds of the sale of the private placement warrants, was placed in a segregated trust account located in London at Citibank maintained by Continental Stock Transfer & Trust Company, acting as trustee. The amounts held in the trust account is invested in permitted United States “government securities” within the meaning of Section 2(a)(16) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), having a maturity of 180 days or less or in money market funds meeting certain conditions under Rule 2a-7 promulgated under the Investment Company Act that invest only in direct U.S. government treasury obligations. Except with respect to interest earned on the funds in the trust account that may be released to us to pay our taxes, the funds held in the trust account will not be released until the earliest of  (i) the completion of our initial business combination, (ii) the redemption of any of the Class A ordinary shares included in the units sold in the initial public offering (the “public shares”) properly submitted in connection with a shareholder vote to amend our amended and restated certificate of incorporation to modify the substance or timing of our obligation to redeem 100% of the public shares if we do not complete our initial business combination within 24 months from the closing of the initial public offering or (iii) the redemption of the public shares if we are unable to complete our initial business combination within 24 months from the closing of the initial public offering, subject to applicable law. In connection with the initial public offering, we incurred offering costs of approximately $12 million, inclusive of approximately $6.91 million in deferred underwriting commissions. We paid $3.95 million of underwriting fees upon the closing of the initial public offering and deferred $6.91 million of underwriting fees until the consummation of the initial business combination. Our management has broad discretion with respect to the specific application of the net proceeds of the initial public offering, the private placement and the private placement of the forward purchase securities, although substantially all of the net proceeds are intended to be applied toward consummating an initial business combination. If we are unable to complete our initial business combination by July 3, 2020, we will: (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest (less up to $100,000 of interest to pay dissolution expenses and net of taxes payable), divided by the number of then outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any) and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining shareholders and our board of directors, liquidate and dissolve, subject in the case of clauses (ii) and (iii) to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to our warrants, which will expire worthless if we fail to complete our initial business combination by July 3, 2020. Results of Operations For the year ended December 31, 2018, we incurred a loss from operations of  $778,402, which was offset by interest income from the trust account of  $2,961,152 and from the operational account of  $164. Through December 31, 2018, our efforts have been limited to organizational activities, activities relating to the initial public offering, activities relating to identifying and evaluating prospective business combination candidates and activities relating to general corporate matters. We have not generated any revenues, other than interest income earned on the proceeds held in the trust account and operational account. As of December 31, 2018, $290,461,152 was held in the trust account (including $6,912,500 of deferred underwriting commissions) and we had cash outside of trust of  $2,353,541 and $444,561 in accounts payable and accrued expenses. Except for the withdrawal of interest to pay our income taxes, if any, our amended and restated memorandum and articles of association, subject to the requirements of law and regulation, provide that none of the funds held in the trust account will be released from the trust account until the earliest of   (i) the completion of our initial business combination, (ii) the redemption of our public shares if we are unable to complete our initial business combination by July 3, 2020, subject to applicable law, or (iii) the redemption of our public shares properly submitted in connection with a shareholder vote to approve an amendment to our amended and restated memorandum and articles of association to modify the substance or timing of our obligation to redeem 100% of our public shares if we have not consummated an initial business combination by July 3, 2020. As of December 31, 2018, there was approximately $290.46 million in investments and cash held in the trust account and approximately $2.35 million of cash held outside the trust account. As of December 31, 2018, no funds had been withdrawn from the trust account to pay taxes. We have agreed to pay an affiliate of the Sponsor in an amount not to exceed $10,000 per month for office space, and secretarial and administrative services, commencing on the effective date of the initial public offering through the earlier of our consummation of an initial business combination or our liquidation. We recognized $61,000 for the period from March 28, 2018 (inception) to December 31, 2018 in connection with this agreement in the accompanying statement of operations. Liquidity and Capital Resources Through December 31, 2018, our liquidity needs were met by the proceeds of the initial public offering, the receipt of a $25,000 capital contribution from the Sponsor in exchange for the issuance of the founder shares to the Sponsor and the proceeds of the private placement. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account holding the net proceeds of the initial public offering (less taxes payable and deferred underwriting commissions) to complete our initial business combination. To the extent that our equity or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business prior to our initial business combination. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial business combination. In order to fund working capital deficiencies or finance transaction costs in connection with an intended initial business combination, the Sponsor or an affiliate of the Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from the trust account would be used for such repayment. Up to $2,000,000 of such loans may be convertible into warrants of the post business combination entity at a price of  $1.00 per warrant at the option of the lender. The warrants would be identical to the private placement warrants. The terms of such loans, if any, have not been determined and no written agreements exist with respect to such loans. Prior to the completion of our initial business combination, we do not expect to seek loans from parties other than the Sponsor or an affiliate of the Sponsor as we do not believe third parties will be willing to loan such funds and provide a waiver against any and all rights to seek access to funds in the trust account. Off-Balance Sheet Arrangements As of December 31, 2018, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S- K and did not have any commitments or contractual obligations. Contractual Obligations Registration Rights The holders of the private placement warrants, the warrants that may be issued upon conversion of any working capital loans and the founder shares will be entitled to registration rights with respect to such warrants and the ordinary shares underlying such warrants and founder shares. These holders will be entitled to make up to three demands, excluding short form registration demands, that we register such securities for sale under the Securities Act. In addition, these holders will have “piggy-back” registration rights to include their securities in other registration statements filed by us. However, the registration rights agreement provides that we will not permit any registration statement filed under the Securities Act to become effective until termination of the applicable lockup period for such securities. Pursuant to the forward purchase agreements, we have agreed that we will use our reasonable best efforts (i) to file within 30 days after the closing of the initial business combination (and, with respect to clause (ii)(B) below, within 30 days following announcement of the results of the shareholder vote relating to our initial business combination or the results of our offer to shareholders to redeem their Class A ordinary shares in connection with our initial business combination (whichever is later), which we refer to as the “disclosure date”) a registration statement with the SEC for a secondary offering of  (A) the forward purchase securities and Class A ordinary shares underlying the forward purchase warrants and the anchor investors’ founder shares, and (B) any other Class A ordinary shares or warrants acquired by the anchor investors any time after we complete our initial business combination, (ii) to cause such registration statement to be declared effective promptly thereafter, but in no event later than 60 days after the closing of the initial business combination or the disclosure date, as the case may be and (iii) to maintain the effectiveness of such registration statement until the earliest of    (A) the date on which the anchor investor ceases to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act and without the requirement to be in compliance with Rule 144(c)(1) under the Securities Act, subject to certain conditions and limitations set forth in the forward purchase agreements. We will bear the cost of registering these securities. Underwriting Agreement We granted the underwriters a 45-day option from June 27, 2018 to purchase up to 3,750,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions, which was fully exercised on July 3, 2018. We recognized an underwriting discount of  $0.55 per unit, or $10.86 million in the aggregate, and paid $3.95 million upon the consummation of the initial public offering. $0.35 per unit, or $6.91 million in the aggregate will be payable to the underwriters for deferred underwriting fees. The deferred fee will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete an initial business combination, subject to the terms of the underwriting agreement. Critical Accounting Policy Ordinary Shares Subject to Possible Redemption We account for our Class A ordinary shares subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity”. Ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable ordinary shares (including ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, Class A ordinary shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ equity section of our accompanying balance sheet. Recent Accounting Pronouncements In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, Disclosure Update and Simplification, amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of shareholders’ equity for interim financial statements. Under the amendments, an analysis of changes in each caption of shareholders’ equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. The Company anticipates its first presentation of changes in shareholders’ equity, in accordance with the new guidance, will be included in its Form 10-Q for the quarter ended March 31, 2019. Management does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statements.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Form 10K, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forwardlooking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Form 10K should be read as being applicable to all forwardlooking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forwardlooking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on March 28, 2018 as a Cayman Islands exempted company formed for the purpose of effecting a business combination. We have reviewed, and continue to review a number of opportunities to enter into a business combination, but we are not able to determine at this time whether we will complete a business combination with any of the target businesses that we have reviewed or with any other target business. We also have neither engaged in any operations nor generated any revenue to date. Based on our business activities, the Company is a “shell company” as defined under the Exchange Act because we have no operations and nominal assets consisting almost entirely of cash. On July 3, 2018, we consummated the initial public offering of 28,750,000 units, including 3,750,000 units issued pursuant to the exercise of the underwriters’ overallotment option in full. Each unit consists of one Class A ordinary share and onehalf of one warrant, with each whole warrant entitling the holder thereof to purchase one Class A ordinary share for $11.50 per share. The units were sold at a price of  $10.00 per unit, generating gross proceeds of  $287.5 million. Simultaneously with the consummation of the initial public offering, we completed the private placement of 7,750,000 private placement warrants to the Sponsor at a purchase price of  $1.00 per private placement warrant, generating gross proceeds to the Company of  $7,750,000. Prior to the consummation of the initial public offering, on April 19, 2018, the Sponsor purchased 10,750,000 founder shares, which issuance was reflected on the register of members of the company on May 29, 2018 in exchange for a capital contribution of $25,000, or approximately $0.002 per share, 5,000,000 of which were issued in connection with the forward purchase agreements. In addition, as an inducement to the anchor investors to enter into with the forward purchase agreements, on June 19, 2018, the Sponsor transferred to the anchor investors an aggregate of 2,262,500 founder shares for no cash consideration. On June 12, 2018, the Sponsor forfeited 475,000 founder shares to us for no consideration. On June 18, 2018, we effected a share capitalization resulting in the Sponsor holding an aggregate of 8,8 [/INST] Negative. </s>

Gores Metropoulos, Inc.

2019-03-29

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Certain information contained in the discussion and analysis set forth below includes forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. We had not completed our Public Offering as of December 31, 2018. Except as specified herein, this discussion and analysis of our financial condition and results of operations does not give effect to the Public Offering. Overview We are a blank check company incorporated on August 28, 2018 as a Delaware corporation and formed for the purpose of effecting a business combination with one or more target businesses. We completed our Public Offering on February 5, 2019. As of December 31, 2018, we had not identified any business combination target nor initiated any substantive discussions directly or indirectly, with respect to identifying any business combination target. Since completing our Public Offering, we have reviewed, and continue to review, a number of opportunities to enter into a business combination with an operating business, but we are not able to determine at this time whether we will complete a business combination with any of the target businesses that we have reviewed or with any other target business. We intend to effectuate our business combination using cash from the proceeds of our Public Offering and the sale of the Private Placement Warrants, our Capital Stock, debt, or a combination of cash, stock and debt. Results of Operations For the period from August 28, 2018 to December 31, 2018, we had a net loss of $21,985. Subsequent to December 31, 2018, our activities mainly consisted of identifying and evaluating prospective acquisition candidates for a business combination. We believe that we have sufficient funds available to complete our efforts to effect a business combination with an operating business by February 5, 2021. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. At December 31, 2018, we had $52,489 in cash. As of December 31, 2018, we had neither engaged in any operations nor generated any revenues. Our only activities prior to December 31, 2018 were organizational activities and those necessary to prepare for the Public Offering. We will not generate any operating revenues until after completion of our business combination, at the earliest. Since completing our Public Offering, we generate non-operating income in the form of interest income on funds held in the Trust Account. We expect to incur significant expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as expenses in the pursuit of our acquisition plans. We cannot assure you that our plans to complete our business combination will be successful. Liquidity and Capital Resources In October 2018, our Sponsor purchased an aggregate of 10,781,250 Founder Shares for an aggregate purchase price of $25,000, or approximately $0.002 per share. Subsequently, our Sponsor transferred an aggregate of 75,000 Founder Shares to our independent directors. On March 18, 2019, following the expiration of the unexercised portion of the underwriter’s over-allotment option, our Sponsor forfeited 781,250 Founder Shares so that the remaining Founder Shares held by our Initial Stockholders represented 20.0% of the outstanding shares upon completion of our Public Offering. On February 5, 2019, we consummated our Public Offering of 40,000,000 Units at a price of $10.00 per Unit, including 2,500,000 Units as a result of the underwriter’s partial exercise of their over-allotment option, generating gross proceeds of $400,000,000. On the IPO Closing Date, we completed the private sale of an aggregate of 6,666,666 Private Placement Warrants, each exercisable to purchase one share of Common Stock at $11.50 per share, to our Sponsor, at a price of $1.50 per Private Placement Warrant, generating gross proceeds, before expenses, of $10,000,000. After deducting the underwriting discounts and commissions (excluding the Deferred Discount, which amount will be payable upon consummation of the business combination, if consummated) and the estimated offering expenses, the total net proceeds from our Public Offering and the sale of the Private Placement Warrants were $401,055,000, of which $400,000,000 (or $10.00 per share sold in the Public Offering) was placed in the Trust Account. The amount of proceeds not deposited in the Trust Account was $1,055,000 at the closing of our Public Offering. Interest earned on the funds held in the Trust Account may be released to us to fund our Regulatory Withdrawals (subject to an annual limit of $750,000, for a maximum of 24 months) and/or to pay our franchise and income taxes. On October 18, 2018, our Sponsor loaned us an aggregate of $150,000 by the issuance of an unsecured promissory note for $300,000 to cover expenses related to the Public Offering. On December 31, 2018, the outstanding balance on the loan was $150,000. On January 25, 2019, our Sponsor loaned us an additional $150,000 to cover expenses related to the Public Offering. These Notes were non-interest bearing and payable on the earlier of September 30, 2019 or the completion of the Public Offering. The carrying amount of the Notes approximates fair value because of their short maturity. These Notes were repaid in full upon the completion of the Public Offering. As of December 31, 2018, we had cash of $52,489, which is available to fund our working capital requirements. At December 31, 2018, the Company had current liabilities of $486,849 and working capital of $3,015 largely due to amounts owed to professionals, consultants, advisors and others who were working on organizational and Public Offering matters. Subsequent to our Public Offering work on seeking a business combination began, and expenses are continuing to accrue. The Company intends to use substantially all of the funds held in the Trust Account, including interest (which interest shall be net of Regulatory Withdrawals and taxes payable) to consummate our business combination. Moreover, we may need to obtain additional financing either to complete a business combination or because we become obligated to redeem a significant number of shares of our Common Stock upon completion of a business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our business combination. If we are unable to complete our business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the Trust Account. In addition, following our business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. To the extent that our capital stock or debt is used, in whole or in part, as consideration to consummate our business combination, the remaining proceeds held in our Trust Account, if any, will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategy. Off-balance sheet financing arrangements We had no obligations, assets or liabilities which would be considered off-balance sheet arrangements at December 31, 2018. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We had not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or entered into any non-financial agreements involving assets as of December 31, 2018. Contractual obligations We did not have any long-term debt obligations, capital lease obligations, operating lease obligations, purchase obligations or long-term liabilities at December 31, 2018. In connection with the Public Offering, we entered into an administrative services agreement to pay monthly recurring expenses of $20,000 to The Gores Group for office space, utilities and secretarial support. The administrative services agreement terminates upon the earlier of the completion of a business combination or the liquidation of the Company. The underwriter is entitled to underwriting discounts and commissions of 5.5%, of which 2.0% ($8,000,000) was paid at the IPO Closing Date, and 3.5% ($14,000,000) was deferred. The Deferred Discount will become payable to the underwriter from the amounts held in the Trust Account solely in the event that the Company completes a business combination, subject to the terms of the underwriting agreement. The underwriter is not entitled to any interest accrued on the Deferred Discount. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with U.S. GAAP requires our management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following as our critical accounting policies: Offering costs The Company complies with the requirements of the Accounting Standards Codification (the “ASC”) 340-10-S99-1 and SEC Staff Accounting Bulletin Topic 5A - “Expenses of Offering.” Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to our Public Offering and were charged to stockholder’s equity upon the completion of our Public Offering. Accordingly, at December 31, 2018, offering costs totaling approximately $437,375 have been deferred and will be charged to stockholders’ equity upon close of the Public Offering. Net loss per common share The Company has two classes of shares, which are referred to as Class A common stock and Class F common stocks. Net income/(loss) per common share is computed utilizing the two-class method. The two-class method is an earnings allocation formula that determines earnings per share separately for each class of common stock based on an allocation of undistributed earnings per the rights of each class. As of December 31, 2018, the Company did not have any dilutive securities or other contracts that could, potentially, be exercised or converted into Common Stock and then share in the earnings of the Company under the treasury stock method. As a result, diluted net income/(loss) per common share is the same as basic net income/(loss) per common share for the period. Recently Issued Accounting Pronouncements Not Yet Adopted Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements based on current operations of the Company. The impact of any recently issued accounting standards will be re-evaluated on a regular basis or if a business combination is completed where the impact could be material.

<s>[INST] The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10K. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of many factors, including those set forth under “Special Note Regarding ForwardLooking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10K. We had not completed our Public Offering as of December 31, 2018. Except as specified herein, this discussion and analysis of our financial condition and results of operations does not give effect to the Public Offering. Overview We are a blank check company incorporated on August 28, 2018 as a Delaware corporation and formed for the purpose of effecting a business combination with one or more target businesses. We completed our Public Offering on February 5, 2019. As of December 31, 2018, we had not identified any business combination target nor initiated any substantive discussions directly or indirectly, with respect to identifying any business combination target. Since completing our Public Offering, we have reviewed, and continue to review, a number of opportunities to enter into a business combination with an operating business, but we are not able to determine at this time whether we will complete a business combination with any of the target businesses that we have reviewed or with any other target business. We intend to effectuate our business combination using cash from the proceeds of our Public Offering and the sale of the Private Placement Warrants, our Capital Stock, debt, or a combination of cash, stock and debt. Results of Operations For the period from August 28, 2018 to December 31, 2018, we had a net loss of $21,985. Subsequent to December 31, 2018, our activities mainly consisted of identifying and evaluating prospective acquisition candidates for a business combination. We believe that we have sufficient funds available to complete our efforts to effect a business combination with an operating business by February 5, 2021. However, if our estimates of the costs of identifying a target business, undertaking indepth due diligence and negotiating a business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. At December 31, 2018, we had $52,489 in cash. As of December 31, 2018, we had neither engaged in any operations nor generated any revenues. Our only activities prior to December 31, 2018 were organizational activities and those necessary to prepare for the Public Offering. We will not generate any operating revenues until after completion of our business combination, at the earliest. Since completing our Public Offering, we generate nonoperating income in the form of interest income on funds held in the Trust Account. We expect to incur significant expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as expenses in the pursuit of our acquisition plans. We cannot assure you that our plans to complete our business combination will be successful. Liquidity and Capital Resources In October 2018, our Sponsor purchased an aggregate of 10,781,250 Founder Shares for an aggregate purchase price of $25,000, or approximately $0.002 per share. Subsequently, our Sponsor transferred an aggregate of 75,000 Founder Shares to our independent directors. On March 18, 2019, following the expiration of the unexercised portion of the underwriter’s overallotment option, our Sponsor forfeited 781,250 Founder Shares so that the remaining Founder Shares held by our Initial Stockholders represented 20.0% of the outstanding shares upon completion of our Public Offering. On February 5, 2019, we consummated our Public Offering of 40, [/INST] Positive. </s>

Gores Metropoulos, Inc.

2020-03-13

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Certain information contained in the discussion and analysis set forth below includes forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. Overview We are a blank check company incorporated on August 28, 2018 as a Delaware corporation and formed for the purpose of effecting a Business Combination with one or more target businesses. We completed our Public Offering on February 5, 2019. As of December 31, 2019, we had not identified any Business Combination target nor initiated any substantive discussions directly or indirectly, with respect to identifying any Business Combination target. Since completing our Public Offering, we have reviewed, and continue to review, a number of opportunities to enter into a Business Combination with an operating business, but we are not able to determine at this time whether we will complete a Business Combination with any of the target businesses that we have reviewed or with any other target business. We intend to effectuate our Business Combination using cash from the proceeds of our Public Offering and the sale of the Private Placement Warrants, our Capital Stock, debt, or a combination of cash, stock and debt. Results of Operations For the calendar year ended December 31, 2019 and the period from August 28, 2018 (inception) to December 31, 2018, we had a net income/(loss) $5,445,176 and ($21,985), respectively. Subsequent to December 31, 2019, our activities mainly consisted of identifying and evaluating prospective acquisition candidates for a Business Combination. We believe that we have sufficient funds available to complete our efforts to effect a Business Combination with an operating business by February 5, 2021. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our Business Combination. As indicated in the accompanying financial statements, as of December 31, 2019 and 2018, we had $1,365,240 and $52,489, respectively, in cash, and deferred offering costs of $0 and $437,375, respectively. Further, we expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete our Business Combination will be successful. Liquidity and Capital Resources In October 2018, our Sponsor purchased an aggregate of 10,781,250 Founder Shares for an aggregate purchase price of $25,000, or approximately $0.002 per share. Subsequently, our Sponsor transferred an aggregate of 75,000 Founder Shares to our independent directors. On March 18, 2019, following the expiration of the unexercised portion of the underwriter’s over-allotment option, our Sponsor forfeited 781,250 Founder Shares so that the remaining Founder Shares held by our Initial Stockholders represented 20.0% of the outstanding shares upon completion of our Public Offering. On February 5, 2019, we consummated our Public Offering of 40,000,000 Units at a price of $10.00 per Unit, including 2,500,000 Units as a result of the underwriter’s partial exercise of their over-allotment option, generating gross proceeds of $400,000,000. On the IPO Closing Date, we completed the private sale of an aggregate of 6,666,666 Private Placement Warrants, each exercisable to purchase one share of Common Stock at $11.50 per share, to our Sponsor, at a price of $1.50 per Private Placement Warrant, generating gross proceeds, before expenses, of $10,000,000. After deducting the underwriting discounts and commissions (excluding the Deferred Discount, which amount will be payable upon consummation of the Business Combination, if consummated) and the estimated offering expenses, the total net proceeds from our Public Offering and the sale of the Private Placement Warrants were $401,055,000, of which $400,000,000 (or $10.00 per share sold in the Public Offering) was placed in the Trust Account. The amount of proceeds not deposited in the Trust Account was $1,055,000 at the closing of our Public Offering. Interest earned on the funds held in the Trust Account may be released to us to fund our Regulatory Withdrawals (subject to an annual limit of $750,000, for a maximum of 24 months) and/or additional amounts necessary to pay our franchise and income taxes. On October 18, 2018, our Sponsor loaned us an aggregate of $150,000 by the issuance of an unsecured promissory note for $300,000 to cover expenses related to the Public Offering. On December 31, 2019, the outstanding balance on the loan was $150,000. On January 25, 2019, our Sponsor loaned us an additional $150,000 to cover expenses related to the Public Offering. These Notes were non-interest bearing and payable on the earlier of September 30, 2019 or the completion of the Public Offering. The carrying amount of the Notes approximates fair value because of their short maturity. These Notes were repaid in full upon the completion of the Public Offering. As of December 31, 2019 and 2018, we had cash held outside of the Trust Account of $1,365,240 and $52,489, respectively, which is available to fund our working capital requirements. As of December 31, 2019 and 2018, the Company had current liabilities of $1,355,865 and $486,849, respectively and working capital of $145,774 and $3,015, respectively, largely due to amounts owed to professionals, consultants, advisors and others who were working on organizational and Public Offering matters. Subsequent to our Public Offering work on seeking a Business Combination began, and expenses are continuing to accrue. The Company intends to use substantially all of the funds held in the Trust Account, including interest (which interest shall be net of Regulatory Withdrawals and taxes payable) to consummate our Business Combination. Moreover, we may need to obtain additional financing either to complete a Business Combination or because we become obligated to redeem a significant number of shares of our Common Stock upon completion of a Business Combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our Business Combination. If we are unable to complete our Business Combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the Trust Account. In addition, following our Business Combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. To the extent that our capital stock or debt is used, in whole or in part, as consideration to consummate our Business Combination, the remaining proceeds held in our Trust Account, if any, will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategy. Off-balance sheet financing arrangements We had no obligations, assets or liabilities which would be considered off-balance sheet arrangements at December 31, 2019. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We had not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or entered into any non-financial agreements involving assets as of December 31, 2019. Contractual obligations We did not have any long-term debt obligations, capital lease obligations, operating lease obligations, purchase obligations or long-term liabilities at December 31, 2019. In connection with the Public Offering, we entered into an administrative services agreement to pay monthly recurring expenses of $20,000 to The Gores Group for office space, utilities and secretarial support. The administrative services agreement terminates upon the earlier of the completion of a Business Combination or the liquidation of the Company. The underwriter is entitled to underwriting discounts and commissions of 5.5%, of which 2.0% ($8,000,000) was paid at the IPO Closing Date, and 3.5% ($14,000,000) was deferred. The Deferred Discount will become payable to the underwriter from the amounts held in the Trust Account solely in the event that the Company completes a Business Combination, subject to the terms of the underwriting agreement. The underwriter is not entitled to any interest accrued on the Deferred Discount. Recently Issued Accounting Pronouncements Not Yet Adopted Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements based on current operations of the Company. The impact of any recently issued accounting standards will be re-evaluated on a regular basis or if a Business Combination is completed where the impact could be material.

<s>[INST] The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10K. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements. Our actual results may differ materially from those anticipated in these forwardlooking statements as a result of many factors, including those set forth under “Special Note Regarding ForwardLooking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10K. Overview We are a blank check company incorporated on August 28, 2018 as a Delaware corporation and formed for the purpose of effecting a Business Combination with one or more target businesses. We completed our Public Offering on February 5, 2019. As of December 31, 2019, we had not identified any Business Combination target nor initiated any substantive discussions directly or indirectly, with respect to identifying any Business Combination target. Since completing our Public Offering, we have reviewed, and continue to review, a number of opportunities to enter into a Business Combination with an operating business, but we are not able to determine at this time whether we will complete a Business Combination with any of the target businesses that we have reviewed or with any other target business. We intend to effectuate our Business Combination using cash from the proceeds of our Public Offering and the sale of the Private Placement Warrants, our Capital Stock, debt, or a combination of cash, stock and debt. Results of Operations For the calendar year ended December 31, 2019 and the period from August 28, 2018 (inception) to December 31, 2018, we had a net income/(loss) $5,445,176 and ($21,985), respectively. Subsequent to December 31, 2019, our activities mainly consisted of identifying and evaluating prospective acquisition candidates for a Business Combination. We believe that we have sufficient funds available to complete our efforts to effect a Business Combination with an operating business by February 5, 2021. However, if our estimates of the costs of identifying a target business, undertaking indepth due diligence and negotiating a Business Combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our Business Combination. As indicated in the accompanying financial statements, as of December 31, 2019 and 2018, we had $1,365,240 and $52,489, respectively, in cash, and deferred offering costs of $0 and $437,375, respectively. Further, we expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete our Business Combination will be successful. Liquidity and Capital Resources In October 2018, our Sponsor purchased an aggregate of 10,781,250 Founder Shares for an aggregate purchase price of $25,000, or approximately $0.002 per share. Subsequently, our Sponsor transferred an aggregate of 75,000 Founder Shares to our independent directors. On March 18, 2019, following the expiration of the unexercised portion of the underwriter’s overallotment option, our Sponsor forfeited 781,250 Founder Shares so that the remaining Founder Shares held by our Initial Stockholders represented 20.0% of the outstanding shares upon completion of our Public Offering. On February 5, 2019, we consummated our Public Offering of 40,000,000 Units at a price of $10.00 per Unit, including 2,500,000 Units as a result of the underwriter’s partial exercise of their overallotment option, generating gross proceeds of $400,000,000. On the IPO Closing Date, we [/INST] Negative. </s>

DiaMedica Therapeutics Inc.

2019-03-19

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon accounting principles generally accepted in the United States of America and discusses the financial condition and results of operations for DiaMedica Therapeutics Inc. and subsidiaries for the years ended December 31, 2018 and 2017. This discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. The following discussion contains forward-looking statements that involve numerous risks and uncertainties. Our actual results could differ materially from the forward-looking statements as a result of these risks and uncertainties. See “Cautionary Note Regarding Forward-Looking Statements” for additional cautionary information. Overview We are a clinical stage biopharmaceutical company primarily focused on the development of novel recombinant proteins. Our goal is to use our patented and licensed technologies to establish our company as a leader in the development and commercialization of therapeutic treatments for novel recombinant proteins to treat kidney and neurological diseases. Our current primary focus is on AIS and CKD. We plan to advance DM199, our lead drug candidate, through required clinical trials to create shareholder value by establishing its clinical and commercial potential as a therapy for AIS and CKD. In February 2018, we initiated treatment on the first patient in our Phase II REMEDY trial assessing the safety, tolerability and markers of therapeutic efficacy of DM199 in patients suffering from AIS. Our REMEDY trial is expected to enroll up to 100 patients to evaluate DM199 in patients with AIS. In December 2018, the FDA accepted our Investigational New Drug application for the initiation of a Phase Ib clinical trial of DM199 in patients with moderate or severe CKD caused by Type I or Type II diabetes and in February 2019, we initiated dosing patients in this study. The results from this Phase Ib study will assist us in the design of upcoming Phase II studies in patients suffering from rare diseases and CKD. The DM199 drug levels from this Phase Ib study will also help determine the optimal dose levels for testing in the Phase II studies. In September 2018, we entered into a license and collaboration agreement with Ahon Pharmaceutical Co Ltd. (“Ahon Pharma”), which grants Ahon Pharma exclusive rights to develop and commercialize DM199 for acute ischemic stroke in mainland China, Taiwan, Hong Kong S.A.R. and Macau S.A.R. Under the terms of the agreement, we received an upfront payment of $500,000 on signing and are entitled to receive an additional payment of $4.5 million upon regulatory clearance to initiate a clinical trial in China. We also have the potential to receive up to an additional $27.5 million in development and sales related milestones and up to approximately 10% royalties on net sales of DM199 in the licensed territories. All development, regulatory, sales, marketing, and commercial activities and associated costs in the licensed territories will be the sole responsibility of Ahon Pharma. This agreement may be terminated at any time by Ahon Pharma by providing 120 days written notice. Fosun Pharma, through its partnership with SK Group, a South Korea based company is an investor in DiaMedica through its equity investment in 2016. We have not generated any revenues from product sales. Since our inception, we have financed our operations from public and private sales of equity, the exercise of warrants and stock options, interest income on funds available for investment, and government grants and tax credits. We have incurred losses in each year since our inception. Our net losses were $5.7 million and $4.3 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of $46.0 million. Substantially all of our operating losses resulted from expenses incurred in connection with product candidate development programs, our R&D activities and G&A support costs associated with our operations. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. In the near term, we anticipate that our expenses will increase as we: ● advance the ongoing clinical development of DM199; ● maintain, expand and protect our intellectual property portfolio; and ● provide G&A support for our operations. In addition, we expect our operating expenses to increase in 2019 compared to 2018 as a result of our recently obtained Nasdaq-listed U.S. public reporting company status. In December 2018, we completed an initial public offering of our common shares in the United States, by issuing 4,100,000 common shares at an offering price of $4.00 per share, for net proceeds to us of approximately $14.7 million, after deducting underwriting discounts and commissions and offering expenses. While we expect our rate of future negative cash flow per month to vary due to the timing of expenses incurred, we expect our current cash, which includes the net proceeds of our initial public offering, to be sufficient to allow us to complete our current ongoing Phase II Remedy trial in patients with AIS and our current Phase Ib trial in patients with CKD and a Phase II study in patients with CKD and to otherwise fund our planned operations through the end of 2020. Financial Overview Revenues Since our inception, we have incurred losses while advancing the R&D of our therapeutic product candidates. We have not generated any revenues from product sales and do not expect to do so for a number of years. We may never generate sales revenues from our current DM199 product candidate as we may never succeed in obtaining regulatory approval or commercial sale of this product candidate. In September 2018, we entered into a license and collaboration agreement with Ahon Pharma under the terms of which we granted exclusive rights to develop and commercialize DM199 for acute ischemic stroke in mainland China, Taiwan, Hong Kong S.A.R. and Macau S.A.R. Under the terms of the agreement, we received a non-refundable upfront payment of $500,000, due upon signing the agreement, and we are entitled to an additional non-refundable payment of $4.5 million upon regulatory clearance to initiate a clinical trial in China. We also have the potential to receive up to an additional $27.5 million in development and sales related milestones and up to approximately 10% royalties on net sales of DM199 in the licensed territories. All development, regulatory, sales, marketing, and commercial activities and associated costs in the licensed territories will be the sole responsibility of Ahon Pharma. This agreement may be terminated at any time by Ahon Pharma by providing 120 days written notice. Research and Development Expenses R&D expenses consist primarily of fees paid to external service providers such as contract research organizations and contract manufacturing organizations related to clinical trials, contractual obligations for clinical development, clinical sites, laboratory testing, preclinical trials, development of DM199 and the related manufacturing processes, salaries, benefits, share-based compensation and other personnel costs. We incurred $4.5 million and $3.2 million in R&D expenses for the years ended December 31, 2018 and 2017, respectively. Over the past approximately eight years, our R&D efforts have been primarily focused on developing DM199. At this time, due to the risks inherent in the clinical development process and the early stage of our product development programs, we are unable to estimate with any certainty the costs we will incur in the continued development of DM199 or any of our preclinical development programs. We expect that our R&D expenses may increase if we are successful in advancing DM199, or any of our preclinical programs, into advanced stages of clinical development. The process of conducting clinical trials necessary to obtain regulatory approval and manufacturing scale-up to support expanded development and potential future commercialization is costly and time consuming. Any failure by us or delay in completing clinical trials, manufacturing scale-up or in obtaining regulatory approvals could lead to increased R&D expenses and, in turn, have a material adverse effect on our results of operations. General and Administrative Expenses G&A expenses consist primarily of salaries and related benefits, including share-based compensation related to our executive, finance, business development and support functions. Other G&A expenses include rent and utilities, travel expenses and professional fees for auditing, tax and legal services. We expect that G&A expenses will increase in the future as we expand our operating activities. In addition, G&A expenses are expected to reflect increased costs associated with our listing on The Nasdaq Capital Market and U.S. public reporting company status, which commenced in December 2018. We incurred one-time costs of approximately $360,000 in 2018, associated with the Nasdaq listing process and related legal and accounting fees. Other (Income) Expense Other (income) expense consists primarily of governmental assistance - research incentives, change in the fair value of our warrants that are accounted for as derivative liabilities, interest income, and foreign currency exchange gains and losses. Critical Accounting Policies and Estimates Management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements requires us to make estimates and assumptions for the reported amounts of assets, liabilities, revenue, expenses and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions and any such differences may be material. While our significant accounting policies are more fully described in Note 3 to our consolidated financial statements included elsewhere in this report, we believe the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective and complex judgments. Revenue Recognition We followed Accounting Standards Codification (“ASC”) 606, “Revenue from Contracts with Customers” in accounting for our license and collaboration agreement with Ahon Pharma. Accordingly, the Company recognizes revenue upon transfer of control of the product to our customer in an amount that reflects the consideration we expect to receive in exchange. We intend to enter into arrangements for the research and development and/or manufacture of products and product candidates. Such arrangements may require us to deliver various rights, services and/or goods, including (i) intellectual property rights or licenses, (ii) R&D services or (iii) manufacturing services. The underlying terms of these arrangements generally would provide for consideration to DiaMedica in the form of nonrefundable, up-front license fees, development and commercial-performance milestone payments, cost sharing, royalty payments and/or profit sharing. In arrangements involving more than one performance obligation, each required performance obligation is evaluated to determine whether it qualifies as a distinct performance obligation based on whether (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available and (ii) the good or service is separately identifiable from other promises in the contract. The consideration under the arrangement is then allocated to each separate distinct performance obligation based on its respective relative stand-alone selling price. The estimated selling price of each deliverable reflects our best estimate of what the selling price would be if the deliverable was regularly sold by us on a stand-alone basis or using an adjusted market assessment approach if selling price on a stand-alone basis is not available. The consideration allocated to each distinct performance obligation is recognized as revenue when control of the related goods or services is transferred. Consideration associated with at-risk substantive performance milestones is recognized as revenue when it is probable that a significant reversal of the cumulative revenue recognized will not occur. We intend to utilize the sales and usage-based royalty exception in arrangements that result from the license of intellectual property, recognizing revenues generated from royalties or profit sharing as the underlying sales occur. Share-based Compensation We account for all share-based compensation awards using a fair value method. The cost of employee and non-employee services received in exchange for awards of equity instruments is measured and recognized based on the estimated grant date fair value of those awards. Compensation cost is recognized ratably using the straight-line attribution method over the vesting period, which is considered to be the requisite service period. We record forfeitures in the periods in which they occur. The fair value of share-based awards is estimated using the Black-Scholes option pricing model. The determination of the fair value of share-based awards is affected by our common share price, as well as assumptions regarding a number of complex and subjective variables. Risk-free interest rates are based upon Canadian Government bond rates appropriate for the expected term of each award. Expected volatility rates are based on the historical volatility equal to the expected life of the option. The assumed dividend yield is zero, as we do not expect to declare any dividends in the foreseeable future. The expected term of options is estimated considering the vesting period at the grant date, the life of the option and the average length of time similar grants have remained outstanding in the past. The assumptions used in calculating the fair value under the Black-Scholes option valuation model are set forth in the following table for options issued by us for the years ended December 31, 2018 and 2017: Recently Adopted Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued a new accounting standard that amends the guidance for the recognition of revenue from contracts with customers to transfer goods and services. The FASB subsequently issued additional, clarifying standards to address issues arising from implementation of the new revenue recognition standard. The new revenue recognition standard and clarifying standards require an entity to recognize revenue when control of promised goods or services is transferred to the customer at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. We adopted this new standard as of January 1, 2018, but the adoption as of this date had no impact on our financial statements as we had no revenue until the third quarter of 2018. Recently Issued Accounting Pronouncements In February 2016, the FASB issued Accounting Standards Update (“ASU”) No. 2016-02, Leases. The guidance in ASU 2016-02 supersedes the lease recognition requirements in the Accounting Standards Codification Topic 840, Leases. ASU 2016-02 requires an entity to recognize assets and liabilities arising from a lease for both financing and operating leases, along with additional qualitative and quantitative disclosures. The new standard requires the immediate recognition of all excess tax benefits and deficiencies in the income statement and requires classification of excess tax benefits as an operating activity as opposed to a financing activity in the statements of cash flows. This standard became effective for us on January 1, 2019. The FASB has subsequently issued the following amendments to ASU 2016-02, which have the same effective date and transition date of January 1, 2019, and which we collectively refer to as the new leasing standards: ● ASU No. 2018-01, Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842, which permits an entity to elect an optional transition practical expedient to not evaluate under Topic 842 land easements that exist or expired prior to adoption of Topic 842 and that were not previously accounted for as leases under the prior standard, ASC 840, Leases. ● ASU No. 2018-10, Codification Improvements to Topic 842, Leases, which amends certain narrow aspects of the guidance issued in ASU 2016-02. ● ASU No. 2018-11, Leases (Topic 842): Targeted Improvements, which allows for a transition approach to initially apply ASU 2016-02 at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption as well as an additional practical expedient for lessors to not separate non-lease components from the associated lease component. ● ASU No. 2018-20, Narrow-Scope Improvements for Lessors, which contains certain narrow scope improvements to the guidance issued in ASU 2016-02. We adopted the new leasing standards on January 1, 2019, using a modified retrospective transition approach to be applied to leases existing as of, or entered into after, January 1, 2019; and consequently, financial information will not be updated and the disclosures required under Topic 842 will not be provided for dates and periods prior to January 1, 2019. We have reviewed our existing lease contracts and the impact of the new leasing standards on our consolidated results of operations, financial position and disclosures. Upon adoption of the new leasing standards, we expect to recognize a lease liability and related right-of-use asset on our consolidated balance sheet of approximately $200,000. The impact of adoption of the new leasing standards will have not have a material impact to our consolidated statements of operations. In June 2018, the FASB issued ASU No. 2018-07, “Improvements to Nonemployee Share-Based Payment Accounting," to simplify the accounting for share-based payments to nonemployees by aligning it with the accounting for share-based payments to employees, with certain exceptions. This ASU is effective for public entities for fiscal years beginning after December 15, 2018, with early adoption permitted. Prior to the adoption of this ASU, stock-based compensation awarded to non-employees was subject to revaluation over its vesting terms. Subsequent to the adoption of this ASU, non-employee share-based payment awards are measured on the date of grant, similar to share-based payment awards granted to employees. We do not expect that the adoption of this ASU will impact our financial position or our consolidated statements of operations. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017 (in thousands): License Revenue License revenue for 2018 was comprised of the initial $500,000 license payment we were entitled to receive upon signing of the September 27, 2018 license and collaboration agreement with Ahon Pharma. Research and Development Expenses R&D expenses were $4.5 million for the year ended December 31, 2018 compared to $3.2 million for the year ended December 31, 2017, an increase of $1.3 million. The increase was primarily due to the additional preclinical testing and related costs required to support an application for an investigational new drug application in the United States, higher study costs for the REMEDY Phase 2 stroke study as compared with the DM199 bridging study which was substantially completed in 2017, and increased personnel and non-cash stock-based compensation costs. General and Administrative Expenses G&A expenses were $2.7 million for the year ended December 31, 2018 compared to $1.3 million for the year ended December 31, 2017. General and administrative costs increased due to one-time costs incurred associated with our planned public offering in the United States, primarily the Nasdaq listing process and related legal and accounting fees. Higher salaries, fees and short-term benefits due to the addition of staff and higher share-based compensation also contributed to the increase during 2018. Other (Income) Expense Other income, net, was $1.1 million for the year ended December 31, 2018 compared to $259,000 for 2017. The increase resulted primarily from the recognition of the R&D incentive from the Australian Government paid for qualifying research work performed by DiaMedica Australia. This increase was partially offset by increased foreign currency transaction losses. Liquidity and Capital Resources The following table summarizes our liquidity and capital resources as of December 31, 2018 and 2017 and for each of years ended December 31, 2018 and 2017, and is intended to supplement the more detailed discussion that follows (in thousands): Working Capital We had cash of $16.8 million, current liabilities of $1.3 million and working capital of $15.5 million as of December 31, 2018, compared $1.4 million in cash, $1.0 million in current liabilities and $491,000 in working capital as of December 31, 2017. The increases in cash and working capital are due to our December 2018 initial public offering in the United States and March 2018 private placement. Cash Flows Operating Activities Net cash used in operating activities for the year ended December 31, 2018 was $5.7 million compared to $3.9 million for the year ended December 31, 2017. This increase relates primarily to an increase in the net loss, in addition to the effects of the changes in operating assets and liabilities. Investing Activities Investing activities consist primarily of purchases of property and equipment. Net cash used in investing activities was $50,000 for the year ended December 31, 2018 compared to $22,000 for the year ended December 31, 2017. This increase relates primarily to the expansion of our office space and staff. Financing Activities Financing activities consist primarily of net proceeds from the sale of common shares and warrants and proceeds from the exercise of stock options and warrants. Net cash provided by financing activities was $21.2 million for the year ended December 31, 2018 compared to $3.5 million for the year ended December 31, 2017. Cash flows from financing activities for 2018 included net proceeds from our December 2018 initial public offering and private placements of our common shares and warrants to purchase common shares in March 2018. In December 2018, we completed an initial public offering of our common shares in the United States by issuing 4,100,000 common shares at an offering price of $4.00 per share, resulting in net proceeds to us of approximately $14.7 million, after deducting underwriting discounts and commissions and offering expenses. On March 29, 2018, we completed, in two tranches, a brokered and non-brokered private placement of 1,322,965 units at a price of $4.90 per unit for aggregate gross proceeds of approximately $6.3 million. Each unit consisted of one common share and one-half of one common share purchase warrant. Each whole warrant entitles the holder to purchase one common share at a price of $7.00 at any time prior to expiration on March 19, 2020 and March 29, 2020 for tranche 1 and tranche 2, respectively. The warrants are subject to early expiration under certain conditions. In connection with the offering, we paid an aggregate cash fee of approximately $384,000 to brokers and issued an aggregate of 80,510 compensation options. Each compensation option entitles the holder to purchase one common share at $4.90, the offering price, for a period of two years from the closing of the offering, subject to acceleration on the same terms as the warrants issued to the investors. On December 18, 2017, we completed a non-brokered private placement of 181,220 units at a price of $5.20 per unit for aggregate gross proceeds of approximately $944,000. Each unit consisted of one common share and one-half of one common share purchase warrant. Each whole warrant entitles the holder to purchase one common share at a price of $7.00 at any time prior to expiration on December 19, 2019, subject to early expiration under certain conditions. On April 17, 2017, we completed a non-brokered private placement of 526,316 units at a price of $3.80 per unit for aggregate proceeds of approximately $2,000,000. Each unit consists of one common share and one-half common share purchase warrant. Each whole warrant entitles the holder to purchase one common share at a price of $4.60 at any time prior to expiration on April 17, 2019. The warrant expiration date can be accelerated at our option in the event that the volume-weighted average trading price of our common shares exceeds $6.00 per common share for any 10 consecutive trading days. Capital Requirements Since our inception, we have incurred losses while advancing the R&D of our product candidates. We have not generated any revenues from product sales and do not expect to do so for a number of years. We do not know when, or if, we will generate any sales revenue from our DM199 product candidate or any future product candidates. We do not expect to generate any revenue from sales of product candidates unless and until we obtain regulatory approval. We expect to continue to incur substantial operating losses until such time as any future product sales, royalty payments, licensing fees, and/or milestone payments are sufficient to generate revenues to fund our continuing operations. We expect our operating losses to increase in the near term as we continue the research, development and clinical trials of, and seek regulatory approval for, our DM199 product candidate. In addition, we expect our operating expenses to increase in 2019 compared to 2018 as a result of our recently obtained Nasdaq-listed U.S. public reporting company status. In the long-term, subject to obtaining regulatory approval of our DM199 product candidate or any other future product candidates, we expect to incur significant commercialization expenses for product sales, marketing, manufacturing and distribution. Accordingly, despite our recent initial public offering, we expect we will need substantial additional capital to further our R&D activities, planned clinical trials, regulatory activities and otherwise develop our product candidate, DM199, or any future product candidates, to a point where they may be commercially sold. While we are striving to achieve these plans, there is no assurance these and other strategies will be achieved or that additional funding will be obtained on favorable terms or at all. While our rate of future negative cash flow per month will vary due to the timing of expenses incurred, we expect our current cash, which includes the net proceeds of our recent initial public offering, to be sufficient to allow us to complete our current ongoing Phase II Remedy trial in patients with AIS and our current Phase Ib trial in patients with CKD and a Phase II study in patients with CKD and to otherwise fund our planned operations through 2020. However, the amount and timing of future funding requirements will depend on many factors, including the timing and results of our ongoing development efforts, the potential expansion of our current development programs, potential new development programs and related G&A support. We may require significant additional funds earlier than we currently expect and there is no assurance that we will not need or seek additional funding prior to such time. We may elect to raise additional funds even before we need them if market conditions for raising additional capital are favorable. Since our inception, we have financed our operations from public and private sales of equity, the exercise of warrants and stock options, interest income on funds available for investment, and government grants and tax credits, and we expect to continue this practice for the foreseeable future. We do not have any existing credit facilities under which we could borrow funds. We may seek to raise additional funds through various sources, such as equity and debt financings, or through strategic collaborations and license agreements. We can give no assurances that we will be able to secure additional sources of funds to support our operations, or if such funds are available to us, that such additional financing will be sufficient to meet our needs or on terms acceptable to us. This is particularly true if our clinical data is not positive or economic and market conditions deteriorate. To the extent we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our shareholders will be diluted. Debt financing, if available, may involve agreements that include conversion discounts or covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise additional funds through government or other third-party funding, marketing and distribution arrangements or other collaborations, or strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. The availability of financing will be affected by our clinical data and other results of scientific and clinical research; the ability to attain regulatory approvals; market acceptance of our product candidates; the state of the capital markets generally with particular reference to pharmaceutical, biotechnology, and medical companies; the status of strategic alliance agreements; and other relevant commercial considerations. If adequate funding is not available, we may be required to implement cost reduction strategies; delay, reduce, or eliminate one or more of our product development programs; relinquish significant rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us; and/or divest assets or cease operations through a merger, sale, or liquidation of our company. Commitments and Contingencies In the normal course of business, we incur obligations to make future payments as we execute our business plan. As of December 31, 2018, we had outstanding commitments, including R&D contracts and other commitments, that are known and committed of approximately $1.9 million over the next 12 months and approximately $600,000 in the following 12 months. These contracts relate to preclinical, clinical, and development activities, including the clinical research organization conducting the Phase II clinical trial for DM199 related to AIS. These commitments are subject to significant change and the ultimate amounts due may be materially different as these obligations are affected by, among other factors, the number and pace of patients enrolled, the number of clinical study sites, amount of time to complete study enrollments and the time required to finalize the analysis and reporting of study results. These commitments are generally cancelable upon 30 days’ notice, with our obligation then limited to costs incurred up to that date. As of December 31, 2018, we had future operating lease commitments totaling approximately $240,000 over the remainder of the lease, of which $62,000 is due over the next 12 months. We have entered into a license agreement with Catalent Pharma Solutions, LLC (“Catalent”) whereby we have licensed certain gene expression technology and we contract with Catalent for the manufacture of DM199. Under the terms of this license, certain milestone and royalty payments may become due under this agreement and are dependent upon, among other factors, clinical trials, regulatory approvals and ultimately the successful development of a new drug, the outcome and timing of which is uncertain. As of December 31, 2018, two milestones remain which include $185,000 due upon the initiation of dosing in our first Phase III trial and $185,000 upon our first regulatory approval for commercial sale. Following the launch of our first product, we will also incur a royalty of less than 1% on net sales. The royalty term is indefinite but may be canceled by us on 90 days’ prior written notice. The license may not be terminated by Catalent unless we fail to make required milestone and royalty payments. Off-Balance Sheet Arrangements During 2018 and 2017, we did not have any off-balance sheet arrangements (as defined by applicable SEC regulations) that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources. Internal Control Over Financial Reporting Pursuant to Section 404(a) of the Sarbanes-Oxley Act, commencing with our annual report on Form 10-K next year, our management will be required to report on the effectiveness of our internal control over financial reporting. The rules governing the standards that must be met for management to assess our internal control over financial reporting are complex and require significant documentation, testing and possible remediation. To comply with the requirements of being a U.S. public reporting company under the Exchange Act, we may need to upgrade our systems, including information technology, implement additional financial and management controls, reporting systems and procedures and hire additional accounting and finance staff.

<s>[INST] This discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. The following discussion contains forwardlooking statements that involve numerous risks and uncertainties. Our actual results could differ materially from the forwardlooking statements as a result of these risks and uncertainties. See “Cautionary Note Regarding ForwardLooking Statements” for additional cautionary information. Overview We are a clinical stage biopharmaceutical company primarily focused on the development of novel recombinant proteins. Our goal is to use our patented and licensed technologies to establish our company as a leader in the development and commercialization of therapeutic treatments for novel recombinant proteins to treat kidney and neurological diseases. Our current primary focus is on AIS and CKD. We plan to advance DM199, our lead drug candidate, through required clinical trials to create shareholder value by establishing its clinical and commercial potential as a therapy for AIS and CKD. In February 2018, we initiated treatment on the first patient in our Phase II REMEDY trial assessing the safety, tolerability and markers of therapeutic efficacy of DM199 in patients suffering from AIS. Our REMEDY trial is expected to enroll up to 100 patients to evaluate DM199 in patients with AIS. In December 2018, the FDA accepted our Investigational New Drug application for the initiation of a Phase Ib clinical trial of DM199 in patients with moderate or severe CKD caused by Type I or Type II diabetes and in February 2019, we initiated dosing patients in this study. The results from this Phase Ib study will assist us in the design of upcoming Phase II studies in patients suffering from rare diseases and CKD. The DM199 drug levels from this Phase Ib study will also help determine the optimal dose levels for testing in the Phase II studies. In September 2018, we entered into a license and collaboration agreement with Ahon Pharmaceutical Co Ltd. (“Ahon Pharma”), which grants Ahon Pharma exclusive rights to develop and commercialize DM199 for acute ischemic stroke in mainland China, Taiwan, Hong Kong S.A.R. and Macau S.A.R. Under the terms of the agreement, we received an upfront payment of $500,000 on signing and are entitled to receive an additional payment of $4.5 million upon regulatory clearance to initiate a clinical trial in China. We also have the potential to receive up to an additional $27.5 million in development and sales related milestones and up to approximately 10% royalties on net sales of DM199 in the licensed territories. All development, regulatory, sales, marketing, and commercial activities and associated costs in the licensed territories will be the sole responsibility of Ahon Pharma. This agreement may be terminated at any time by Ahon Pharma by providing 120 days written notice. Fosun Pharma, through its partnership with SK Group, a South Korea based company is an investor in DiaMedica through its equity investment in 2016. We have not generated any revenues from product sales. Since our inception, we have financed our operations from public and private sales of equity, the exercise of warrants and stock options, interest income on funds available for investment, and government grants and tax credits. We have incurred losses in each year since our inception. Our net losses were $5.7 million and $4.3 million for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2018, we had an accumulated deficit of $46.0 million. Substantially all of our operating losses resulted from expenses incurred in connection with product candidate development programs, our R&D activities and G&A support costs associated with our operations. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. In the near term, we anticipate that our expenses will increase as we: advance the ongoing clinical development of DM199; maintain, expand and protect our intellectual property portfolio; and provide G&A support for our operations. In [/INST] Positive. </s>

DiaMedica Therapeutics Inc.

2020-03-23

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon accounting principles generally accepted in the United States of America and discusses the financial condition and results of operations for DiaMedica Therapeutics Inc. and subsidiaries for the years ended December 31, 2019 and 2018. This discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. The following discussion contains forward-looking statements that involve numerous risks and uncertainties. Our actual results could differ materially from the forward-looking statements as a result of these risks and uncertainties. See “Cautionary Note Regarding Forward-Looking Statements” for additional cautionary information. Business Overview We are a clinical stage biopharmaceutical company primarily focused on the development of novel recombinant proteins. Our goal is to use our patented and licensed technologies and trade secrets to establish our company as a leader in the development and commercialization of therapeutic treatments for novel recombinant proteins. Our current focus is on CKD and AIS. We plan to advance DM199, our lead drug candidate, through required clinical trials to create shareholder value by establishing its clinical and commercial potential as a therapy for CKD and AIS. DM199 is a recombinant form of human tissue kallikrein-1 (KLK1). KLK1 is a serine protease (protein) produced primarily in the kidneys, pancreas and salivary glands, which plays a critical role in the regulation of local blood flow and vasodilation (the widening of blood vessels which decreases vascular resistance) in the body, as well as an important role in inflammation and oxidative stress (an imbalance between potentially damaging reactive oxygen species, or free radicals, and antioxidants in your body). We believe DM199 has the potential to treat a variety of diseases where healthy functioning requires sufficient activity of KLK1 and its system, the kallikrein-kinin system (KKS). Our DM199 product candidate is in clinical development as follows: During 2019, DiaMedica initiated and completed a Phase Ib clinical trial of DM199 in 32 subjects with moderate or severe CKD caused by Type I or Type II diabetes mellitus. The study was performed at 3 sites in the U.S. and was designed to assess the pharmacokinetics (PK) of three dose levels of DM199 (3, 5 and 8 µg/kg), administered in a single subcutaneous (SC) dose, as well as the evaluation of safety, tolerability and secondary pharmacodynamic (PD) endpoints. Results from the study were also used to guide the design of Phase II CKD studies. In October 2019, the FDA accepted our Phase II clinical trial protocol for the treatment of CKD caused by rare or significant unmet diseases. The trial named REDUX, Latin for restore, is a multi-center, open-label investigation of approximately 60 participants with CKD, who are being enrolled in two cohorts (30 participants per cohort). The study is being conducted in the United States at up to 12 sites and is focused on participants with CKD: Cohort I is focused on non-diabetic, hypertensive African Americans with Stage II or III CKD. African Americans are at greater risk for CKD than Caucasians, and those who have the APOL1 gene mutation are at an even higher risk. The study is designed to capture the APOL1 gene mutation as an exploratory biomarker in this cohort; Cohort II is focused on participants with IgA Nephropathy (IgAN). The study will evaluate two dose levels of DM199 within each cohort. Study participants will receive DM199 by subcutaneous injection twice weekly for 95 days. The primary study endpoints include safety, tolerability, blood pressure, albuminuria and kidney function, which will be evaluated by changes from baseline in eGFR and albuminuria, as measured by the UACR. Participant enrollment and dosing for this study commenced in December 2019. We are currently experiencing slower than expected enrollment in the REDUX clinical trial. In addition, the novel strain of coronavirus (COVID: 19) has adversely affected and may continue to adversely affect our ability to recruit or enroll subjects. If this slow enrollment continues, the completion of these studies will take longer than expected. In February 2018, treatment was initiated for the first patient in our Phase II REMEDY trial assessing the safety, tolerability and markers of therapeutic efficacy of DM199 in patients suffering from AIS. Our REMEDY trial was expected to enroll up to 100 patients to evaluate DM199 in patients with AIS. The study drug (DM199 or placebo) will be administered as an intravenous (IV) infusion within 24 hours of stroke symptom onset, followed by SC injections later that day and once every 3 days for 21 days. The study was designed to measure safety and tolerability along with multiple tests designed to investigate DM199’s therapeutic potential including plasma-based biomarkers and standard functional stroke measures assessed at 90 days post-stroke. Standard functional stroke measurements include the Modified Rankin Scale, National Institutes of Health Stroke Scale, the Barthel Index and C-reactive protein, a measure of inflammation. In the fourth quarter of 2019, we completed enrollment in the REMEDY trial. Final enrollment was 92 participants. In September 2018, we entered into a license and collaboration agreement with Ahon Pharma, which granted Ahon Pharma exclusive rights to develop and commercialize DM199 for acute ischemic stroke in mainland China, Taiwan, Hong Kong S.A.R. and Macau S.A.R. Under the terms of the agreement, we received an upfront payment of $500,000 on signing and were entitled to receive an additional payment of $4.5 million upon the earlier of regulatory clearance to initiate a clinical trial in China or July 1, 2019. On August 12, 2019, after extensive good faith discussions with Ahon Pharma, we were unable to agree upon mutually acceptable revised terms to the agreement and we terminated the agreement for non-payment of the $4.5 million milestone, thereby regaining worldwide rights for DM199 for acute ischemic stroke. On February 13, 2020, we issued and sold an aggregate of 2,125,000 common shares in a public underwritten offering at a public offering price of $4.00 per share, receiving gross proceeds of $8.5 million and net proceeds of approximately $7.7 million, after deducting the underwriting discount and offering expenses. See Note 16 titled “Subsequent Event.” We have not generated any revenues from product sales. Since our inception, we have financed our operations from public and private sales of equity, the exercise of warrants and stock options, interest income on funds available for investment and government grants and tax credits. We have incurred losses in each year since our inception. Our net losses were $10.6 million and $5.7 million for the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, we had an accumulated deficit of $56.6 million. Substantially all of our operating losses resulted from expenses incurred in connection with our product candidate development programs, our primary research and development (R&D) activities, and general and administrative (G&A) support costs associated with our operations. We expect to continue to incur significant expenses and increased operating losses for at least the next several years. In the near term, we anticipate that our expenses will increase as we: ● advance the ongoing clinical development of DM199; ● provide G&A support for our operations; and ● maintain, expand and protect our intellectual property portfolio. In addition, our operating expenses increased in 2019 compared to 2018 as a result of our Nasdaq-listed U.S. public reporting company status obtained in December 2018. While we expect our rate of future negative cash flow per month will vary due to the timing of expenses incurred, we expect our current cash resources, together with the $7.7 million in net proceeds from our February 2020 public offering, to be sufficient to allow us to complete our current ongoing Phase II REMEDY trial in patients with AIS and the first two cohorts in the Phase II study in patients with CKD and to otherwise fund our planned operations through 2021. However, the amount and timing of future funding requirements will depend on many factors, including the timing and results of our ongoing development efforts, including enrollment in our clinical trials, the potential expansion of our current development programs, potential new development programs, and related G&A support. We may require significant additional funds earlier than we currently expect and there is no assurance that we will not need or seek additional funding prior to such time. We may elect to raise additional funds even before we need them if market conditions for raising additional capital are favorable. From a strategic perspective, we continue to believe that strategic alternatives with respect to our DM199 product candidate, including licenses and business collaborations, with other regional and global pharmaceutical and biotechnology companies can be important in advancing the clinical development of DM199. Therefore, as a matter of course and from time to time, we continue to engage in discussions with third parties regarding these matters. Financial Overview Revenues Since our inception, we have incurred losses while advancing the development of our therapeutic product candidates. We have not generated any revenues from product sales and do not expect to do so for a number of years. We may never generate sales revenues from our current DM199 product candidate as we may never succeed in obtaining regulatory approval or commercial sale of this product candidate. We received $500,000 in license revenue during 2018. Research and Development Expenses R&D expenses consist primarily of fees paid to external service providers such as contract research organizations and contract manufacturing organizations related to clinical trials, contractual obligations for clinical development, clinical sites, laboratory testing, preclinical trials, development of DM199 and the related manufacturing processes, salaries, benefits, share-based compensation and other personnel costs. We incurred $7.9 million and $4.5 million in R&D expenses for the years ended December 31, 2019 and 2018, respectively. Over the past approximately eight years, our R&D efforts have been primarily focused on developing DM199. At this time, due to the risks inherent in the clinical development process and the early stage of our product development programs, we are unable to estimate with any certainty the costs we will incur in the continued development of DM199 or any of our preclinical development programs. We expect that our R&D expenses may increase if we are successful in advancing DM199, or any of our preclinical programs, into advanced stages of clinical development. The process of conducting clinical trials necessary to obtain regulatory approval and manufacturing scale-up to support expanded development and potential future commercialization is costly and time consuming. Any failure by us or delay in completing clinical trials, manufacturing scale-up or in obtaining regulatory approvals could lead to increased R&D expenses and, in turn, have a material adverse effect on our results of operations. General and Administrative Expenses G&A expenses consist primarily of salaries and related benefits, including share-based compensation related to our executive, finance, business development and support functions. Other G&A expenses include rent and utilities, travel expenses and professional fees for auditing, tax and legal services. We expect that G&A expenses will increase in the future as we expand our operating activities. In 2019, our G&A expenses increased significantly due to increased costs associated with our listing on The Nasdaq Capital Market and U.S. public reporting company status, which commenced in December 2018. This increase in 2019 was partially offset by one-time costs of approximately $360,000 incurred in 2018, associated with the Nasdaq listing process and related legal and accounting fees. Other (Income) Expense Other (income) expense consists primarily of governmental assistance comprised of research and development incentives earned by DiaMedica Australia Pty Ltd., interest income and foreign currency exchange gains and losses. Critical Accounting Policies and Estimates Management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these consolidated financial statements requires us to make estimates and assumptions for the reported amounts of assets, liabilities, revenue, expenses and related disclosures. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions and any such differences may be material. While our significant accounting policies are more fully described in Note 3 to our consolidated financial statements included elsewhere in this report, we believe the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require our most difficult, subjective and complex judgments. Revenue Recognition We followed Accounting Standards Codification (ASC) 606, “Revenue from Contracts with Customers” in accounting for our former license and collaboration agreement with Ahon Pharma. Accordingly, the Company recognizes revenue upon transfer of control of the product to our customer in an amount that reflects the consideration we expect to receive in exchange. We intend to enter into arrangements for the research and development and/or manufacture of products and product candidates. Such arrangements may require us to deliver various rights, services and/or goods, including (i) intellectual property rights or licenses, (ii) R&D services or (iii) manufacturing services. The underlying terms of these arrangements generally would provide for consideration to DiaMedica in the form of nonrefundable, up-front license fees, development and commercial-performance milestone payments, cost sharing, royalty payments and/or profit sharing. In arrangements involving more than one performance obligation, each required performance obligation is evaluated to determine whether it qualifies as a distinct performance obligation based on whether (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available and (ii) the good or service is separately identifiable from other promises in the contract. The consideration under the arrangement is then allocated to each separate distinct performance obligation based on its respective relative stand-alone selling price. The estimated selling price of each deliverable reflects our best estimate of what the selling price would be if the deliverable was regularly sold by us on a stand-alone basis or using an adjusted market assessment approach if selling price on a stand-alone basis is not available. The consideration allocated to each distinct performance obligation is recognized as revenue when control of the related goods or services is transferred. Consideration associated with at-risk substantive performance milestones is recognized as revenue when it is probable that a significant reversal of the cumulative revenue recognized will not occur. We intend to utilize the sales and usage-based royalty exception in arrangements that result from the license of intellectual property, recognizing revenues generated from royalties or profit sharing as the underlying sales occur. Research and Development Costs Research and development costs include expenses incurred in the conduct of human clinical trials, for third-party service providers performing various treatment, testing and data accumulation and for analysis related to clinical studies; sponsored non-clinical research agreements; developing the manufacturing process necessary to produce sufficient amounts of the DM199 compound for use in our clinical studies; consulting resources with specialized expertise related to execution of our development plan for our DM199 product candidate; and personnel costs, including salaries, benefits and share-based compensation. We charge research and development costs, including clinical trial costs, to expense when incurred. Our human clinical trials are performed at clinical trial sites and are administered jointly by us with assistance from contract research organizations. Costs of setting up clinical trial sites are accrued upon execution of the study agreement. Expenses related to the performance of clinical trials are accrued based on estimates of work completed to date by CROs, outside contractors and clinical trial sites that manage and perform the trials, and those that manufacture the investigational product. We obtain initial estimates of total costs based on the trial protocol, extent of enrollment of subjects, trial duration, project management costs, manufacturing costs, patient treatment costs and other activities as required by the trial protocol. Additionally, actual costs may be charged to us and are recognized as the tasks are completed by the clinical trial site. Accrued clinical trial costs may be subject to revisions as clinical trials progress and any revisions are recorded in the period in which the facts that give rise to the revisions become known. Share-based Compensation We account for all share-based compensation awards using a fair value method. The cost of employee and non-employee services received in exchange for awards of equity instruments is measured and recognized based on the estimated grant date fair value of those awards. Compensation cost is recognized ratably using the straight-line attribution method over the vesting period, which is considered to be the requisite service period. We record forfeitures in the periods in which they occur. The fair value of share-based awards is estimated using the Black-Scholes option pricing model. The determination of the fair value of share-based awards is affected by our common share price, as well as assumptions regarding a number of complex and subjective variables. Risk-free interest rates are based upon United States Government bond rates appropriate for the expected term of each award. Expected volatility rates are based on the historical volatility equal to the expected life of the option. The assumed dividend yield is zero, as we do not expect to declare any dividends in the foreseeable future. The expected term of options is estimated considering the vesting period at the grant date, the life of the option and the average length of time similar grants have remained outstanding in the past. The assumptions used in calculating the fair value under the Black-Scholes option valuation model are set forth in the following table for options issued by us for the years ended December 31, 2019 and 2018: Recently Adopted Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (FASB) issued a new accounting standard that amends the guidance for the recognition of revenue from contracts with customers to transfer goods and services. The FASB subsequently issued additional, clarifying standards to address issues arising from implementation of the new revenue recognition standard. The new revenue recognition standard and clarifying standards require an entity to recognize revenue when control of promised goods or services is transferred to the customer at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. We adopted this new standard as of January 1, 2018, but the adoption as of this date had no impact on our financial statements as we had no revenue until the third quarter of 2018. In February 2016, the FASB issued Accounting Standards Update (ASU) No. 2016-02, Leases. The guidance in ASU 2016-02 supersedes the lease recognition requirements in the Accounting Standards Codification Topic 840, Leases. ASU 2016-02 requires an entity to recognize assets and liabilities arising from a lease for both financing and operating leases, along with additional qualitative and quantitative disclosures. The new standard requires the immediate recognition of all excess tax benefits and deficiencies in the income statement and requires classification of excess tax benefits as an operating activity as opposed to a financing activity in the statements of cash flows. This standard became effective for us on January 1, 2019. The FASB has subsequently issued the following amendments to ASU 2016-02, which have the same effective date and transition date of January 1, 2019, and which we collectively refer to as the new leasing standards: ● ASU No. 2018-01, Leases (Topic 842): Land Easement Practical Expedient for Transition to Topic 842, which permits an entity to elect an optional transition practical expedient to not evaluate under Topic 842 land easements that existed or expired prior to adoption of Topic 842 and that were not previously accounted for as leases under the prior standard, ASC 840, Leases. ● ASU No. 2018-10, Codification Improvements to Topic 842, Leases, which amends certain narrow aspects of the guidance issued in ASU 2016-02. ● ASU No. 2018-11, Leases (Topic 842): Targeted Improvements, which allows for a transition approach to initially apply ASU 2016-02 at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption as well as an additional practical expedient for lessors to not separate non-lease components from the associated lease component. ● ASU No. 2018-20, Narrow-Scope Improvements for Lessors, which contains certain narrow scope improvements to the guidance issued in ASU 2016-02. We adopted the new leasing standards on January 1, 2019, using a modified retrospective transition approach to be applied to leases existing as of, or entered into after, January 1, 2019; and, consequently, financial information will not be updated and the disclosures required under Topic 842 will not be provided for dates and periods prior to January 1, 2019. We have reviewed our existing lease contracts and the impact of the new leasing standards on our consolidated results of operations, financial position and disclosures. Upon adoption of the new leasing standards, we recognized a lease liability and related right-of-use asset on our consolidated balance sheet of approximately $205,000. In June 2018, the FASB issued ASU No. 2018-07, “Improvements to Nonemployee Share-Based Payment Accounting,” to simplify the accounting for share-based payments to nonemployees by aligning it with the accounting for share-based payments to employees, with certain exceptions. This ASU is effective for public entities for fiscal years beginning after December 15, 2018. Prior to the adoption of this ASU, share-based compensation awarded to non-employees was subject to revaluation over its vesting terms. Subsequent to the adoption of this ASU, non-employee share-based payment awards are measured on the date of grant, similar to share-based payment awards granted to employees. We adopted this standard on January 1, 2019 and the adoption of this ASU did not have a material impact on our financial position or our consolidated statements of operations. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table summarizes our results of operations for the years ended December 31, 2019 and 2018 (in thousands): License Revenue License revenue for 2018 was comprised of the initial $500,000 license payment we received upon signing of the September 27, 2018 license and collaboration agreement with Ahon Pharma. No license revenue was recognized in 2019. Research and Development Expenses R&D expenses were $7.9 million for the year ended December 31, 2019 compared to $4.5 million for the year ended December 31, 2018, an increase of $3.4 million. The increase was due to costs of approximately $1.4 million incurred for a new production run of the DM199 drug substance, as well as costs incurred in conjunction with the Phase Ib and Phase II clinical studies in CKD patients and related non-clinical testing. Increased non-cash share-based compensation costs also contributed to the increase. These increases were partially offset by a reduction in cost incurred in conjunction with the REMEDY Phase II clinical study in AIS patients for which we completed enrollment in October 2019. General and Administrative Expenses G&A expenses were $3.7 million and $2.7 million for the years ended December 31, 2019 and 2018, respectively. This $1.0 million increase was primarily due to costs associated with our status as a Nasdaq-listed U.S. public reporting company, which commenced in December 2018, including increased professional service, compliance and non-cash share-based compensation costs. Increased personnel costs also contributed to the increase on a year-to-date basis. This increase was partially offset by one-time costs of approximately $360,000 incurred in 2018, associated with the Nasdaq listing process and related legal and accounting fees. Other (Income) Expense Other income, net, was $1.0 million for the year ended December 31, 2019 compared to $1.1 million for 2018. This decrease is primarily related to the initial recognition of R&D incentives, from the Australian Government, paid for qualifying research work performed by DiaMedica Australia Pty Ltd. during 2018, which included research work performed in 2017 and 2018. The decrease was partially offset by increased interest income earned on marketable securities during 2019. Liquidity and Capital Resources The following table summarizes our liquidity and capital resources as of December 31, 2019 and 2018 and for each of the years ended December 31, 2019 and 2018, and is intended to supplement the more detailed discussion that follows (in thousands): Working Capital We had cash, cash equivalents and marketable securities of $7.9 million, current liabilities of $1.3 million and working capital of $7.5 million as of December 31, 2019, compared to $16.8 million in cash and cash equivalents and marketable securities, $1.3 million in current liabilities and $16.7 million in working capital as of December 31, 2018. The decreases in cash, cash equivalents and marketable securities and working capital are mainly due to our use of cash to fund operating activities during 2019. On February 13, 2020, we issued and sold an aggregate of 2,125,000 common shares in a public underwritten offering at a public offering price of $4.00 per share, receiving gross proceeds of $8.5 million and net proceeds of approximately $7.7 million, after deducting the underwriting discount and offering expenses. See Note 16 titled “Subsequent Event.” On December 27, 2019, we entered into a litigation funding agreement with LEGALIST FUND II, L.P. (the Funder) for the purpose of funding our currently pending lawsuit against PRA Netherlands. Our management believes, but cannot guarantee, that this litigation funding agreement will allow us to pursue this litigation more effectively. Although the Funder made its evaluation as to the likelihood of success, litigation is very uncertain, and no assurance can be provided that, just because we have obtained litigation funding, we will be successful or that any recovery we may obtain will be significant. Under the terms of the litigation funding agreement, the Funder agreed to pay up to an aggregate of $1.0 million to fund reasonable legal fees, court costs, and other expenses incurred by us in connection with the litigation, including $200,000 for fees and costs previously paid by us. These payments, however, are conditioned upon the transfer of venue of the litigation from Delaware to Minnesota and if the venue is not transferred we will not be entitled to receive any payments under the litigation funding agreement. If the venue is transferred, we agreed to repay the Funder from any proceeds arising from the litigation the amount of costs actually paid or otherwise funded by the Funder in connection with the litigation, plus the reimbursement of $10,000 for its diligence and underwriting costs. Additionally, we agreed to pay the Funder from the Claim Proceeds the greater of: (i) $1.0 million if repayment occurs within nine months of the Transfer, $2.0 million if repayment occurs more than nine months after the Transfer but before trial has begun, or $3.0 million thereafter; or (ii) 20% of the Claim Proceeds. In the event the Funder has not been repaid 3½ years after the Transfer, the Funder is entitled to receive interest on the unpaid amounts equal to 20% per annum commencing on the 3½ year anniversary of the Transfer. Our obligation under the litigation funding agreement to make the foregoing payments to the Funder is non-recourse and limited only to the Claim Proceeds. As a result of the agreement, if we obtain Claim Proceeds, it is possible, depending on the amount of the Claim Proceeds, that we will receive no net recovery after all payments have been made to the Funder. Cash Flows Operating Activities Net cash used in operating activities for the year ended December 31, 2019 was $9.1 million compared to $5.7 million for the year ended December 31, 2018. This increase relates primarily to an increase in the net loss, partially offset by non-cash expenses and the effects of the changes in operating assets and liabilities. Investing Activities Investing activities consist primarily of purchases of marketable securities and property and equipment. Net cash used in investing activities was $3.9 million for the year ended December 31, 2019 compared to $50,000 for the year ended December 31, 2018. This increase relates primarily to the investment of excess cash in short-term marketable securities. Financing Activities Financing activities consist primarily of net proceeds from the sale of common shares and warrants and proceeds from the exercise of stock options and warrants. Net cash provided by financing activities was $70,000 for the year ended December 31, 2019 compared to $21.2 million for the year ended December 31, 2018. Cash flows from financing activities for 2018 included net proceeds from our December 2018 initial public offering and private placements of our common shares and warrants to purchase common shares in March 2018. In December 2018, we completed an initial public offering of our common shares in the United States by issuing 4,100,000 common shares at an offering price of $4.00 per share, resulting in net proceeds to us of approximately $14.7 million, after deducting the underwriting discount and offering expenses. On March 29, 2018, we completed, in two tranches, a brokered and non-brokered private placement of 1,322,965 units at a price of $4.90 per unit for aggregate gross proceeds of approximately $6.3 million. Each unit consisted of one common share and one-half of one common share purchase warrant. Each whole warrant entitles the holder to purchase one common share at a price of $7.00 at any time prior to expiration on March 19, 2020 and March 29, 2020 for tranche 1 and tranche 2, respectively. The warrants are subject to early expiration under certain conditions. In connection with the offering, we paid an aggregate cash fee of approximately $384,000 to brokers and issued an aggregate of 80,510 compensation options. Each compensation option entitles the holder to purchase one common share at $4.90, the offering price, for a period of two years from the closing of the offering, subject to acceleration on the same terms as the warrants issued to the investors. Capital Requirements Since our inception, we have incurred losses while advancing the R&D of our product candidates. We have not generated any revenues from product sales and do not expect to do so for a number of years. We do not know when, or if, we will generate any revenues from product sales of our DM199 product candidate or any future product candidates. We do not expect to generate any revenue from product sales unless and until we obtain regulatory approval. We expect to continue to incur substantial operating losses until such time as any future product sales, royalty payments, licensing fees, and/or milestone payments are sufficient to generate revenues to fund our continuing operations. We expect our operating losses to increase in the near term as we continue the research, development and clinical trials of, and seek regulatory approval for, our DM199 product candidate. In addition, our operating expenses increased in 2019 compared to 2018 as a result of our recently obtained Nasdaq-listed U.S. public reporting company status and we expect to continue to incur costs at or above this level. In the long-term, subject to obtaining regulatory approval of our DM199 product candidate or any other future product candidates, we expect to incur significant commercialization expenses for product sales, marketing, manufacturing and distribution. Accordingly, we expect we will need substantial additional capital to further our R&D activities, planned clinical trials, regulatory activities and otherwise develop our product candidate, DM199, or any future product candidates, to a point where they may be commercially sold. While we are striving to achieve these plans, there is no assurance these and other strategies will be achieved or that additional funding will be obtained on favorable terms or at all. While our rate of future negative cash flow per month will vary due to the timing of expenses incurred, we expect our current cash, cash equivalents and marketable securities, supplemented by the net proceeds of our February 2020 public offering, to be sufficient to allow us to complete our current ongoing Phase II REMEDY trial in patients with AIS and our current Phase Ib trial in patients with CKD and a Phase II study in patients with CKD and to otherwise fund our planned operations through 2021. However, the amount and timing of future funding requirements will depend on many factors, including the timing and results of our ongoing development efforts, the potential expansion of our current development programs, potential new development programs and related G&A support. We may require significant additional funds earlier than we currently expect and there is no assurance that we will not need or seek additional funding prior to such time. We may elect to raise additional funds even before we need them if market conditions for raising additional capital are favorable. Since our inception, we have financed our operations primarily from public and private sales of equity, the exercise of warrants and stock options, interest income on funds available for investment, and government grants and tax incentives, and we expect to continue this practice for the foreseeable future. We do not have any existing credit facilities under which we could borrow funds. We may seek to raise additional funds through various sources, such as equity and debt financings, or through strategic collaborations and license agreements. We can give no assurances that we will be able to secure additional sources of funds to support our operations, or if such funds are available to us, that such additional financing will be sufficient to meet our needs or on terms acceptable to us. This is particularly true if our clinical data is not positive or economic and market conditions deteriorate. To the extent we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our shareholders will be diluted. Debt financing, if available, may involve agreements that include conversion discounts or covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise additional funds through government or other third-party funding, marketing and distribution arrangements or other collaborations, or strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us. The availability of financing will be affected by our clinical data and other results of scientific and clinical research; the ability to attain regulatory approvals; market acceptance of our product candidates; the state of the capital markets generally with particular reference to pharmaceutical, biotechnology, and medical companies; the status of strategic alliance agreements; and other relevant commercial considerations. If adequate funding is not available, we may be required to implement cost reduction strategies; delay, reduce, or eliminate one or more of our product development programs; relinquish significant rights to our technologies, future revenue streams, research programs or product candidates or grant licenses on terms that may not be favorable to us; and/or divest assets or cease operations through a merger, sale, or liquidation of our company. Commitments and Contingencies In the normal course of business, we incur obligations to make future payments as we execute our business plan. As of December 31, 2019, we had outstanding commitments, including R&D contracts and other commitments, that are known and committed of approximately $4.9 million over the next 12 months and $0 in the following 12 months. These contracts relate to clinical, and development activities, including the clinical study sites and related professional service providers conducting or supporting the conduct of the REDUX study and the clinical research organization conducting the Phase II clinical trial for DM199 related to AIS. These commitments are subject to significant change and the ultimate amounts due may be materially different as these obligations are affected by, among other factors, the number and pace of patients enrolled, the number of clinical study sites, the amount of time to complete study enrollments and the time required to finalize the analysis and reporting of study results. These commitments are generally cancelable upon 30 days’ notice, with our obligation then limited to costs incurred up to that date. As of December 31, 2019, we had future operating lease commitments totaling approximately $158,000 over the remainder of the lease, of which $66,000 is due over the next 12 months. We have entered into a license agreement with Catalent Pharma Solutions, LLC whereby we have licensed certain gene expression technology and we contract with Catalent for the manufacture of DM199. Under the terms of this license, certain milestone and royalty payments may become due under this agreement and are dependent upon, among other factors, clinical trials, regulatory approvals and ultimately the successful development of a new drug, the outcome and timing of which is uncertain. As of December 31, 2019, two milestones remain which include $185,000 due upon the initiation of dosing in our first Phase III trial and $185,000 upon our first regulatory approval for commercial sale. Following the launch of our first product, we will also incur a royalty of less than 1% on net sales. The royalty term is indefinite but the license agreement may be canceled by us on 90 days’ prior written notice. The license may not be terminated by Catalent unless we fail to make required milestone and royalty payments. Off-Balance Sheet Arrangements During 2019 and 2018, we did not have any off-balance sheet arrangements (as defined by applicable SEC regulations) that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations is based upon accounting principles generally accepted in the United States of America and discusses the financial condition and results of operations for DiaMedica Therapeutics Inc. and subsidiaries for the years ended December 31, 2019 and 2018. This discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this report. The following discussion contains forwardlooking statements that involve numerous risks and uncertainties. Our actual results could differ materially from the forwardlooking statements as a result of these risks and uncertainties. See “Cautionary Note Regarding ForwardLooking Statements” for additional cautionary information. Business Overview We are a clinical stage biopharmaceutical company primarily focused on the development of novel recombinant proteins. Our goal is to use our patented and licensed technologies and trade secrets to establish our company as a leader in the development and commercialization of therapeutic treatments for novel recombinant proteins. Our current focus is on CKD and AIS. We plan to advance DM199, our lead drug candidate, through required clinical trials to create shareholder value by establishing its clinical and commercial potential as a therapy for CKD and AIS. DM199 is a recombinant form of human tissue kallikrein1 (KLK1). KLK1 is a serine protease (protein) produced primarily in the kidneys, pancreas and salivary glands, which plays a critical role in the regulation of local blood flow and vasodilation (the widening of blood vessels which decreases vascular resistance) in the body, as well as an important role in inflammation and oxidative stress (an imbalance between potentially damaging reactive oxygen species, or free radicals, and antioxidants in your body). We believe DM199 has the potential to treat a variety of diseases where healthy functioning requires sufficient activity of KLK1 and its system, the kallikreinkinin system (KKS). Our DM199 product candidate is in clinical development as follows: During 2019, DiaMedica initiated and completed a Phase Ib clinical trial of DM199 in 32 subjects with moderate or severe CKD caused by Type I or Type II diabetes mellitus. The study was performed at 3 sites in the U.S. and was designed to assess the pharmacokinetics (PK) of three dose levels of DM199 (3, 5 and 8 µg/kg), administered in a single subcutaneous (SC) dose, as well as the evaluation of safety, tolerability and secondary pharmacodynamic (PD) endpoints. Results from the study were also used to guide the design of Phase II CKD studies. In October 2019, the FDA accepted our Phase II clinical trial protocol for the treatment of CKD caused by rare or significant unmet diseases. The trial named REDUX, Latin for restore, is a multicenter, openlabel investigation of approximately 60 participants with CKD, who are being enrolled in two cohorts (30 participants per cohort). The study is being conducted in the United States at up to 12 sites and is focused on participants with CKD: Cohort I is focused on nondiabetic, hypertensive African Americans with Stage II or III CKD. African Americans are at greater risk for CKD than Caucasians, and those who have the APOL1 gene mutation are at an even higher risk. The study is designed to capture the APOL1 gene mutation as an exploratory biomarker in this cohort; Cohort II is focused on participants with IgA Nephropathy (IgAN). The study will evaluate two dose levels of DM199 within each cohort. Study participants will receive DM199 by subcutaneous injection twice weekly for 95 days. The primary study endpoints include safety, tolerability, blood pressure, albuminuria and kidney function, which will be evaluated by changes from baseline in eGFR and albuminuria, as measured by the UACR. Participant enrollment and dosing for this study commenced in December 2019. We [/INST] Negative. </s>

HighPoint Resources Corp

2019-02-26

2018-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Introduction The following discussion and analysis should be read in conjunction with the "Selected Financial Data" and the accompanying consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This section and other parts of this Annual Report on Form 10-K contain forward-looking statements that involve risks and uncertainties. See the "Cautionary Note Regarding Forward-Looking Statements" at the beginning of this Annual Report on Form 10-K. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in "Items 1 and 2. Business and Properties - Business - Operations - Environmental Matters and Regulation;" "Items 1 and 2. Business and Properties - Business - Operations - Other Regulation of the Oil and Gas Industry;" and "Item 1A. Risk Factors" above, all of which are incorporated herein by reference. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law. Overview We develop oil and natural gas in the Rocky Mountain region of the United States. We seek to build stockholder value by delivering profitable growth in cash flow, reserves and production through the development of oil and natural gas assets. In order to deliver profitable growth, we allocate capital to our highest return assets, concentrate expenditures on exploiting our core assets, maintain capital discipline and optimize operations while upholding high-level standards for health, safety and the environment. Substantially all of our revenues are generated through the sale of oil and natural gas production and NGL recovery at market prices. We are committed to developing and producing oil and natural gas in a responsible and safe manner. Our employees work diligently with regulatory agencies, as well as environmental, wildlife and community organizations, to ensure that exploration and development activities meet stakeholders' expectations and regulatory requirements. Future acquisitions or dispositions could have a material impact on our financial condition and results of operations by increasing or decreasing our reserves, production and revenues as well as expenses and future capital expenditures. We currently anticipate that we would finance any future acquisitions with available borrowings under our Amended Credit Facility, sales of properties, and/or the issuance of debt, equity or equity-linked securities. Our prior acquisitions and capital expenditures were financed with a combination of cash on hand, funding from the sale of our equity securities, our Amended Credit Facility, other debt financing and cash flows from operations. As a result of acquisitions and dispositions of properties, our historical results of operations and period-to-period comparisons of these results and certain financial data may not be meaningful. In addition, past results are not necessarily indicative of future results. The following table summarizes the estimated net proved reserves and related Standardized Measure for the years indicated. The Standardized Measure is not intended to represent the current market value of our estimated oil and natural gas reserves. (1) December 31, 2018 reserves were based on average prices of $65.56 WTI per Bbl of oil, $3.10 Henry Hub per Mcf of natural gas and $32.71 per Bbl of NGLs. December 31, 2017 reserves were based on average prices of $51.34 WTI for oil, $2.98 Henry Hub for natural gas and $27.40 for NGLs. December 31, 2016 reserves were based on average prices of $42.75 WTI for oil, $2.48 Henry Hub for natural gas and $19.70 for NGLs. Commodity prices are inherently volatile and are influenced by many factors outside of our control. As of February 21, 2019, we have hedged 6,736,184 barrels of oil and 3,275,000 MMbtu of natural gas, or approximately 57% of our expected 2019 production, and 3,292,000 barrels of oil for our 2020 production at price levels that provide some economic certainty to our cash flows. We focus our efforts on increasing oil, natural gas and NGL reserves and production while controlling costs at a level that is appropriate for long-term operations. Our future earnings and cash flows are dependent on our ability to manage our revenues and overall cost structure to a level that allows for profitable production. Significant Business Developments On March 19, 2018, we completed the Merger with Fifth Creek. The Merger was effected through the issuance of 100 million shares of our common stock, with a fair value of $484.0 million on the date of closing, and the repayment of $53.9 million of Fifth Creek debt. Assets acquired included approximately 81,000 net acres in Weld County in the DJ Basin, substantially all of which are operated, and 62 producing standard-length lateral wells and 10 producing extended-reach lateral wells. In addition, we recorded net proved reserves of 9.3 MMBoe, of which 4.7 MMBoe were proved developed reserves and 4.6 MMBoe were proved undeveloped reserves. As a result of the closing of the Merger on March 19, 2018, Fifth Creek's revenues and expenses are included in the Consolidated Statement of Operations beginning on March 19, 2018. See Note 4 for additional information regarding the accounting for the Merger. Results of Operations Year Ended December 31, 2018 Compared with Year Ended December 31, 2017 The following table sets forth selected operating data for the periods indicated: * Not meaningful. (1) Included in general and administrative expense is long-term cash and equity incentive compensation of $7.2 million (or $0.71 per Boe) and $8.3 million (or $1.18 per Boe) for the years ended December 31, 2018 and 2017, respectively. Production Revenues and Volumes. Production revenues increased to $452.9 million for the year ended December 31, 2018 from $251.2 million for the year ended December 31, 2017. The increase in production revenues was due to a 45% increase in production volumes and a 24% increase in the average realized prices per Boe before hedging. The increase in production volumes increased production revenues by approximately $141.1 million, while the increase in average prices increased production revenues by approximately $60.6 million. Total production volumes of 10.2 MMBoe for the year ended December 31, 2018 increased from 7.0 MMBoe for the year ended December 31, 2017 primarily due to a 63% increase in the DJ Basin as a result of new wells placed into production, along with wells acquired in the Merger, offset by the sale of our remaining assets in the Uinta Oil Program in December 2017. Additional information concerning production is in the following table: * Not meaningful. (1) Other includes 689 Mbbls of oil, 12 MBbls of NGLs and 348 MMcf of natural gas production in the Uinta Oil Program for the year ended December 31, 2017. Lease Operating Expense ("LOE"). LOE decreased to $2.74 per Boe for the year ended December 31, 2018 from $3.46 per Boe for the year ended December 31, 2017. The decrease per Boe for the year ended December 31, 2018 compared with the year ended December 31, 2017 is primarily related to operational efficiencies in our legacy DJ Basin assets and the sale of our remaining assets in the Uinta Oil Program in December 2017, which had relatively high LOE costs on a per Boe basis. Gathering, Transportation and Processing ("GTP") Expense. GTP expense increased to $0.46 per Boe for the year ended December 31, 2018 from $0.37 per Boe for the year ended December 31, 2017. Costs incurred to gather, transport and/or process our oil, gas and NGLs prior to the transfer of control to the customer are included in GTP expense. Costs incurred to gather, transport and/or process our oil, gas and NGLs after control has transferred to the customer are considered components of the consideration received from the customer and thus recorded in oil, gas and NGL production revenues. In general, based on specific contract arrangements, costs incurred in the Hereford Field in the DJ Basin, which was acquired in the Merger, are included in GTP expense and costs incurred in the Northeast Wattenberg Field in the DJ Basin are included in production revenues. See the "Revenue Recognition" section in Note 2 for additional information. The increase in GTP expense for the year ended December 31, 2018 to $0.46 per Boe is primarily associated with the Hereford Field. We expect GTP expense per Boe to increase in the future as we further develop and increase our production mix from the Hereford Field under the existing contractual arrangements. Production Tax Expense. Total production taxes increased to $36.8 million for the year ended December 31, 2018 from $14.5 million for the year ended December 31, 2017. The increase is attributable to the 45% increase in production and the 24% increase in average realized prices before hedging. Production taxes are primarily based on the wellhead values of production, which exclude gains and losses associated with hedging activities. We expect production taxes as a percentage of oil, natural gas and NGL sales to be approximately 8.0% in 2019. Impairment, Dry Hole Costs and Abandonment Expense. Our impairment, dry hole costs and abandonment expense for the years ended December 31, 2018 and 2017 is summarized below: (1) We recognized a non-cash impairment charge associated with our Uinta Oil Program proved properties during the year ended December 31, 2017. The properties were sold on December 29, 2017. (2) As a result of having no future plans to develop certain acreage and/or estimated market values below carrying value, we recognized non-cash impairment charges of $9.1 million associated with certain unproved properties in the Cottonwood Gulch area of the Piceance Basin and $2.1 million associated with certain non-core unproved properties in the DJ Basin during the year ended December 31, 2017. We review our oil and natural gas properties for impairment on a quarterly basis or whenever events and circumstances indicate that a decline in the recoverability of their carrying value may have occurred. Whenever we conclude the carrying value may not be recoverable, we estimate the expected undiscounted future net cash flows of our oil and gas properties using proved and risked probable and possible reserves based on our development plans and best estimate of future production, commodity pricing, reserve risking, gathering and transportation deductions, production tax rates, lease operating expenses and future development costs. We compare such undiscounted future net cash flows to the carrying amount of the oil and gas properties to determine if the carrying amount is recoverable. If the undiscounted future net cash flows exceed the carrying amount of the oil and gas properties, no impairment is taken. If the carrying amount of a property exceeds the undiscounted future net cash flows, we will impair the carrying value to fair value based on an analysis of quantitative and qualitative factors existing as of the balance sheet date. The factors used to determine fair value may include, but are not limited to, recent sales prices of comparable properties, indications from marketing activities, the present value of future revenues, net of estimated operating and development costs using estimates of reserves, future commodity pricing, future production estimates, anticipated capital expenditures and various discount rates commensurate with the risk and current market conditions associated with realizing the projected cash flows. Unproved oil and gas properties are assessed periodically for impairment based on remaining lease terms, drilling results, reservoir performance, commodity price outlooks, future plans to develop acreage, recent sales prices of comparable properties and other relevant matters. We generally expect impairments of unproved properties to be more likely to occur in periods of low commodity prices because we will be less likely to devote capital to exploration activities. Given current and projected future commodity prices, we will continue to review our acreage position and future drilling plans. In addition, we will assess the carrying value of our properties relative to their estimated future net cash flows. Estimated future net cash flows from our properties are based on our aggregate best estimates of future production, commodity pricing, gathering and transportation deducts, production tax rates, lease operating expenses and future development costs as of the balance sheet date. Our current recoverability test on our existing proved oil and gas properties as of December 31, 2018 uses commodity pricing based on a combination of assumptions, which are closely aligned with the assumptions management uses in its budgeting and forecasting process, including adjustments for geographical location and quality differentials as well as other factors that management believes will impact realized prices. The decline in future oil prices as of December 31, 2018 relative to prices as of December 31, 2017 has decreased our net undiscounted cash flows used in our recoverability test. If the recoverability test calculated with proved reserves would result in the carrying value exceeding future estimated net cash flows, we would complete the recoverability test with risked probable and possible reserves to determine the appropriate undiscounted net cash flows for the DJ Basin. If impairment is necessary, we would reduce the carrying value to fair value using proved reserves and risked probable and possible reserves. If future commodity prices assumed in the recoverability test are not realized, we could incur a significant impairment charge related to our oil and gas properties. Depreciation, Depletion and Amortization ("DD&A"). DD&A increased to $228.5 million for the year ended December 31, 2018 compared with $160.0 million for the year ended December 31, 2017. The increase of $68.5 million was the result of a 45% increase in production, offset by a 2% decrease in the DD&A rate for the year ended December 31, 2018 compared with the year ended December 31, 2017. The increase in production accounted for a $72.4 million increase in DD&A expense, while the decrease in the DD&A rate accounted for a decrease of $3.9 million in DD&A expense. Under successful efforts accounting, depletion expense is calculated on a field-by-field basis with a common geological structure using the unit-of-production method. The capital expenditures for proved properties for each field compared to the proved reserves corresponding to each producing field determine a depletion rate for current production. For the year ended December 31, 2018, the relationship of capital expenditures, proved reserves and production from certain producing fields yielded a depletion rate of $22.46 per Boe compared with $22.85 per Boe for the year ended December 31, 2017. We expect DD&A per Boe to increase in the future as a result of moving Merger-related purchase price allocated costs from unevaluated oil and gas properties to proved oil and gas properties as we further develop the Hereford Field. Unused Commitments. Unused commitments expense for each of the years ended December 31, 2018 and December 31, 2017 consisted of $18.2 million related to gas transportation contracts. During March 2010, we entered into two firm natural gas pipeline transportation contracts to provide a guaranteed outlet for production from the West Tavaputs area of the Uinta Basin and the Gibson Gulch area of the Piceance Basin. These transportation contracts were not included in the sales of these assets in December 2013 and September 2014, respectively. Both firm transportation contracts require the pipeline to provide transportation capacity and require us to pay monthly transportation charges regardless of the amount of pipeline capacity utilized. The agreements expire July 31, 2021. General and Administrative Expense. General and administrative expense increased to $45.1 million for the year ended December 31, 2018 from $42.5 million for the year ended December 31, 2017, primarily due to an increase in employee compensation and benefits associated with an increase in headcount. Included in general and administrative expense is long-term cash and equity incentive compensation of $7.2 million and $8.3 million for the years ended December 31, 2018 and 2017, respectively. The components of long-term cash and equity incentive compensation for each of the years ended December 31, 2018 and 2017 are shown in the following table: (1) The nonvested performance cash units are accounted for as liability awards and will be settled in cash for the performance metrics that are met. The expense for the period will increase or decrease based on updated fair values of these awards at each reporting date. Merger Transaction Expense. Merger transaction expense was $8.0 million and $8.7 million for the years ended December 31, 2018 and December 31, 2017, respectively. We entered into the Merger Agreement on December 4, 2017 and closed on March 19, 2018. Transaction expenses included severance, consulting, advisory, legal and other merger-related fees that were not capitalized as part of the Merger. Commodity Derivative Gain (Loss). Commodity derivative gain (loss) was a gain of $93.3 million for the year ended December 31, 2018 compared to a loss of $9.1 million for the year ended December 31, 2017. The increase for the year ended December 31, 2018 from the year ended December 31, 2017 is related to fluctuations of oil and natural gas future pricing compared to actual pricing of commodity hedges in place as of December 31, 2018 and December 31, 2017. The fair value of our open but not yet settled derivative contracts is based on an income approach using various assumptions, such as quoted forward prices for commodities, risk-free discount rates, volatility factors and time value factors. The mark-to-market fair value of the open commodity derivative contracts will generally be inversely related to the price movement of the underlying commodity. If commodity price trends reverse from period to period, prior unrealized gains may become unrealized losses and vice versa. Higher underlying commodity price volatility will generally lead to higher volatility in our unrealized gains and losses and, by association, the fair value of our commodity derivative contracts. These unrealized gains and losses will impact our net income in the period reported. The mark-to-market fair value can create non-cash volatility in our reported earnings during periods of commodity price volatility. We have experienced such volatility in the past and are likely to experience it in the future. Gains on our derivatives generally indicate lower wellhead revenues in the future while losses indicate higher future wellhead revenues. The table below summarizes our commodity derivative gains and losses that were recognized in the periods presented: (1) Realized and unrealized gains and losses on commodity derivatives are presented herein as separate line items but are combined for a total commodity derivative gain (loss) in the Consolidated Statements of Operations. This separate presentation is a non-GAAP measure. Management believes the separate presentation of the realized and unrealized commodity derivative gains and losses is useful because the realized cash settlement portion provides a better understanding of our hedge position. We also believe that this disclosure allows for a more accurate comparison to our peers. In 2018, approximately 73% of our oil volumes and 14% of our natural gas volumes were subject to financial hedges, which resulted in decreases in oil income of $47.7 million and increases in natural gas income of $0.1 million after settlements. In 2017, approximately 62% of our oil volumes and 39% of our natural gas volumes were covered by financial hedges, which resulted in increases in oil revenues of $18.3 million and natural gas revenues of $0.8 million after settlements. Income Tax (Expense) Benefit. For the year ended December 31, 2018, we have determined that it is more likely than not that we will be able to realize a portion of our deferred tax assets. This determination was made by considering all available evidence in assessing the need for a valuation allowance. Such evidence included the scheduled reversal of deferred tax liabilities, assets acquired in connection with the Merger and their classification as proved or unproved, current and projected future taxable income and tax planning strategies. In making this assessment, judgment is required in considering the relative weight of negative and positive evidence. As a result of the analysis conducted, we have reversed the majority of the valuation allowance on certain deferred tax assets and recorded income tax expense of $1.8 million for the year ended December 31, 2018. For the year ended December 31, 2017, we recorded a full valuation allowance against our deferred tax assets with the exception of certain provisions of the TCJA allowing us to eliminate the valuation allowance related to refundable alternative minimum tax ("AMT") credits, resulting in an income tax benefit of $1.4 million. Per the provisions of the TCJA, we are anticipating receiving 50% of the AMT credit upon filing the 2018 tax return. The remaining income tax receivable will be refunded in future periods. We continue to monitor facts and circumstances in the reassessment of the likelihood that NOL carryforwards, credits and other deferred tax assets will be utilized prior to their expiration. In 2018 and 2017, our effective tax rate differs from the federal statutory rate as a result of recording the impacts of the Section 382 change of ownership, state income taxes, the change in our valuation allowance and permanent differences related to non-deductible Merger costs, officer and stock-based compensation expense and lobbying expense. Results of Operations Year Ended December 31, 2017 Compared with Year Ended December 31, 2016 The following table sets forth selected operating data for the periods indicated: * Not meaningful. (1) Included in general and administrative expense is long-term cash and equity incentive compensation of $8.3 million (or $1.18 per Boe) and $11.9 million (or $1.96 per Boe) for the years ended December 31, 2017 and 2016, respectively. Production Revenues and Volumes. Production revenues increased to $251.2 million for the year ended December 31, 2017 from $178.3 million for the year ended December 31, 2016. The increase in production revenues was due to a 23% increase in the average realized prices per Boe before hedging and a 15% increase in production volumes. The increase in average prices increased production revenues by approximately $40.2 million, while the increase in production volumes increased production revenues by approximately $32.7 million. Total production volumes of 7.0 MMBoe for the year ended December 31, 2017 increased from 6.1 MMBoe for the year ended December 31, 2016 primarily due to a 23% increase in the DJ Basin as a result of new wells placed into production, offset by a 26% decrease in production from the Uinta Oil Program primarily due to the sale of certain non-core Uinta Oil Program assets during July 2016. Additional information concerning production is in the following table: * Not meaningful. Lease Operating Expense. LOE decreased to $3.46 per Boe for the year ended December 31, 2017 from $4.58 per Boe for the year ended December 31, 2016. The decrease per Boe for the year ended December 31, 2017 compared with the year ended December 31, 2016 is primarily related to operational efficiencies and sales of certain non-core assets in the Uinta Oil Program during July 2016, which had relatively high LOE costs on a per Boe basis. Production Tax Expense. Total production taxes increased to $14.5 million for the year ended December 31, 2017 from $10.6 million for the year ended December 31, 2016. The increase is attributable to the 23% increase in average realized prices before hedging and the 15% increase in production. Production taxes are primarily based on the wellhead values of production, which exclude gains and losses associated with hedging activities. We expect production taxes as a percentage of oil, natural gas and NGL sales to be approximately 7.5% in 2018. Impairment, Dry Hole Costs and Abandonment Expense. Our impairment, dry hole costs and abandonment expense for the years ended December 31, 2017 and 2016 is summarized below: (1) We recognized a non-cash impairment charge associated with our Uinta Oil Program proved properties during the year ended December 31, 2017. The properties were sold on December 29, 2017. (2) As a result of having no future plans to develop certain acreage and/or estimated market values below carrying value, we recognized non-cash impairment charges of $9.1 million associated with certain unproved properties in the Cottonwood Gulch area of the Piceance Basin and $2.1 million associated with certain non-core unproved properties in the DJ Basin during the year ended December 31, 2017. We review our oil and natural gas properties for impairment on a quarterly basis or whenever events and circumstances indicate that a decline in the recoverability of their carrying value may have occurred. Whenever we conclude the carrying value may not be recoverable, we estimate the expected undiscounted future net cash flows of our oil and gas properties using proved and risked probable and possible reserves based on our development plans and best estimate of future production, commodity pricing, reserve risking, gathering and transportation deductions, production tax rates, lease operating expenses and future development costs. We compare such undiscounted future net cash flows to the carrying amount of the oil and gas properties to determine if the carrying amount is recoverable. If the undiscounted future net cash flows exceed the carrying amount of the oil and gas properties, no impairment is taken. If the carrying amount of a property exceeds the undiscounted future net cash flows, we will impair the carrying value to fair value based on an analysis of quantitative and qualitative factors existing as of the balance sheet date. We do not believe that the undiscounted future net cash flows of our oil and gas properties represent the applicable market value. The factors used to determine fair value may include, but are not limited to, recent sales prices of comparable properties, indications from marketing activities, the present value of future revenues, net of estimated operating and development costs using estimates of reserves, future commodity pricing, future production estimates, anticipated capital expenditures and various discount rates commensurate with the risk and current market conditions associated with realizing the projected cash flows. Oil and gas properties are assessed for impairment once they meet the criteria to be classified as held for sale. Assets held for sale are carried at the lower of carrying cost or fair value less costs to sell. The fair value of the assets is determined using a market approach, based on an estimated selling price, as evidenced by current marketing activities, if possible. If an estimated selling price is not available, we utilize the income valuation technique, which involves calculating the present value of future net cash flows, as discussed above. If the carrying amount of the assets exceeds the fair value less costs to sell, an impairment will result to reduce the value of the properties down to fair value less costs to sell. The estimated fair value of assets held for sale may be materially different from sales proceeds that we eventually realize due to a number of factors including but not limited to the differences in expected future commodity pricing, location and quality differentials, our relative desire to dispose of such properties based on facts and circumstances impacting our business at the time we agree to sell, such as our position in the field subsequent to the sale and plans for future acquisitions or development in core areas. Unproved oil and gas properties are assessed periodically for impairment based on remaining lease terms, drilling results, reservoir performance, commodity price outlooks, future plans to develop acreage, recent sales prices of comparable properties and other relevant matters. We generally expect impairments of unproved properties to be more likely to occur in periods of low commodity prices because we will be less likely to devote capital to exploration activities. Given current and projected future commodity prices, we will continue to review our acreage position and future drilling plans. In addition, we will assess the carrying value of our properties relative to their estimated future net cash flows. Estimated future net cash flows from our properties are based on our aggregate best estimates of future production, commodity pricing, gathering and transportation deducts, production tax rates, lease operating expenses and future development costs as of the balance sheet date. Depreciation, Depletion and Amortization. DD&A decreased to $160.0 million for the year ended December 31, 2017 compared with $171.6 million for the year ended December 31, 2016. The decrease of $11.7 million was the result of a 19% decrease in the DD&A rate, offset by a 15% increase in production for the year ended December 31, 2017 compared with the year ended December 31, 2016. The decrease in the DD&A rate accounted for a decrease of $36.9 million in DD&A expense, while the increase in production accounted for a $25.3 million increase in DD&A expense. Under successful efforts accounting, depletion expense is calculated on a field-by-field basis with a common geological structure using the unit-of-production method. The capital expenditures for proved properties for each field compared to the proved reserves corresponding to each producing field determine a depletion rate for current production. For the year ended December 31, 2017, the relationship of capital expenditures, proved reserves and production from certain producing fields yielded a depletion rate of $22.85 per Boe compared with $28.18 per Boe for the year ended December 31, 2016. Unused Commitments. Unused commitments were $18.2 million for the year ended December 31, 2017 compared to $18.3 million for the year ended December 31, 2016. During March 2010, we entered into two firm natural gas pipeline transportation contracts to provide a guaranteed outlet for production from the West Tavaputs area of the Uinta Basin and the Gibson Gulch area of the Piceance Basin. These transportation contracts were not included in the sales of these assets in December 2013 and September 2014, respectively. Both firm transportation contracts require the pipeline to provide transportation capacity and require us to pay monthly transportation charges regardless of the amount of pipeline capacity utilized. These transportation contracts expire July 31, 2021. General and Administrative Expense. General and administrative expense increased to $42.5 million for the year ended December 31, 2017 from $42.2 million for the year ended December 31, 2016 primarily due to an increase in variable employee compensation related to performance, legal and professional services fees, offset by a decrease in long-term cash and equity compensation discussed below. Included in general and administrative expense is long-term cash and equity incentive compensation of $8.3 million and $11.9 million for the years ended December 31, 2017 and 2016, respectively. The components of long-term cash and equity incentive compensation for each of the years ended December 31, 2017 and 2016 are shown in the following table: (1) The nonvested performance cash units are accounted for as liability awards and will be settled in cash for the performance metrics that are met. The expense for the period will increase or decrease based on updated fair values of these awards at each reporting date. Merger Transaction Expense. Merger transaction expense was $8.7 million for the year ended December 31, 2017. We entered into the Merger Agreement on December 4, 2017 and closed on March 19, 2018. Transaction expenses included advisory, banking, legal, and accounting fees that had been incurred as of December 31, 2017 and will not be capitalized as part of the Merger. Interest Expense. Interest expense decreased to $57.7 million for the year ended December 31, 2017 from $59.4 million for the year ended December 31, 2016. The decrease for the year ended December 31, 2017 was primarily due to a decrease in the outstanding debt balance due to debt exchanged for common stock in June 2016 and the redemption of our remaining 7.625% Senior Notes and 5.0% Convertible Notes in May 2017, offset by the issuance of our 8.75% Senior Notes in April 2017. See Note 5 for additional information. Our weighted average interest rate for the year ended December 31, 2017 was 8.1% compared with 7.9% for the year ended December 31, 2016. Commodity Derivative Gain (Loss). Commodity derivative gain (loss) was a loss of $9.1 million for the year ended December 31, 2017 compared to a loss of $20.7 million for the year ended December 31, 2016. The decreased loss for the year ended December 31, 2017 from the year ended December 31, 2016 is related to fluctuations of oil and natural gas future pricing compared to actual pricing of commodity hedges in place as of December 31, 2017 and December 31, 2016. The table below summarizes our commodity derivative gains and losses that were recognized in the periods presented: In 2017, approximately 62% of our oil volumes and 39% of our natural gas volumes were covered by financial hedges, which resulted in increases in oil revenues of $18.3 million and natural gas revenues of $0.8 million after settlements for all commodity derivatives. In 2016, approximately 71% of our oil volumes and 24% of our natural gas volumes were covered by financial hedges, which resulted in increases in oil revenues of $92.2 million and natural gas revenues of $3.4 million after settlements for all commodity derivatives. Income Tax (Expense) Benefit. For the year ended December 31, 2017, we continued to record a valuation allowance against our deferred tax assets, which would ordinarily reduce the effective tax to zero. However, the TCJA allowed us to eliminate the valuation allowance related to the alternative minimum tax credits, resulting in an income tax benefit of $1.4 million. For the year ended December 31, 2016, we recorded a full valuation allowance against our deferred tax assets, reducing our effective tax rate to zero. In regard to the valuation allowance recorded against our deferred tax asset balance, we considered all available evidence in assessing the need for a valuation allowance. Such evidence included the scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies. In making this assessment, judgment is required in considering the relative weight of negative and positive evidence. We continue to monitor facts and circumstances in the reassessment of the likelihood that operating loss carryforwards, credits and other deferred tax assets will be utilized prior to their expiration. Additionally, for both the 2017 and 2016 periods, our effective tax rate differs from the federal statutory rate as a result of recording permanent differences for stock-based compensation expense, lobbying and political contributions, officer compensation and the effect of state income taxes. Capital Resources and Liquidity Our primary sources of liquidity since our formation have been net cash provided by operating activities, sales and other issuances of equity and debt securities, bank credit facilities, proceeds from sale-leasebacks, joint exploration agreements and sales of interests in properties. Our primary use of capital has been for the development, exploration and acquisition of oil and natural gas properties. As we pursue profitable reserves and production growth, we continually monitor the capital resources available to us to meet our future financial obligations, fund planned capital expenditure activities and ensure adequate liquidity. Our future success in growing proved reserves and production will be highly dependent on capital resources being available to us. We believe that we have sufficient liquidity available to us from cash on hand, cash flows from operations and under our Amended Credit Facility for our planned uses of capital over the next twelve months. At December 31, 2018, we had cash and cash equivalents of $32.8 million and no amounts outstanding under our Amended Credit Facility. At December 31, 2017, we had cash and cash equivalents of $314.5 million and no amounts outstanding under our Amended Credit Facility. On September 14, 2018, we entered into the Amended Credit Facility to incorporate the proved reserves and assets acquired in the Merger. The Amended Credit Facility provides for a maximum credit amount of $1.5 billion, an initial elected commitment amount of $500.0 million and an initial borrowing base of $500.0 million, with interest rates and commitment fees unchanged. Our effective borrowing capacity as of December 31, 2018 was reduced by $26.0 million to $474.0 million due to an outstanding irrevocable letter of credit related to a firm transportation agreement. On March 19, 2018, we completed the Merger with Fifth Creek. The Merger was effected through the issuance of 100 million shares of our common stock, with a fair value of $484.0 million on the date of closing, and the repayment of $53.9 million of Fifth Creek debt. See "Items 1. and 2. Business and Properties - Business - Significant Business Developments - Merger with Fifth Creek Energy Operating Company, LLC" for additional information. Cash Flow from Operating Activities Net cash provided by operating activities was $231.4 million, $122.0 million and $121.7 million in 2018, 2017 and 2016, respectively. The changes in net cash provided by operating activities are discussed above in "Results of Operations". The increase in cash provided by operating activities from 2016 to 2018 was primarily due to an increase in production revenues. Commodity Hedging Activities Our operating cash flow is sensitive to many variables, the most significant of which are the prices we receive for the oil, natural gas and NGLs we produce. Prices for these commodities are determined primarily by prevailing market conditions. National and worldwide economic activity and political stability, weather, infrastructure capacity to reach markets, supply levels and other variable factors influence market conditions for these products. These factors are beyond our control and are difficult to predict. To mitigate some of the potential negative impact on cash flow caused by changes in oil, natural gas and NGL prices, we have entered into financial commodity swap contracts and cashless collars to receive fixed prices for a portion of our production. At December 31, 2018, we had in place crude oil swaps covering portions of our 2019 and 2020 production, natural gas swaps covering portions of our 2019 production, and crude oil and natural gas cashless collars covering portions of our 2019 production. In addition to financial contracts, we may at times enter into various physical commodity contracts for the sale of oil and natural gas that cover varying periods of time and have varying pricing provisions. These physical commodity contracts qualify for the normal purchase and normal sales exception and, therefore, are not subject to hedge or mark-to-market accounting. The financial impact of physical commodity contracts is included in oil, gas and NGL production revenues at the time of settlement. All derivative instruments, other than those that meet the normal purchase and normal sales exception as mentioned above, are recorded at fair market value and are included in the Consolidated Balance Sheets as assets or liabilities. All fair values are adjusted for non-performance risk. All changes in the derivative's fair value are recorded in earnings. These mark-to-market adjustments produce a degree of earnings volatility but have no cash flow impact relative to changes in market prices. Our cash flow is only impacted when the associated derivative instrument contract is settled by making a payment to or receiving a payment from the counterparty. The following table includes all hedges entered into through February 21, 2019. (1) WTI refers to West Texas Intermediate price as quoted on the New York Mercantile Exchange. NWPL refers to the Northwest Pipeline Corporation price as quoted in Platt's Inside FERC on the first business day of each month. By removing the price volatility from a portion of our oil and natural gas revenue, we have mitigated, but not eliminated, the potential effects of changing prices on our operating cash flow for the relevant period. While mitigating negative effects of falling commodity prices, these derivative contracts also limit the benefits we would receive from increases in commodity prices. It is our policy to enter into derivative contracts with counterparties that are lenders in the Amended Credit Facility, affiliates of lenders in the Amended Credit Facility or potential lenders in the Amended Credit Facility. Our derivative contracts are documented using an industry standard contract known as a Schedule to the Master Agreement and International Swaps and Derivative Association, Inc. ("ISDA") Master Agreement or other contracts. Typical terms for these contracts include credit support requirements, cross default provisions, termination events and set-off provisions. We are not required to provide any credit support to our counterparties other than cross collateralization with the properties securing the Amended Credit Facility. We have set-off provisions in our derivative contracts with lenders under our Amended Credit Facility which, in the event of a counterparty default, allow us to set-off amounts owed to the defaulting counterparty under the Amended Credit Facility or other obligations against monies owed to us under the derivative contracts. Where the counterparty is not a lender under the Amended Credit Facility, we may not be able to set-off amounts owed by us under the Amended Credit Facility, even if such counterparty is an affiliate of a lender under such facility. Capital Expenditures Our capital expenditures are summarized in the following tables for the periods indicated: (1) Includes exploration, dry hole and abandonment costs, which are expensed under successful efforts accounting, of $0.8 million, $0.5 million and $4.1 million for the years ended December 31, 2018, 2017 and 2016, respectively. (2) Excludes $716.2 million related to the proved and unproved oil and gas properties and furniture, equipment and other assets acquired in the Merger. Capital expenditures for acquisitions of proved and unproved properties and other real estate were $19.9 million for the year ended December 31, 2018. This was primarily related to acquisitions of unproved properties in the DJ Basin. The increase in drilling, development, exploration and exploitation of oil and natural gas properties to $448.9 million for the year ended December 31, 2018 from $226.9 million for the year ended December 31, 2017 primarily related to an increase in development drilling and completion activities within the DJ Basin, including drilling and completion activities associated with properties acquired in the Merger. Capital expenditures for the year ended December 31, 2018 exclude any amounts associated with the purchase price of the Merger. Capital expenditures for acquisitions of proved and unproved properties and other real estate were $20.4 million for the year ended December 31, 2017. This was primarily related to acquisitions of proved and unproved properties in the DJ Basin. The increase in drilling, development, exploration and exploitation of oil and natural gas properties to $226.9 million from $86.3 million for the year ended December 31, 2016 primarily related to an increase in development drilling and completion activities within the DJ Basin as a result of higher oil and gas commodity prices. Our current estimated capital expenditure budget for 2019 is $350.0 million to $380.0 million. The budget includes facilities costs and excludes acquisitions. We may adjust capital expenditures as business conditions and operating results warrant. The amount, timing and allocation of capital expenditures is generally discretionary and within our control. If oil, natural gas and NGL prices decline to below acceptable levels or costs increase above acceptable levels, we could choose to defer a portion of our budgeted capital expenditures until later periods to achieve the desired balance between sources and uses of liquidity. We would generally do this by prioritizing capital projects to first focus on those that we believe will have the highest expected financial returns and ability to generate near-term cash flow. We believe that we have sufficient available liquidity with available cash on hand, cash under the Amended Credit Facility and cash flow from operations to fund our 2019 budgeted capital expenditures. Future cash flows are subject to a number of variables, including our level of oil and natural gas production, commodity prices and operating costs. There can be no assurance that operations and other capital resources will provide sufficient amounts of cash flow to maintain planned levels of capital expenditures. Financing Activities Merger Financing. On March 19, 2018, we completed the Merger with Fifth Creek. The Merger was effected through the issuance of 100,000,000 shares of our common stock, with a fair value of $484.0 million, and the repayment of $53.9 million of Fifth Creek debt. Amended Credit Facility. There were no borrowings under the Amended Credit Facility (or, as applicable, the facility then in place) in 2018 or 2017. On September 14, 2018, we entered into the Amended Credit Facility to incorporate the proved reserves and assets acquired in the Merger. The Amended Credit Facility provides for a maximum credit amount of $1.5 billion, an initial elected commitment amount of $500.0 million and an initial borrowing base of $500.0 million, with interest rate and commitment fees unchanged. The Amended Credit Facility extended the maturity date of the facility to September 14, 2023. Borrowing bases are computed based on proved oil, natural gas and NGL reserves, hedge positions and estimated future cash flows from those reserves calculated using future commodity pricing provided by our lenders, as well as any other outstanding debt. Lower commodity prices will generally result in a lower borrowing base. We are currently in compliance with all financial covenants and have complied with all financial covenants since issuance. We expect to be in compliance with all financial covenants based on the 2019 budget at current commodity prices. Our outstanding debt is summarized below: (1) Includes all or a portion of the Lease Financing Obligation. (2) See Note 5 for additional information. Credit Ratings. Our credit risk is evaluated by two independent rating agencies based on publicly available information and information obtained during our ongoing discussions with the rating agencies. Moody's Investor Services and Standard & Poor's Rating Services currently rate our 7.0% Senior Notes and 8.75% Senior Notes and have assigned a credit rating. We do not have any provisions that are linked to our credit ratings, nor do we have any credit rating triggers that would accelerate the maturity of amounts due under our Amended Credit Facility, the 7.0% Senior Notes or the 8.75% Senior Notes. However, our ability to raise funds and the costs of any financing activities will be affected by our credit rating at the time any such financing activities are conducted. Contractual Obligations. A summary of our contractual obligations as of and subsequent to December 31, 2018 is provided in the following table: (1) Notes payable includes interest on a $26.0 million letter of credit that accrues at 2.0% and 0.125% per annum for participation fees and fronting fees, respectively. The expected term for the letter of credit is January 31, 2020. There is currently no balance outstanding under our Amended Credit Facility due September 14, 2023. (2) The aggregate principal amount of our 7.0% Senior Notes is $350.0 million. We are obligated to make semi-annual interest payments through maturity on October 15, 2022 equal to $12.3 million. See Note 5 to the accompanying financial statements for additional information. (3) The aggregate principal amount of our 8.75% Senior Notes is $275.0 million. We are obligated to make semi-annual interest payments through maturity on June 15, 2025 equal to $12.0 million. See Note 5 to the accompanying financial statements for additional information. (4) The Lease Financing Obligation is calculated based on the aggregate undiscounted minimum future lease payments, which include both an interest and principal component. We have elected to exercise the early buyout option pursuant to which we will purchase the equipment for $1.8 million on February 10, 2019. (5) The lease for our principal office in Denver expires in March 2019. Due to the Merger, we acquired the office lease of Fifth Creek in Greenwood Village, Colorado, which extends through July 2023. In addition, we entered into a new lease for office space in Denver, Colorado which will serve as our principal office starting in April 2019 through April 2028. (6) We have entered into contracts that provide firm transportation capacity on pipeline systems. The contracts require us to pay transportation demand charges regardless of the amount of gas we deliver to the processing facility or pipeline. (7) We have entered into gas gathering and processing contracts which require us to deliver a minimum volume of natural gas to midstream entities for gathering and processing on a monthly basis. The contracts require us to pay a fee associated with the contracted volumes regardless of the amount delivered. (8) Includes a reimbursement obligation of $6.8 million. The reimbursement obligation requires us to pay a monthly gathering fee per Mcf of production over a one year period to reimburse a midstream entity for its costs to construct gas gathering and processing facilities. If the costs are not reimbursed by us via the monthly gathering and processing fees through August 2019, we must pay the difference. (9) Neither the ultimate settlement amounts nor the timing of our asset retirement obligations can be precisely determined in advance. See "Critical Accounting Policies and Estimates" below for a more detailed discussion of the nature of the accounting estimates involved in estimating asset retirement obligations. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as of December 31, 2018. Trends and Uncertainties Regulatory Trends Our future Rockies operations and cost of doing business may be affected by changes in regulations and the ability to obtain drilling permits. The regulatory environment continues to become more restrictive, which limits our ability to, and increases the costs of, conducting our operations. Areas in which we operate are subject to federal, state and local regulations. Additional and more restrictive regulations have been seen at each of these governmental levels recently and there are initiatives underway to implement additional regulations and prohibitions on oil and gas activities. New rules may further impact our ability to obtain drilling permits and other required approvals in a timely manner and increase the costs of such permits or approvals. This may create substantial uncertainty about our production and capital expenditure targets. Efforts related to climate change organized around a "keep it in the ground" message have gained traction in New York and other coastal states, as well as internationally, notably in France and Germany. Federal. Federal leases make up a significant portion of our leaseholds. At the federal level, policies have been implemented in the past that have resulted in a more restrictive regulatory environment for oil and gas activities on public lands. Many of these policies are being rescinded or relaxed by the current administration, however, litigation and activism seeking to halt exploration and development activities on public lands is pervasive. State. We also are experiencing more strict regulation of oil and gas activities at the state level. The Colorado Oil & Gas Conservation Commission ("COGCC") passed rules in 2016 that: (i) increase advance consultation requirements with local governments when large scale oil and gas facilities are proposed in "urban mitigation areas" (generally within 1000' feet of subdivisions, schools, hospitals and other public facilities) and (ii) registration with local governments and provision of development plans to municipalities upon request. We do not anticipate significant disruption to our activities from these new rules given the rural nature of the majority of our leasehold (see discussion below under Local). In February 2018, the COGCC comprehensively amended its regulations for oil, gas, and water flowlines to expand requirements addressing flowline registration and safety, integrity management, leak detection, and other matters. The COGCC has also adopted or amended numerous other rules in recent years, including rules relating to safety, flood protection, and spill reporting. Over the past several years, numerous other rules and policies have been imposed by the COGCC requiring disclosure of chemicals used in hydraulic fracturing, ground water monitoring, increased setbacks from occupied structures and existing wells, and strengthened enforcement, including increases in mandatory monetary penalties for certain violations. Colorado continues to look at air emissions from the oil and natural gas sector and additional regulations are probable with respect to the Colorado ozone non-attainment standard. Other states, and the EPA, have considered Colorado's air quality rules, including the most recent rules governing methane emissions, as potential models for additional regulation of the oil and natural gas sector. Democratic leadership in the Colorado General Assembly has indicated that major new climate change legislation will be introduced. Such legislation is likely to be enacted and could have substantial impacts on our development activities. In combination, these new state rules and policies could impose additional costs on our operations, including enforcement penalties, delay permitting, and potentially impact profitability. Local. Counties and municipalities regulate oil and gas activities primarily through local land use rules. Weld County, Colorado, the focus of nearly all of our current development activities, has in place an ordinance that requires permitting of essentially all oil and gas operations and is currently considering new pipeline regulations. These changes have the potential to add 60-90 days of delay and may expose our development activities to a new level of political opposition. We expect additional attempts to regulate activities related to oil and gas operations by local governments, including drilling moratoria or bans on hydraulic fracturing, despite 2016 decisions by the Colorado Supreme Court overturning such measures adopted by two municipalities. Hydraulic Fracturing. The well completion technique known as hydraulic fracturing to stimulate production of natural gas and oil has come under increased scrutiny by the environmental community, and local, state, and federal jurisdictions. Hydraulic fracturing involves the injection of water, sand and additives under pressure, usually down casing that is cemented in the wellbore, into prospective rock formations at depth to stimulate oil and natural gas production. We use this completion technique on substantially all our wells. A more comprehensive discussion of potential risks and trends related to hydraulic fracturing is contained above in Items 1 and 2. Business Properties - Operations - Environmental Matters and Regulations. Although it is not possible at this time to predict the final outcome of any new legislation, or potential regulatory or policy developments regarding hydraulic fracturing, any new restrictions on hydraulic fracturing that may be imposed in areas in which we conduct business could result in increased compliance costs or additional operating restrictions and could lead to our inability to access, develop, and record natural gas and oil reserves in the future. Air Quality Regulation. The regulation of air emissions from the oil and natural gas sector continues to be a significant focus for policy makers and regulators at all levels-federal, tribal, state, and local-as well as environmental groups. A more comprehensive discussion of government regulation and potential risks related to air emissions from our operations is included above in "Items 1 and 2. Business and Properties - Operations - Environmental Matters and Regulation". New or more stringent policies, rules, or regulations governing air emissions from the oil and natural gas sector could result in our inability to obtain permits necessary to construct and operate new facilities or operate existing facilities. In addition, even if we are able to obtain necessary permits, such new requirements could substantially increase our operating expenses and reduce our profits or make certain operations uneconomic. Both EPA and the Colorado Department of Health and Environment ("CDPHE") have stepped up inspection and enforcement activities. In 2016, and 2017, we received initial and supplemental EPA "Section 114" mandatory information directives, as well as parallel "compliance advisories" from CDPHE. These directives led to an enforcement proceeding and settlement negotiations. We expect to reach a settlement in early 2019, including agreeing to pay a substantial, but not material, penalty, as well as committing to certain facility design, inspection and maintenance procedures. Agreeing to these measures may restrict our ability to divest the covered facilities, which are generally, older legacy properties. Potential Impacts of Regulatory Trends. The increase in regulatory burdens and potential for continued lawsuits seeking to block activities as described above is likely to cause delays to our planned activities and could prevent some of these activities. This is expected to increase our costs and could result in lower production and reserves as our properties naturally decline without replacement production and reserves from new wells in addition to a reduction in the value of our current leases. For additional detail, see "Items 1 and 2. Business and Properties - Operations - Environmental Matters and Regulation" and "Items 1 and 2. Business and Properties - Business - Operations - Other Regulation of the Oil and Gas Industry". Declining Commodity Prices. The severe decline in oil prices that occurred in 2014 and 2015 increased the volatility and amplitude of the other risks facing us as described in this report and had an impact on our business and financial condition. The significant decrease in oil prices in late 2018 had a similar effect. If oil prices decrease from current levels, our planned drilling projects may become uneconomic, which could affect future drilling plans and growth rates. Low commodity prices impact our revenue, which we partially mitigate with our hedging program. The sustained decline in commodity prices may also expose us to unexpected liability for plugging and abandoning wells, and associated reclamation, including for assets that were sold to other industry parties in prior years. If such third parties become unable to fulfill their contract obligations to us as provided for in purchase and sale agreements, regulatory agencies and landowners may demand that we perform such activities. Recent case law in Wyoming has increased such exposure for companies that have divested assets to no longer viable entities, and we have received demands from the Bureau of Land Management and a several large ranches to plug and abandon wells, and conduct associated reclamation, on properties we no longer own. We recognized $1.9 million and $0.7 million associated with these obligations in other operating expenses in the Consolidated Statement of Operations for the years ended December 31, 2018 and 2017, respectively. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. Certain accounting policies involve judgments and uncertainties to such an extent that there is reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been used. We evaluate our estimates and assumptions on a regular basis. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our consolidated financial statements. We provide expanded discussion of our more significant accounting policies, estimates and judgments below. We believe these accounting policies reflect our more significant estimates and assumptions used in preparation of our consolidated financial statements. See Note 2 of the Notes to the Consolidated Financial Statements for a discussion of additional accounting policies and estimates made by management. Oil and Gas Properties Our oil, natural gas and NGL exploration and production activities are accounted for using the successful efforts method. Under this method, all property acquisition costs and costs of exploratory and development wells are capitalized when incurred, pending determination of whether the well has found proved reserves. If an exploratory well does not find proved reserves, the costs of drilling the well are charged to expense and remain within cash flows from investing activities in the Consolidated Statements of Cash Flows. If an exploratory well does find proved reserves, the costs remain capitalized, are included within additions to oil and gas properties and remain within cash flows from investing activities in the Consolidated Statements of Cash Flows. The costs of development wells are capitalized whether proved reserves are added or not. All exploratory wells are evaluated for economic viability within one year of well completion, and the related capitalized costs are reviewed quarterly. Exploratory wells that discover potentially economic reserves in areas where a major capital expenditure would be required before production could begin and where the economic viability of that major capital expenditure depends upon the successful completion of further exploratory work in the area remain capitalized if the well finds a sufficient quantity of reserves to justify its completion as a producing well, and we are making sufficient progress assessing the reserves and the economic and operating viability of the project. Oil and gas lease acquisition costs are also capitalized. Upon sale or retirement of depreciable or depletable property, the cost and related accumulated DD&A are eliminated from the accounts and the resulting gain or loss is recognized. Interest cost is capitalized as a component of property cost for significant exploration and development projects that require greater than six months to be readied for their intended use. The application of the successful efforts method of accounting requires managerial judgment to determine the proper classification of wells designated as developmental or exploratory, which will ultimately determine the proper accounting treatment of the costs incurred. In addition to development on exploratory wells, we may drill scientific wells that are only used for data gathering purposes. The costs associated with these scientific wells are expensed as incurred as exploration expense. The results from a drilling operation can take considerable time to analyze, and the determination that commercial reserves have been discovered requires both judgment and industry experience. Other exploration costs, including certain geological and geophysical expenses and delay rentals for oil and gas leases, are charged to expense as incurred. The sale of a partial interest in a proved property is accounted for as a cost recovery and no gain or loss is recognized as long as this treatment does not significantly affect the unit-of-production amortization rate. Maintenance and repairs are charged to expense, and renewals and betterments are capitalized to the appropriate property and equipment accounts. Unproved oil and gas property costs are transferred to proved oil and gas properties if the properties are subsequently determined to be productive or are assigned proved reserves. Proceeds from sales of partial interests in unproved leases are accounted for as a recovery of cost without recognizing any gain until all costs are recovered. Unproved oil and gas properties are assessed periodically for impairment based on remaining lease terms, drilling results, reservoir performance, commodity price outlooks, future plans to develop acreage, recent sales prices of comparable properties and other relevant matters. We review our oil and natural gas properties for impairment on a quarterly basis or whenever events and circumstances indicate that a decline in the recoverability of their carrying value may have occurred. We estimate the expected undiscounted future net cash flows of our oil and gas properties using proved and risked probable and possible reserves based on our development plans and best estimate of future production, commodity pricing, reserve risking, gathering and transportation deductions, production tax rates, lease operating expenses and future development costs. We compare such undiscounted future net cash flows to the carrying amount of the oil and gas properties to determine if the carrying amount is recoverable. If the undiscounted future net cash flows exceed the carrying amount of the oil and gas properties, no impairment is taken. If the carrying amount of a property exceeds the undiscounted future net cash flows, we will impair the carrying value to fair value based on an analysis of quantitative and qualitative factors existing as of the balance sheet date. The factors used to determine fair value may include, but are not limited to, recent sales prices of comparable properties, indications from marketing activities, the present value of future revenues, net of estimated operating and development costs using estimates of reserves, future commodity pricing, future production estimates, anticipated capital expenditures and various discount rates commensurate with the risk and current market conditions associated with realizing the projected cash flows. Oil and gas properties are assessed for impairment once they meet the criteria to be classified as held for sale. Assets held for sale are carried at the lower of carrying cost or fair value less costs to sell. The fair value of the assets is determined using a market approach, based on an estimated selling price, as evidenced by current marketing activities, if possible. If an estimated selling price is not available, we utilize the income valuation technique, which involves calculating the present value of future net cash flows, as discussed above. If the carrying amount of the assets exceeds the fair value less costs to sell, an impairment will result to reduce the value of the properties down to fair value less costs to sell. The estimated fair value of assets held for sale may be materially different from sales proceeds that we eventually realize due to a number of factors including but not limited to the differences in expected future commodity pricing, location and quality differentials, our relative desire to dispose of such properties based on facts and circumstances impacting our business at the time we agree to sell, such as our position in the field subsequent to the sale and plans for future acquisitions or development in core areas. Our investment in producing oil and natural gas properties includes an estimate of the future costs associated with dismantlement, abandonment and restoration of our properties. The present value of the estimated future costs to dismantle, abandon and restore a well location are added to the capitalized costs of our oil and gas properties and recorded as a long-term liability. The capitalized cost is included in the oil and natural gas property costs that are depleted over the life of the assets. The provision for depletion of oil and gas properties is calculated on a field-by-field basis using the unit-of-production method. Natural gas and NGLs are converted to an oil equivalent, Boe, at the standard rate of six Mcf to one Boe and forty-two gallons to one Boe, respectively. Our rate of recording DD&A is dependent upon our estimates of total proved and proved developed reserves, which incorporate assumptions regarding future development and abandonment costs as well as our level of capital spending. If the estimates of total proved or proved developed reserves decline, the rate at which we record DD&A expense increases, reducing our net income. This decline may result from lower market prices, which may make it uneconomic to drill for and produce higher cost fields. We are unable to predict changes in reserve quantity estimates as such quantities are dependent on the success of our exploitation and development program, as well as future economic conditions. Oil and Gas Reserve Quantities Our estimate of proved reserves is based on the quantities of oil and natural gas that geological and engineering data demonstrate with reasonable certainty to be commercially recoverable in future years from known reservoirs under existing economic and operating conditions. Our proved reserves estimates are audited on a well-by-well basis by an independent third party engineering firm. In the aggregate, the independent third party petroleum engineer estimates of total net proved reserves are within 10% of our internal estimates as of December 31, 2018. Reserves and their relation to estimated future net cash flows impact our depletion and impairment calculations. As a result, adjustments to depletion and impairment are made concurrently with changes to reserves estimates. We prepare our reserves estimates, and the projected cash flows derived from these reserves estimates, in accordance with SEC guidelines. Our independent third party engineering firm adheres to the same guidelines when auditing our reserve reports. The accuracy of our reserves estimates is a function of many factors including the following: the quality and quantity of available data, the interpretation of that data, the accuracy of various mandated economic assumptions and the judgments of the individuals preparing the reserves estimates. The process of estimating oil and natural gas reserves is very complex, requiring significant decisions in the evaluation of all available geological, geophysical, engineering and economic data. The data for a given field may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and continued reassessment of the viability of production under varying economic conditions. As a result, material revisions to existing reserves estimates may occur from time to time. Although every reasonable effort is made to ensure that the reported reserves estimates represent the most accurate assessments possible, the subjective decisions and variances in available data for various fields make these estimates generally less precise than other estimates included in our financial statements. As such, reserves estimates may materially vary from the ultimate quantities of oil and natural gas eventually recovered. Please refer to the reserve disclosures in "Items 1 and 2 - Business and Properties" for further detail on reserves data. Revenue Recognition All of our sales of oil, gas and NGLs are made under contracts with customers, whereby revenues are recognized when we satisfy our performance obligations and the customer obtains control of the product. Performance obligations under our contracts with customers are typically satisfied at a point-in-time through monthly delivery of oil, gas and/or NGLs. Accordingly, at the end of the reporting period, we do not have any unsatisfied performance obligations. Our contracts with customers typically include variable consideration based on monthly pricing tied to local indices and volumes delivered in the current month. The nature of our contracts with customers do not require us to constrain variable consideration for accounting purposes. Our contracts with customers typically require payment within one month of delivery. Under our contracts with customers, natural gas and its components, including NGLs, are either sold to a midstream entity (which processes the natural gas and subsequently sells the resulting residue gas and NGLs) or are sold to a gas or NGL purchaser after being processed by a third party for a fee. Regardless of the contract structure type, the terms of these contracts compensate us for the value of the residue gas and NGLs at current market prices for each product. Our oil is sold to multiple oil purchasers at specific delivery points at or near the wellhead. All costs incurred to gather, transport and/or process our oil, gas and NGLs after control has transferred to the customer are considered components of the consideration received from the customer and thus recorded in oil, gas and NGL production revenues in the Consolidated Statements of Operations. All costs incurred prior to the transfer of control to the customer are included in gathering, transportation and processing expense in the Consolidated Statements of Operations. Gas imbalances from the sale of natural gas are recorded on the basis of gas actually sold by us. If our aggregate sales volumes for a well are greater (or less) than its proportionate share of production from the well, a liability (or receivable) is established to the extent there are insufficient proved reserves available to make-up the overproduced (or underproduced) imbalance. Imbalances have not been significant in the periods presented. Income Taxes and Uncertain Tax Positions Income taxes are provided for the tax effects of transactions reported in the financial statements and consist of taxes currently payable plus deferred income taxes related to certain income and expenses recognized in different periods for financial and income tax reporting purposes. Deferred income tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when assets are recovered or liabilities are settled. Deferred income taxes are also recognized for net operating loss carry forwards and tax credits that are available to offset future income taxes. Deferred income taxes are measured by applying currently enacted tax rates to the differences between financial statement and income tax reporting. We routinely assess the realizability of our deferred tax assets. If we conclude that it is more likely than not that some portion or all of the deferred tax assets will not be realized under accounting standards, the tax asset would be reduced by a valuation allowance. We consider estimated future taxable income in making such assessments, including the future reversal of taxable temporary differences. Numerous judgments and assumptions are inherent in the determination of future taxable income, including factors such as future operating conditions (particularly as related to prevailing oil and natural gas prices). There can be no assurance that facts and circumstances will not materially change and require us to adjust deferred tax asset valuation allowances in the future. Accounting guidance for recognizing and measuring uncertain tax positions prescribes a more likely than not recognition threshold that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Guidance is also provided regarding de-recognition, classification and disclosure of these uncertain tax positions. Based on this guidance, we regularly analyze tax positions taken or expected to be taken in a tax return based on the threshold prescribed. Tax positions that do not meet or exceed this threshold are considered uncertain tax positions. Penalties, if any, related to uncertain tax positions would be recorded in other expenses. We currently do not have any uncertain tax positions recorded as of December 31, 2018. We are subject to taxation in many jurisdictions, and the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in various taxing jurisdictions. If we ultimately determine that the payment of these liabilities will be unnecessary, we reverse the liability and recognize a tax benefit during the period in which we determine the liability no longer applies. Conversely, we record additional tax charges in a period in which we determine that a recorded tax liability is less than we expect the ultimate assessment to be. See "Results of Operations- Income Tax (Expense) Benefit" above for a discussion of changes to the valuation allowance during 2018. New Accounting Pronouncements For further information on the effects of recently adopted accounting pronouncements and the potential effects of new accounting pronouncements, refer to the Summary of Significant Accounting Policies (in Note 2) of the Notes to Consolidated Financial Statements.

<s>[INST] The following discussion and analysis should be read in conjunction with the "Selected Financial Data" and the accompanying consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10K. This section and other parts of this Annual Report on Form 10K contain forwardlooking statements that involve risks and uncertainties. See the "Cautionary Note Regarding ForwardLooking Statements" at the beginning of this Annual Report on Form 10K. Forwardlooking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forwardlooking statements. Factors that might cause such differences include, but are not limited to, those discussed in "Items 1 and 2. Business and Properties Business Operations Environmental Matters and Regulation;" "Items 1 and 2. Business and Properties Business Operations Other Regulation of the Oil and Gas Industry;" and "Item 1A. Risk Factors" above, all of which are incorporated herein by reference. We assume no obligation to revise or update any forwardlooking statements for any reason, except as required by law. Overview We develop oil and natural gas in the Rocky Mountain region of the United States. We seek to build stockholder value by delivering profitable growth in cash flow, reserves and production through the development of oil and natural gas assets. In order to deliver profitable growth, we allocate capital to our highest return assets, concentrate expenditures on exploiting our core assets, maintain capital discipline and optimize operations while upholding highlevel standards for health, safety and the environment. Substantially all of our revenues are generated through the sale of oil and natural gas production and NGL recovery at market prices. We are committed to developing and producing oil and natural gas in a responsible and safe manner. Our employees work diligently with regulatory agencies, as well as environmental, wildlife and community organizations, to ensure that exploration and development activities meet stakeholders' expectations and regulatory requirements. Future acquisitions or dispositions could have a material impact on our financial condition and results of operations by increasing or decreasing our reserves, production and revenues as well as expenses and future capital expenditures. We currently anticipate that we would finance any future acquisitions with available borrowings under our Amended Credit Facility, sales of properties, and/or the issuance of debt, equity or equitylinked securities. Our prior acquisitions and capital expenditures were financed with a combination of cash on hand, funding from the sale of our equity securities, our Amended Credit Facility, other debt financing and cash flows from operations. As a result of acquisitions and dispositions of properties, our historical results of operations and periodtoperiod comparisons of these results and certain financial data may not be meaningful. In addition, past results are not necessarily indicative of future results. The following table summarizes the estimated net proved reserves and related Standardized Measure for the years indicated. The Standardized Measure is not intended to represent the current market value of our estimated oil and natural gas reserves. (1) December 31, 2018 reserves were based on average prices of $65.56 WTI per Bbl of oil, $3.10 Henry Hub per Mcf of natural gas and $32.71 per Bbl of NGLs. December 31, 2017 reserves were based on average prices of $51.34 WTI for oil, $2.98 Henry Hub for natural gas and $27.40 for NGLs. December 31, 2016 reserves were based on average prices of $42.75 WTI for oil, $2.48 Henry Hub for natural gas and $19.70 for NGLs. Commodity prices are inherently volatile and are influenced by many factors outside of our control. As of February 21, 2019, we have hedged 6,736,184 barrels of oil and 3,275,000 MMbtu of natural gas, or approximately 57% of our expected 2019 production, and 3,292,000 barrels of oil for our 2020 production at price levels that provide some economic certainty to our cash flows. We focus our efforts on [/INST] Negative. </s>

HighPoint Resources Corp

2020-02-26

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. Introduction The following discussion and analysis should be read in conjunction with the "Selected Historical Financial Information" and the accompanying consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. This section and other parts of this Annual Report on Form 10-K contain forward-looking statements that involve risks and uncertainties. See the "Cautionary Note Regarding Forward-Looking Statements" at the beginning of this Annual Report on Form 10-K. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in "Items 1 and 2. Business and Properties - Business - Operations - Environmental Matters and Regulation;" "Items 1 and 2. Business and Properties - Business - Operations - Other Regulation of the Oil and Gas Industry;" and "Item 1A. Risk Factors" above, all of which are incorporated herein by reference. We assume no obligation to revise or update any forward-looking statements for any reason, except as required by law. Overview We develop oil and natural gas in the Rocky Mountain region of the United States. We seek to build stockholder value by delivering profitable growth in cash flow, reserves and production through the development of oil and natural gas assets. In order to deliver profitable growth, we allocate capital to our highest return assets, concentrate expenditures on exploiting our core assets, maintain capital discipline and optimize operations while upholding high-level standards for health, safety and the environment. Substantially all of our revenues are generated through the sale of oil and natural gas production and NGL recovery at market prices. We are committed to developing and producing oil and natural gas in a responsible and safe manner. Our employees work diligently with regulatory agencies, as well as environmental, wildlife and community organizations, to ensure that exploration and development activities meet stakeholders' expectations and regulatory requirements. Future acquisitions or dispositions could have a material impact on our financial condition and results of operations by increasing or decreasing our reserves, production and revenues as well as expenses and future capital expenditures. We currently anticipate that we would finance any future acquisitions with available borrowings under our Amended Credit Facility, sales of properties, and/or the issuance of debt, equity or equity-linked securities. Our prior acquisitions and capital expenditures were financed with a combination of cash on hand, funding from the sale of our equity securities, our Amended Credit Facility, other debt financing and cash flows from operations. As a result of acquisitions and dispositions of properties, our historical results of operations and period-to-period comparisons of these results and certain financial data may not be meaningful. In addition, past results are not necessarily indicative of future results. The following table summarizes the estimated net proved reserves and related Standardized Measure for the years indicated. The Standardized Measure is not intended to represent the current market value of our estimated oil and natural gas reserves. (1) December 31, 2019 reserves were based on average prices of $55.85 WTI per Bbl of oil, $2.58 Henry Hub per Mcf of natural gas and a percentage of the of the average oil price per Bbl of NGL. December 31, 2018 reserves were based on average prices of $65.56 WTI for oil, $3.10 Henry Hub for natural gas and $32.71 for NGLs. December 31, 2017 reserves were based on average prices of $51.34 WTI for oil, $2.98 Henry Hub for natural gas and $27.40 for NGLs. Commodity prices are inherently volatile and are influenced by many factors outside of our control. As of February 4, 2020, we have hedged 5,857,500 barrels of oil, or approximately 54% of our expected 2020 production, and 1,912,500 barrels of oil for our 2021 production at price levels that provide some economic certainty to our cash flows. We focus our efforts on increasing oil, natural gas and NGL reserves and production while controlling costs at a level that is appropriate for long-term operations. Our future earnings and cash flows are dependent on our ability to manage our revenues and overall cost structure to a level that allows for profitable production. We operate in one industry segment, which is the development and production of crude oil, natural gas and NGLs, and all of our operations are conducted in the Rocky Mountain region of the United States. Consequently, we currently report a single reportable segment. For the year ended December 31, 2018, as a result of the closing of the Merger on March 19, 2018, Fifth Creek's revenues and expenses are included in the Audited Consolidated Statement of Operations beginning on March 19, 2018. Results of Operations Year Ended December 31, 2019 Compared with Year Ended December 31, 2018 The following table sets forth selected operating data for the periods indicated: * Not meaningful. (1) Included in general and administrative expense is long-term cash and equity incentive compensation of $8.6 million (or $0.69 per Boe) and $7.2 million (or $0.71 per Boe) for the years ended December 31, 2019 and 2018, respectively. Production Revenues and Volumes. Production revenues decreased to $452.3 million for the year ended December 31, 2019 from $452.9 million for the year ended December 31, 2018. The decrease in production revenues was due to a 19% decrease in the average realized prices per Boe before hedging, offset by a 23% increase in production volumes. The decrease in average realized prices per Boe before hedging decreased production revenues by approximately $86.0 million, while the increase in production volumes increased production revenues by approximately $85.4 million. Total production volumes of 12.5 MMBoe for the year ended December 31, 2019 increased from 10.2 MMBoe for the year ended December 31, 2018 primarily as a result of new wells placed into production throughout 2019. Lease Operating Expense ("LOE"). LOE increased to $3.01 per Boe for the year ended December 31, 2019 from $2.74 per Boe for the year ended December 31, 2018. The increase per Boe for the year ended December 31, 2019 compared with the year ended December 31, 2018 is primarily related to higher initial LOE related to our early development program in the Hereford field. Gathering, Transportation and Processing ("GTP") Expense. GTP expense increased to $0.85 per Boe for the year ended December 31, 2019 from $0.46 per Boe for the year ended December 31, 2018. Costs incurred to gather, transport and/or process our oil, gas and NGLs prior to the transfer of control to the customer are included in GTP expense. Costs incurred to gather, transport and/or process our oil, gas and NGLs after control has transferred to the customer are considered components of the consideration received from the customer and thus recorded in oil, gas and NGL production revenues. In general, based on specific contract arrangements, costs incurred associated with gas and NGLs in the Hereford Field are included in GTP expense and costs incurred associated with gas and NGLs in the Northeast Wattenberg Field are included in production revenues. Costs incurred associated with oil are included in production revenues for both areas. See the "Revenue Recognition" section in Note 2 for additional information. GTP expense for the year ended December 31, 2019 of $0.85 per Boe is primarily associated with the Hereford Field. We expect GTP expense per Boe to increase in the future as we further develop and increase our production from the Hereford Field under the existing contractual arrangement, which has a primary term through April 2027. Production Tax Expense. Total production taxes decreased to $23.5 million for the year ended December 31, 2019 from $36.8 million for the year ended December 31, 2018. Production taxes are primarily based on the wellhead values of production, which exclude gains and losses associated with hedging activities. Production taxes as a percentage of oil, natural gas and NGL sales before hedging adjustments were 5.2% and 8.1% for the years ended December 31, 2019 and 2018, respectively. The decrease in the rate for the year ended December 31, 2019 was due to a decrease in our projected 2019 Colorado severance tax effective rate. Impairment and Abandonment Expense. Impairment and abandonment expense increased to $9.6 million for the year ended December 31, 2019 from $0.7 million for the year ended December 31, 2018. Impairment and abandonment expense for the year ended December 31, 2019 included leases that have expired and certain leases that will expire subsequent to the balance sheet date that the Company does not plan to renew. Impairment and abandonment expense for the year ended December 31, 2018 included leases that have expired. We review our oil and natural gas properties for impairment on a quarterly basis or whenever events and circumstances indicate that a decline in the recoverability of their carrying value may have occurred. Whenever we conclude the carrying value may not be recoverable, we estimate the expected undiscounted future net cash flows of our oil and gas properties using proved and risked probable and possible reserves based on our development plans and best estimate of future production, commodity pricing, reserve risking, gathering and transportation deductions, production tax rates, lease operating expenses and future development costs. We compare such undiscounted future net cash flows to the carrying amount of the oil and gas properties to determine if the carrying amount is recoverable. If the undiscounted future net cash flows exceed the carrying amount of the oil and gas properties, no impairment is taken. If the carrying amount of a property exceeds the undiscounted future net cash flows, we will impair the carrying value to fair value based on an analysis of quantitative and qualitative factors existing as of the balance sheet date. The factors used to determine fair value may include, but are not limited to, recent sales prices of comparable properties, indications from marketing activities, the present value of future revenues, net of estimated operating and development costs using estimates of reserves, future commodity pricing, future production estimates, anticipated capital expenditures and various discount rates commensurate with the risk and current market conditions associated with realizing the projected cash flows. Unproved oil and gas properties are assessed periodically for impairment based on remaining lease terms, drilling results, reservoir performance, commodity price outlooks, future plans to develop acreage, recent sales prices of comparable properties and other relevant matters. We generally expect impairments of unproved properties to be more likely to occur in periods of low commodity prices because we will be less likely to devote capital to exploration activities. Given current and projected future commodity prices, we will continue to review our acreage position and future drilling plans. In addition, we will assess the carrying value of our properties relative to their estimated future net cash flows. Estimated future net cash flows from our properties are based on our aggregate best estimates of future production, commodity pricing, gathering and transportation deducts, production tax rates, lease operating expenses and future development costs as of the balance sheet date. Depreciation, Depletion and Amortization ("DD&A"). DD&A increased to $321.3 million for the year ended December 31, 2019 compared with $228.5 million for the year ended December 31, 2018. The increase of $92.8 million was the result of a 23% increase in production and a 14% increase in the DD&A rate for the year ended December 31, 2019 compared with the year ended December 31, 2018. The increase in production accounted for a $53.2 million increase in DD&A expense while the increase in the DD&A rate accounted for a $39.6 million increase in DD&A expense. Under successful efforts accounting, depletion expense is calculated using the units-of-production method on the basis of some reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field. The capital expenditures for proved properties for each field compared to the proved reserves corresponding to each producing field determine a depletion rate for current production. For the year ended December 31, 2019, the relationship of capital expenditures, proved reserves and production from certain producing fields yielded a depletion rate of $25.62 per Boe compared with $22.46 per Boe for the year ended December 31, 2018. The increase in the depletion rate of 14% is the result of year end 2018 reserve adjustments. Unused Commitments. Unused commitments expense of $17.7 million and $18.2 million for the years ended December 31, 2019 and 2018, respectively, related to gas transportation contracts. During March 2010, we entered into two firm natural gas pipeline transportation contracts to provide a guaranteed outlet for production from the West Tavaputs area of the Uinta Basin and the Gibson Gulch area of the Piceance Basin. These transportation contracts were not included in the sales of these assets in December 2013 and September 2014, respectively. Both firm transportation contracts require the pipeline to provide transportation capacity and require us to pay monthly transportation charges regardless of the amount of pipeline capacity utilized. The agreements expire July 31, 2021. General and Administrative Expense. General and administrative expense decreased to $44.8 million for the year ended December 31, 2019 from $45.1 million for the year ended December 31, 2018. General and administrative expense on a per Boe basis decreased to $3.57 for the year ended December 31, 2019 from $4.44 for the year ended December 31, 2018. Included in general and administrative expense is long-term cash and equity incentive compensation of $8.6 million and $7.2 million for the years ended December 31, 2019 and 2018, respectively. The components of long-term cash and equity incentive compensation for each of the years ended December 31, 2019 and 2018 are shown in the following table: (1) The nonvested performance cash units are accounted for as liability awards and will be settled in cash for the performance metrics that are met. The expense for the period will increase or decrease based on updated fair values of these awards at each reporting date. Merger Transaction Expense. Merger transaction expense was $4.5 million and $8.0 million for the years ended December 31, 2019 and December 31, 2018, respectively. Transaction expenses included severance, consulting, advisory, legal and other merger-related fees that were not capitalized as part of the Merger. Interest Expense. Interest expense increased to $58.1 million for the year ended December 31, 2019 from $52.7 million for the year ended December 31, 2018. The increase for the year ended December 31, 2019 was due to borrowings under the Amended Credit Facility. See Note 5 for additional information. Commodity Derivative Gain (Loss). Commodity derivative loss was $99.0 million for the year ended December 31, 2019 compared with a gain of $93.3 million for the year ended December 31, 2018. The gain or loss on commodity derivatives is related to fluctuations of oil and natural gas future pricing compared to actual pricing of commodity hedges in place as of December 31, 2019 and 2018 or during the periods then ended. The fair value of our open but not yet settled derivative contracts is based on an income approach using various assumptions, such as quoted forward prices for commodities, risk-free discount rates, volatility factors and time value factors. The mark-to-market fair value of the open commodity derivative contracts will generally be inversely related to the price movement of the underlying commodity. If commodity price trends reverse from period to period, prior unrealized gains may become unrealized losses and vice versa. Higher underlying commodity price volatility will generally lead to higher volatility in our unrealized gains and losses and, by association, the fair value of our commodity derivative contracts. These unrealized gains and losses will impact our net income in the period reported. The mark-to-market fair value can create non-cash volatility in our reported earnings during periods of commodity price volatility. We have experienced such volatility in the past and are likely to experience it in the future. Gains on our derivatives generally indicate lower wellhead revenues in the future while losses indicate higher future wellhead revenues. The table below summarizes our commodity derivative gains and losses that were recognized in the periods presented: (1) Realized and unrealized gains and losses on commodity derivatives are presented herein as separate line items but are combined for a total commodity derivative gain (loss) in the Consolidated Statements of Operations. This separate presentation is a non-GAAP measure. Management believes the separate presentation of the realized and unrealized commodity derivative gains and losses is useful because the realized cash settlement portion provides a better understanding of our hedge position. We also believe that this disclosure allows for a more accurate comparison to our peers. In 2019, approximately 88% of our oil volumes and 19% of our natural gas volumes were subject to financial hedges, which resulted in an increase in oil income of $11.7 million and a decrease in natural gas income of $1.0 million after settlements. In 2018, approximately 73% of our oil volumes and 14% of our natural gas volumes were covered by financial hedges, which resulted in a decrease in oil revenues of $47.7 million and an increase natural gas revenues of $0.1 million after settlements. Income Tax (Expense) Benefit. For the year ended December 31, 2019, we continue to believe that it is more likely than not that we will be able to realize a portion of our deferred tax assets. This determination was made by considering all available evidence in assessing the need for a valuation allowance. Such evidence includes the scheduled reversal of deferred tax liabilities, assets acquired in connection with the Merger and their classification as proved or unproved, current and projected future taxable income and tax planning strategies. In making this assessment, judgment is required in considering the relative weight of negative and positive evidence. For the year ended December 31, 2018, we determined that it was more likely than not that we would be able to realize a portion of our deferred tax assets. This determination was made by considering all available evidence in assessing the need for a valuation allowance. Such evidence included the scheduled reversal of deferred tax liabilities, assets acquired in connection with the Merger and their classification as proved or unproved, current and projected future taxable income and tax planning strategies. In making this assessment, judgment is required in considering the relative weight of negative and positive evidence. As a result of the analysis conducted, we reversed the majority of the valuation allowance on certain deferred tax assets and recorded income tax expense of $1.8 million for the year ended December 31, 2018. Year Ended December 31, 2018 Compared with Year Ended December 31, 2017 A discussion of our results of operations for the year ended December 31, 2018 compared with December 31, 2017 can be found in the "Management's Discussion and Analysis of Financial Condition and Results of Operations" section of our Annual Report on Form 10-K for the year ended December 31, 2018. Capital Resources and Liquidity Our primary sources of liquidity since our formation have been net cash provided by operating activities, sales and other issuances of equity and debt securities, bank credit facilities, proceeds from sale-leasebacks, joint exploration agreements and sales of interests in properties. Our primary use of capital has been for the development, exploration and acquisition of oil and natural gas properties. As we pursue profitable reserves and production growth, we continually monitor the capital resources available to us to meet our future financial obligations, fund planned capital expenditure activities and ensure adequate liquidity. Our future success in growing proved reserves and production will be highly dependent on capital resources being available to us. We believe that we have sufficient liquidity available to us from cash on hand, cash flows from operations and under our Amended Credit Facility for our planned uses of capital over the next twelve months. The Amended Credit Facility provides for a maximum credit amount of $1.5 billion, an initial elected commitment amount of $500.0 million, and an initial borrowing base of $500.0 million. On October 1, 2019, the commitment and borrowing base amounts were reaffirmed at $500.0 million. At December 31, 2019, we had cash and cash equivalents of $16.4 million and a $140.0 million balance outstanding under our Amended Credit Facility. At December 31, 2018, we had cash and cash equivalents of $32.8 million and no amounts outstanding under our Amended Credit Facility. Our effective borrowing capacity as of December 31, 2019 was reduced by $26.0 million to $334.0 million due to an outstanding irrevocable letter of credit related to a firm transportation agreement. The letter of credit will begin reducing ratably per month beginning April 1, 2020 until it expires on August 31, 2021. On March 19, 2018, we completed the Merger with Fifth Creek. The Merger was effected through the issuance of 100 million shares of our common stock, with a fair value of $484.0 million on the date of closing, and the repayment of $53.9 million of Fifth Creek debt. See "Items 1. and 2. Business and Properties - Business - Significant Business Developments - Merger with Fifth Creek Energy Operating Company, LLC" for additional information. Cash Flow from Operating Activities Net cash provided by operating activities was $278.6 million, $231.4 million and $122.0 million in 2019, 2018 and 2017, respectively. The changes in net cash provided by operating activities are discussed above in "Results of Operations". The increase in cash provided by operating activities from 2017 to 2019 was primarily due to an increase in production revenues. Commodity Hedging Activities Our operating cash flow is sensitive to many variables, the most significant of which are the prices we receive for the oil, natural gas and NGLs we produce. Prices for these commodities are determined primarily by prevailing market conditions. National and worldwide economic activity and political stability, weather, infrastructure capacity to reach markets, supply levels and other variable factors influence market conditions for these products. These factors are beyond our control and are difficult to predict. To mitigate some of the potential negative impact on cash flow caused by changes in oil, natural gas and NGL prices, we have entered into financial commodity swap contracts to receive fixed prices for a portion of our production. At December 31, 2019, we had in place crude oil swaps covering portions of our 2020 and 2021 production. In addition to financial contracts, we may at times enter into various physical commodity contracts for the sale of oil and natural gas that cover varying periods of time and have varying pricing provisions. These physical commodity contracts qualify for the normal purchase and normal sales exception and, therefore, are not subject to hedge or mark-to-market accounting. The financial impact of physical commodity contracts is included in oil, gas and NGL production revenues at the time of settlement. All derivative instruments, other than those that meet the normal purchase and normal sales exception as mentioned above, are recorded at fair market value and are included in the Consolidated Balance Sheets as assets or liabilities. All fair values are adjusted for non-performance risk. All changes in the derivative's fair value are recorded in earnings. These mark-to-market adjustments produce a degree of earnings volatility but have no cash flow impact relative to changes in market prices. Our cash flow is only impacted when the associated derivative instrument contract is settled by making a payment to or receiving a payment from the counterparty. The following table includes all hedges entered into through February 4, 2020. (1) WTI refers to West Texas Intermediate price as quoted on the New York Mercantile Exchange. By removing the price volatility from a portion of our oil revenue, we have mitigated, but not eliminated, the potential effects of changing prices on our operating cash flow for the relevant period. While mitigating negative effects of falling commodity prices, these derivative contracts also limit the benefits we would receive from increases in commodity prices. It is our policy to enter into derivative contracts with counterparties that are lenders in the Amended Credit Facility, affiliates of lenders in the Amended Credit Facility or potential lenders in the Amended Credit Facility. Our derivative contracts are documented using an industry standard contract known as a Schedule to the Master Agreement and International Swaps and Derivative Association, Inc. ("ISDA") Master Agreement or other contracts. Typical terms for these contracts include credit support requirements, cross default provisions, termination events and set-off provisions. We are not required to provide any credit support to our counterparties other than cross collateralization with the properties securing the Amended Credit Facility. We have set-off provisions in our derivative contracts with lenders under our Amended Credit Facility which, in the event of a counterparty default, allow us to set-off amounts owed to the defaulting counterparty under the Amended Credit Facility or other obligations against monies owed to us under the derivative contracts. Where the counterparty is not a lender under the Amended Credit Facility, we may not be able to set-off amounts owed by us under the Amended Credit Facility, even if such counterparty is an affiliate of a lender under such facility. Capital Expenditures Our capital expenditures are summarized in the following tables for the periods indicated: (1) Includes exploration and abandonement expense, which are expensed under successful efforts accounting, of $5.9 million, $0.8 million and $0.5 million for the years ended December 31, 2019, 2018 and 2017, respectively. (2) Excludes $716.2 million related to the proved and unproved oil and gas properties and furniture, equipment and other assets acquired in the Merger for the year ended December 31, 2018. Capital expenditures for acquisitions of proved and unproved properties and other real estate were $4.7 million for the year ended December 31, 2019. This was primarily related to acquisitions of proved and unproved properties in the DJ Basin. The decrease in drilling, development, exploration and exploitation of oil and natural gas properties to $319.3 million for the year ended December 31, 2019 from $448.9 million for the year ended December 31, 2018 was primarily related to a decrease in development drilling and completion activities within the DJ Basin. The increase in geologic and geophysical costs to $12.0 million for the year ended December 31, 2019 from $2.3 million for the year ended December 31, 2018 is related to activity in the Hereford field. Capital expenditures for acquisitions of proved and unproved properties and other real estate were $19.9 million for the year ended December 31, 2018. This was primarily related to acquisitions of proved and unproved properties in the DJ Basin. The increase in drilling, development, exploration and exploitation of oil and natural gas properties to $448.9 million from $226.9 million for the year ended December 31, 2017 primarily related to an increase in development drilling and completion activities within the DJ Basin, including drilling and completion activities associated with properties acquired in the Merger. Capital expenditures for the year ended December 31, 2018 exclude any amounts associated with the purchase price of the Merger. Our current estimated capital expenditure budget for 2020 is $200.0 million to $220.0 million. The budget includes facilities costs and excludes acquisitions. We may adjust capital expenditures as business conditions and operating results warrant. The amount, timing and allocation of capital expenditures is generally discretionary and within our control. If oil, natural gas and NGL prices decline to below acceptable levels or costs increase above acceptable levels, we could choose to defer a portion of our budgeted capital expenditures until later periods to achieve the desired balance between sources and uses of liquidity. We would generally do this by prioritizing capital projects to first focus on those that we believe will have the highest expected financial returns and ability to generate near-term cash flow. We believe that we have sufficient available liquidity with available cash on hand, cash under the Amended Credit Facility and cash flow from operations to fund our 2020 budgeted capital expenditures. Future cash flows are subject to a number of variables, including our level of oil and natural gas production, commodity prices and operating costs. There can be no assurance that operations and other capital resources will provide sufficient amounts of cash flow to maintain planned levels of capital expenditures. Financing Activities Merger Financing. On March 19, 2018, we completed the Merger with Fifth Creek. The Merger was effected through the issuance of 100,000,000 shares of our common stock, with a fair value of $484.0 million, and the repayment of $53.9 million of Fifth Creek debt. Amended Credit Facility. We had $140.0 million and zero outstanding borrowings under the Amended Credit Facility as of December 31, 2019 and 2018, respectively. The Amended Credit Facility provides for a maximum credit amount of $1.5 billion, an initial elected commitment amount of $500.0 million and an initial borrowing base of $500.0 million. On October 1, 2019, the commitment and borrowing base amounts were reaffirmed at $500.0 million. The current maturity date of the Amended Credit Facility is July 16, 2022. While the stated maturity date in the Amended Credit Facility is September 14, 2023, the maturity date is accelerated if the Company has more than $100 million of "Permitted Debt" or "Permitted Refinancing Debt" (as those terms are defined in the Amended Credit Facility) that matures prior to December 14, 2023. If that is the case, the accelerated maturity date is 91 days prior to the earliest maturity of such Permitted Debt or Permitted Refinancing Debt. Because the Company's 7.0% Senior Notes will mature on October 15, 2022, the aggregate amount of those notes exceeds $100 million and the notes represent "Permitted Debt", the maturity date specified in the Amended Credit Facility is accelerated to the date that is 91 days prior to the maturity date of those notes, or July 16, 2022. Borrowing bases are computed based on proved oil, natural gas and NGL reserves, hedge positions and estimated future cash flows from those reserves calculated using future commodity pricing provided by our lenders, as well as any other outstanding debt. Lower commodity prices will generally result in a lower borrowing base. We are in compliance with all financial covenants as of December 31, 2019 and have complied with all financial covenants since issuance. We expect to be in compliance with all financial covenants based on the 2020 budget at current commodity prices. Our outstanding debt is summarized below: (1) As of December 31, 2018, the current portion of long-term debt included the Lease Financing Obligation, which was settled on February 10, 2019. (2) See Note 5 for additional information. Credit Ratings. Our credit risk is evaluated by two independent rating agencies based on publicly available information and information obtained during our ongoing discussions with the rating agencies. Moody's Investor Services and Standard & Poor's Rating Services currently rate our 7.0% Senior Notes and 8.75% Senior Notes and have assigned a credit rating. We do not have any provisions that are linked to our credit ratings, nor do we have any credit rating triggers that would accelerate the maturity of amounts due under our Amended Credit Facility, the 7.0% Senior Notes or the 8.75% Senior Notes. However, our ability to raise funds and the costs of any financing activities will be affected by our credit rating at the time any such financing activities are conducted. Contractual Obligations. A summary of our contractual obligations as of and subsequent to December 31, 2019 is provided in the following table: (1) Included in notes payable is the outstanding principal amount under our Amended Credit Facility due September 14, 2023. This table does not include future commitment fees, interest expense or other fees on our Amended Credit Facility because the Amended Credit Facility is a floating rate instrument, and we cannot determine with accuracy the timing of future loan advances, repayments or future interest rates to be charged. Also included in notes payable is interest on a $26.0 million letter of credit that accrues at 1.75% and 0.125% per annum for participation fees and fronting fees, respectively. The expected term for the letter of credit is January 31, 2020. (2) The aggregate principal amount of our 7.0% Senior Notes is $350.0 million. We are obligated to make semi-annual interest payments through maturity on October 15, 2022 equal to $12.3 million. See Note 5 to the accompanying financial statements for additional information. (3) On April 28, 2017, we issued $275.0 million aggregate principal amount of 8.75% Senior Notes. We are obligated to make semi-annual interest payments through maturity on June 15, 2025 equal to $12.0 million. See Note 5 to the accompanying financial statements for additional information. (4) We have entered into contracts that provide firm transportation capacity on oil and gas pipeline systems. The contracts require us to pay transportation demand charges regardless of the amount we deliver to the processing facility or pipeline. (5) Includes a gas gathering and processing contract which requires us to deliver a minimum volume of natural gas to a midstream entity for gathering and processing on a monthly basis. The contract requires us to pay a fee associated with the contracted volumes regardless of the amount delivered. (6) Includes reimbursement obligations of $2.4 million. The reimbursement obligations require us to pay a monthly gathering and processing fee per Mcf of production to reimburse midstream entities for costs to construct gas gathering and processing facilities. If the costs are not reimbursed by us via the monthly gathering and processing fees, we must pay the difference. (7) Neither the ultimate settlement amounts nor the timing of our asset retirement obligations can be precisely determined in advance. See "Critical Accounting Policies and Estimates" below for a more detailed discussion of the nature of the accounting estimates involved in estimating asset retirement obligations. (8) Derivative liability represents the net fair value for oil commodity derivatives presented as liabilities in our Consolidated Balance Sheets as of December 31, 2019. The ultimate settlement amounts of our derivative liabilities are unknown because they are subject to continuing market fluctuations. See "Critical Accounting Policies and Estimates" in Part II, Item 7 and in "Commodity Hedging Activities" above for a more detailed discussion of the nature of the accounting estimates involved in valuing derivative instruments. (9) Operating leases primarily includes office leases. Also included are leases of operations equipment which are shown as gross amounts that we are financially committed to pay. However, we will record in our financial statements our proportionate share based on our working interest, which will vary from property to property. (10) Primarily includes a fresh water commitment contract which requires us to purchase a minimum volume of fresh water from a supplier. The contract requires us to pay a fee associated with the contracted volumes regardless of the amount delivered. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as of December 31, 2019. Trends and Uncertainties Regulatory Trends Our future Rockies operations and cost of doing business may be affected by changes in regulations and the ability to obtain drilling permits. The regulatory environment continues to become more restrictive, which limits our ability to, and increases the costs of, conducting our operations. Areas in which we operate are subject to federal, state and local regulations. Additional and more restrictive regulations have been seen at each of these governmental levels recently and there are initiatives underway to implement additional regulations and prohibitions on oil and gas activities. New rules may further impact our ability to obtain drilling permits and other required approvals in a timely manner and increase the costs of such permits or approvals. This may create substantial uncertainty about our production and capital expenditure targets. Efforts related to climate change organized around a "keep it in the ground" message have gained traction in New York and other coastal states, as well as internationally, notably in France and Germany. See "Business and Properties-Operations-Environmental Matters and Regulation" for a summary of certain environmental regulations that affect our business and related developments, including potential future regulatory developments. Declining Commodity Prices. The severe decline in oil prices that occurred in 2014 and 2015 increased the volatility and amplitude of the other risks facing us as described in this report and had an impact on our business and financial condition. The significant decrease in oil prices in late 2018 and 2019 had a similar effect. If oil prices decrease from current levels, our planned drilling projects may become uneconomic, which could affect future drilling plans and growth rates. Low commodity prices impact our revenue, which we partially mitigate with our hedging program. The sustained decline in commodity prices may also expose us to unexpected liability for plugging and abandoning wells, and associated reclamation, including for assets that were sold to other industry parties in prior years. If such third parties become unable to fulfill their contract obligations to us as provided for in purchase and sale agreements, regulatory agencies and landowners may demand that we perform such activities. Recent case law in Wyoming has increased such exposure for companies that have divested assets to no longer viable entities, and we have received demands from the Bureau of Land Management and a several large ranches to plug and abandon wells, and conduct associated reclamation, on properties we no longer own. We recognized $0.3 million and $1.9 million associated with these obligations in other operating expenses in the Consolidated Statement of Operations for the years ended December 31, 2019 and 2018, respectively. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. Certain accounting policies involve judgments and uncertainties to such an extent that there is reasonable likelihood that materially different amounts could have been reported under different conditions, or if different assumptions had been used. We evaluate our estimates and assumptions on a regular basis. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and assumptions used in preparation of our consolidated financial statements. We provide expanded discussion of our more significant accounting policies, estimates and judgments below. We believe these accounting policies reflect our more significant estimates and assumptions used in preparation of our consolidated financial statements. See Note 2 of the Notes to the Consolidated Financial Statements for a discussion of additional accounting policies and estimates made by management. Oil and Gas Properties Our oil, natural gas and NGL exploration and production activities are accounted for using the successful efforts method. Under this method, all property acquisition costs and costs of exploratory and development wells are capitalized when incurred, pending determination of whether the well has found proved reserves. If an exploratory well does not find proved reserves, the costs of drilling the well are charged to expense and remain within cash flows from investing activities in the Consolidated Statements of Cash Flows. If an exploratory well does find proved reserves, the costs remain capitalized, are included within additions to oil and gas properties and remain within cash flows from investing activities in the Consolidated Statements of Cash Flows. The costs of development wells are capitalized whether proved reserves are added or not. All exploratory wells are evaluated for economic viability within one year of well completion, and the related capitalized costs are reviewed quarterly. Exploratory wells that discover potentially economic reserves in areas where a major capital expenditure would be required before production could begin and where the economic viability of that major capital expenditure depends upon the successful completion of further exploratory work in the area remain capitalized if the well finds a sufficient quantity of reserves to justify its completion as a producing well, and we are making sufficient progress assessing the reserves and the economic and operating viability of the project. Oil and gas lease acquisition costs are also capitalized. Upon sale or retirement of depreciable or depletable property, the cost and related accumulated DD&A are eliminated from the accounts and the resulting gain or loss is recognized. Interest cost is capitalized as a component of property cost for significant exploration and development projects that require greater than six months to be readied for their intended use. The application of the successful efforts method of accounting requires managerial judgment to determine the proper classification of wells designated as developmental or exploratory, which will ultimately determine the proper accounting treatment of the costs incurred. In addition to development on exploratory wells, we may drill scientific wells that are only used for data gathering purposes. The costs associated with these scientific wells are expensed as incurred as exploration expense. The results from a drilling operation can take considerable time to analyze, and the determination that commercial reserves have been discovered requires both judgment and industry experience. Other exploration costs, including certain geological and geophysical expenses and delay rentals for oil and gas leases, are charged to expense as incurred. The sale of a partial interest in a proved property is accounted for as a cost recovery and no gain or loss is recognized as long as this treatment does not significantly affect the unit-of-production amortization rate. Maintenance and repairs are charged to expense, and renewals and betterments are capitalized to the appropriate property and equipment accounts. Unproved oil and gas property costs are transferred to proved oil and gas properties if the properties are subsequently determined to be productive or are assigned proved reserves. Proceeds from sales of partial interests in unproved leases are accounted for as a recovery of cost without recognizing any gain until all costs are recovered. Unproved oil and gas properties are assessed periodically for impairment based on remaining lease terms, drilling results, reservoir performance, commodity price outlooks, future plans to develop acreage, recent sales prices of comparable properties and other relevant matters. We review our oil and natural gas properties for impairment on a quarterly basis or whenever events and circumstances indicate that a decline in the recoverability of their carrying value may have occurred. We estimate the expected undiscounted future net cash flows of our oil and gas properties using proved and risked probable and possible reserves based on our development plans and best estimate of future production, commodity pricing, reserve risking, gathering and transportation deductions, production tax rates, lease operating expenses and future development costs. We compare such undiscounted future net cash flows to the carrying amount of the oil and gas properties to determine if the carrying amount is recoverable. If the undiscounted future net cash flows exceed the carrying amount of the oil and gas properties, no impairment is taken. If the carrying amount of a property exceeds the undiscounted future net cash flows, we will impair the carrying value to fair value based on an analysis of quantitative and qualitative factors existing as of the balance sheet date. The factors used to determine fair value may include, but are not limited to, recent sales prices of comparable properties, indications from marketing activities, the present value of future revenues, net of estimated operating and development costs using estimates of reserves, future commodity pricing, future production estimates, anticipated capital expenditures and various discount rates commensurate with the risk and current market conditions associated with realizing the projected cash flows. Oil and gas properties are assessed for impairment once they meet the criteria to be classified as held for sale. Assets held for sale are carried at the lower of carrying cost or fair value less costs to sell. The fair value of the assets is determined using a market approach, based on an estimated selling price, as evidenced by current marketing activities, if possible. If an estimated selling price is not available, we utilize the income valuation technique, which involves calculating the present value of future net cash flows, as discussed above. If the carrying amount of the assets exceeds the fair value less costs to sell, an impairment will result to reduce the value of the properties down to fair value less costs to sell. The estimated fair value of assets held for sale may be materially different from sales proceeds that we eventually realize due to a number of factors including but not limited to the differences in expected future commodity pricing, location and quality differentials, our relative desire to dispose of such properties based on facts and circumstances impacting our business at the time we agree to sell, such as our position in the field subsequent to the sale and plans for future acquisitions or development in core areas. Our investment in producing oil and natural gas properties includes an estimate of the future costs associated with dismantlement, abandonment and restoration of our properties. The present value of the estimated future costs to dismantle, abandon and restore a well location are added to the capitalized costs of our oil and gas properties and recorded as a long-term liability. The capitalized cost is included in the oil and natural gas property costs that are depleted over the life of the assets. The provision for depletion of oil and gas properties is calculated on a field-by-field basis using the units-of-production method. Natural gas and NGLs are converted to an oil equivalent, Boe, at the standard rate of six Mcf to one Boe and forty-two gallons to one Boe, respectively. Our rate of recording DD&A is dependent upon our estimates of total proved and proved developed reserves, which incorporate assumptions regarding future development and abandonment costs as well as our level of capital spending. If the estimates of total proved or proved developed reserves decline, the rate at which we record DD&A expense increases, reducing our net income. This decline may result from lower market prices, which may make it uneconomic to drill for and produce higher cost fields. We are unable to predict changes in reserve quantity estimates as such quantities are dependent on the success of our exploitation and development program, as well as future economic conditions. Oil and Gas Reserve Quantities Our estimate of proved reserves is based on the quantities of oil and natural gas that geological and engineering data demonstrate with reasonable certainty to be commercially recoverable in future years from known reservoirs under existing economic and operating conditions. Our proved reserves estimates are audited on a well-by-well basis by an independent third party engineering firm. In the aggregate, the independent third party petroleum engineer estimates of total net proved reserves are within 10% of our internal estimates as of December 31, 2019. Reserves and their relation to estimated future net cash flows impact our depletion and impairment calculations. As a result, adjustments to depletion and impairment are made concurrently with changes to reserves estimates. We prepare our reserves estimates, and the projected cash flows derived from these reserves estimates, in accordance with SEC guidelines. Our independent third party engineering firm adheres to the same guidelines when auditing our reserve reports. The accuracy of our reserves estimates is a function of many factors including the following: the quality and quantity of available data, the interpretation of that data, the accuracy of various mandated economic assumptions and the judgments of the individuals preparing the reserves estimates. The process of estimating oil and natural gas reserves is very complex, requiring significant decisions in the evaluation of all available geological, geophysical, engineering and economic data. The data for a given field may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and continued reassessment of the viability of production under varying economic conditions. As a result, material revisions to existing reserves estimates may occur from time to time. Although every reasonable effort is made to ensure that the reported reserves estimates represent the most accurate assessments possible, the subjective decisions and variances in available data for various fields make these estimates generally less precise than other estimates included in our financial statements. As such, reserves estimates may materially vary from the ultimate quantities of oil and natural gas eventually recovered. Please refer to the reserve disclosures in "Items 1 and 2 - Business and Properties" for further detail on reserves data. Revenue Recognition All of our sales of oil, gas and NGLs are made under contracts with customers, whereby revenues are recognized when we satisfy our performance obligations and the customer obtains control of the product. Performance obligations under our contracts with customers are typically satisfied at a point-in-time through monthly delivery of oil, gas and/or NGLs. Accordingly, at the end of the reporting period, we do not have any unsatisfied performance obligations. Our contracts with customers typically include variable consideration based on monthly pricing tied to local indices and volumes delivered in the current month. The nature of our contracts with customers do not require us to constrain variable consideration for accounting purposes. Our contracts with customers typically require payment within one month of delivery. Under our contracts with customers, natural gas and its components, including NGLs, are either sold to a midstream entity (which processes the natural gas and subsequently sells the resulting residue gas and NGLs) or are sold to a gas or NGL purchaser after being processed by a third party for a fee. Regardless of the contract structure type, the terms of these contracts compensate us for the value of the residue gas and NGLs at current market prices for each product. Our oil is sold to multiple oil purchasers at specific delivery points at or near the wellhead. All costs incurred to gather, transport and/or process our oil, gas and NGLs after control has transferred to the customer are considered components of the consideration received from the customer and thus recorded in oil, gas and NGL production revenues in the Consolidated Statements of Operations. All costs incurred prior to the transfer of control to the customer are included in gathering, transportation and processing expense in the Consolidated Statements of Operations. Gas imbalances from the sale of natural gas are recorded on the basis of gas actually sold by us. If our aggregate sales volumes for a well are greater (or less) than its proportionate share of production from the well, a liability (or receivable) is established to the extent there are insufficient proved reserves available to make-up the overproduced (or underproduced) imbalance. Imbalances have not been significant in the periods presented. Income Taxes and Uncertain Tax Positions Income taxes are provided for the tax effects of transactions reported in the financial statements and consist of taxes currently payable plus deferred income taxes related to certain income and expenses recognized in different periods for financial and income tax reporting purposes. Deferred income tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when assets are recovered or liabilities are settled. Deferred income taxes are also recognized for net operating loss carry forwards and tax credits that are available to offset future income taxes. Deferred income taxes are measured by applying currently enacted tax rates to the differences between financial statement and income tax reporting. We routinely assess the realizability of our deferred tax assets. If we conclude that it is more likely than not that some portion or all of the deferred tax assets will not be realized under accounting standards, the tax asset would be reduced by a valuation allowance. We consider estimated future taxable income in making such assessments, including the future reversal of taxable temporary differences. Numerous judgments and assumptions are inherent in the determination of future taxable income, including factors such as future operating conditions (particularly as related to prevailing oil and natural gas prices). There can be no assurance that facts and circumstances will not materially change and require us to adjust deferred tax asset valuation allowances in the future. Accounting guidance for recognizing and measuring uncertain tax positions prescribes a more likely than not recognition threshold that a tax position must meet for any of the benefit of the uncertain tax position to be recognized in the financial statements. Guidance is also provided regarding de-recognition, classification and disclosure of these uncertain tax positions. Based on this guidance, we regularly analyze tax positions taken or expected to be taken in a tax return based on the threshold prescribed. Tax positions that do not meet or exceed this threshold are considered uncertain tax positions. Penalties, if any, related to uncertain tax positions would be recorded in other expenses. We currently do not have any uncertain tax positions recorded as of December 31, 2019. We are subject to taxation in many jurisdictions, and the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax laws and regulations in various taxing jurisdictions. If we ultimately determine that the payment of these liabilities will be unnecessary, we reverse the liability and recognize a tax benefit during the period in which we determine the liability no longer applies. Conversely, we record additional tax charges in a period in which we determine that a recorded tax liability is less than we expect the ultimate assessment to be. See "Results of Operations- Income Tax (Expense) Benefit" above for a discussion of changes to the valuation allowance during 2018. New Accounting Pronouncements For further information on the effects of recently adopted accounting pronouncements and the potential effects of new accounting pronouncements, refer to the Summary of Significant Accounting Policies (in Note 2) of the Notes to Consolidated Financial Statements.

<s>[INST] The following discussion and analysis should be read in conjunction with the "Selected Historical Financial Information" and the accompanying consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10K. This section and other parts of this Annual Report on Form 10K contain forwardlooking statements that involve risks and uncertainties. See the "Cautionary Note Regarding ForwardLooking Statements" at the beginning of this Annual Report on Form 10K. Forwardlooking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forwardlooking statements. Factors that might cause such differences include, but are not limited to, those discussed in "Items 1 and 2. Business and Properties Business Operations Environmental Matters and Regulation;" "Items 1 and 2. Business and Properties Business Operations Other Regulation of the Oil and Gas Industry;" and "Item 1A. Risk Factors" above, all of which are incorporated herein by reference. We assume no obligation to revise or update any forwardlooking statements for any reason, except as required by law. Overview We develop oil and natural gas in the Rocky Mountain region of the United States. We seek to build stockholder value by delivering profitable growth in cash flow, reserves and production through the development of oil and natural gas assets. In order to deliver profitable growth, we allocate capital to our highest return assets, concentrate expenditures on exploiting our core assets, maintain capital discipline and optimize operations while upholding highlevel standards for health, safety and the environment. Substantially all of our revenues are generated through the sale of oil and natural gas production and NGL recovery at market prices. We are committed to developing and producing oil and natural gas in a responsible and safe manner. Our employees work diligently with regulatory agencies, as well as environmental, wildlife and community organizations, to ensure that exploration and development activities meet stakeholders' expectations and regulatory requirements. Future acquisitions or dispositions could have a material impact on our financial condition and results of operations by increasing or decreasing our reserves, production and revenues as well as expenses and future capital expenditures. We currently anticipate that we would finance any future acquisitions with available borrowings under our Amended Credit Facility, sales of properties, and/or the issuance of debt, equity or equitylinked securities. Our prior acquisitions and capital expenditures were financed with a combination of cash on hand, funding from the sale of our equity securities, our Amended Credit Facility, other debt financing and cash flows from operations. As a result of acquisitions and dispositions of properties, our historical results of operations and periodtoperiod comparisons of these results and certain financial data may not be meaningful. In addition, past results are not necessarily indicative of future results. The following table summarizes the estimated net proved reserves and related Standardized Measure for the years indicated. The Standardized Measure is not intended to represent the current market value of our estimated oil and natural gas reserves. (1) December 31, 2019 reserves were based on average prices of $55.85 WTI per Bbl of oil, $2.58 Henry Hub per Mcf of natural gas and a percentage of the of the average oil price per Bbl of NGL. December 31, 2018 reserves were based on average prices of $65.56 WTI for oil, $3.10 Henry Hub for natural gas and $32.71 for NGLs. December 31, 2017 reserves were based on average prices of $51.34 WTI for oil, $2.98 Henry Hub for natural gas and $27.40 for NGLs. Commodity prices are inherently volatile and are influenced by many factors outside of our control. As of February 4, 2020, we have hedged 5,857,500 barrels of oil, or approximately 54% of our expected 2020 production, and 1,912,500 barrels of oil for our 2021 production at price levels that provide some economic certainty to our cash flows. We focus our efforts on increasing oil, natural gas and NGL reserves and production while cont [/INST] Negative. </s>

Mudrick Capital Acquisition Corp

2019-03-25

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Special Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. When used in this Form 10-K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on August 28, 2017 in Delaware and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our Business Combination using cash from the proceeds of our Initial Public Offering and the Private Placement, the proceeds from the sale of our shares in connection with a Business Combination (pursuant to the forward purchase agreement we entered into with our sponsor or backstop agreements we may enter into in connection with our initial Business Combination), our securities, debt or a combination of cash, securities and debt. The issuance of additional shares of common stock or preferred stock: · may significantly dilute the equity interest of investors, which dilution would increase if the anti-dilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than one-to-one basis upon conversion of the Class B common stock; · may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; · could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; · may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and · may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: · default and foreclosure on our assets if our operating revenues after an initial business combination are insufficient to repay our debt obligations; · acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; · our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; · our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; · our inability to pay dividends on our common stock; · using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; · limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; · increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; · limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and · other purposes and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to raise capital or to complete a Business Combination will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from August 28, 2017 (date of inception) through December 31, 2018 were organizational activities, those necessary to prepare for the Initial Public Offering, which was consummated on February 12, 2018, and identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination. We expect to generate non-operating income in the form of interest income on cash and marketable securities held in the Trust Account. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2018, we had net income of $1,679,963, which consists of interest income on securities held in the Trust Account of $2,836,691 and other interest income of $8,302, offset by operating costs of $609,581 and a provision for income taxes of $555,449. For the period from August 28, 2017 (inception) through December 31, 2017, we had a net loss of $2,784, which consists of operating costs of $2,784. Liquidity and Capital Resources The completion of the Initial Public Offering and simultaneous Private Placement Warrants, inclusive of the underwriters’ partial exercise of their over-allotment option, generated gross proceeds to the Company of $215,740,000. Related transaction costs amounted to $11,974,088, consisting of $4,160,000 of underwriting fees, $7,280,000 of deferred underwriting commissions payable (which are held in the Trust Account) and $534,088 of other costs. As of December 31, 2018, we had securities held in the Trust Account of $212,916,691, substantially all of which is invested in U.S. treasury securities money market fund. Interest income earned on the balance in the Trust Account is available to us to pay taxes. As of December 31, 2018, we had cash of $535,946 held outside the Trust Account, which is available for use by us to cover the costs associated with identifying a target business, negotiating a Business Combination, due diligence procedures and other general corporate uses. In addition, as of December 31, 2018, we had accounts payable and accrued expenses of $201,392. For the year ended December 31, 2018, cash used in operating activities amounted to $452,715. Net income of $1,679,963 was offset by interest earned on securities held in the Trust Account of $2,836,691. Changes in our operating assets and liabilities provided $704,013 of cash. For the period from August 28, 2017 (inception) through December 31, 2017, cash used in operating activities amounted to $55. Net loss of $2,784 was offset by expenses paid through a related party promissory note of $2,196. Changes in our operating assets and liabilities provided $533 of cash. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (which interest shall be net of taxes payable and excluding deferred underwriting commissions) to complete our Business Combination. We may withdraw interest to pay taxes and up to $100,000 for dissolution expenses, if any. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. Our Sponsor has committed, pursuant to the Forward Purchase Contract with us, to purchase, in a private placement for gross proceeds of $25,000,000 to occur concurrently with the consummation of a Business Combination, 2,500,000 Units on substantially the same terms as the sale of Units in Initial Public Offering at $10.00 per Unit, and 625,000 shares of Class A common stock. The funds from the sale will be used as part of the consideration to the sellers in a Business Combination; any excess funds from this private placement will be used for working capital purposes in the post-transaction company. This commitment is independent of the percentage of stockholders electing to redeem their Public Shares and provides us with a minimum funding level for a Business Combination. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses (as well as pay personnel and advisors to do the forgoing), structure, negotiate and complete a Business Combination. Going Concern In order to fund working capital deficiencies or finance transaction costs in connection with an intended Business Combination, our Sponsor or an affiliate of our Sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our Business Combination, we would repay such loaned amounts. In the event that our Business Combination does not close, we may use a portion of the working capital held outside the Trust Account to repay such loaned amounts but no proceeds from our Trust Account would be used for such repayment. Up to $1,500,000 of such loans will be convertible into warrants of the post-business combination entity at a price of $1.00 per warrant at the option of the lender. The warrants would be identical to the Private Placement Warrants. No written agreements currently exist with respect to such loans. As of December 31, 2018, we had no outstanding loans from the Sponsor. In connection with our assessment of going concern considerations in accordance with the Financial Accounting Standard Board’s Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” management has determined that the mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the Company be required to liquidate after February 12, 2020. Off-balance sheet financing arrangements We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay the sponsor a monthly fee of $10,000 for office space, utilities and secretarial and administrative support provided to the Company. We began incurring these fees on February 8, 2018 and will continue to incur these fees monthly until the earlier of the completion of the Business Combination or the Company’s liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have not identified any critical accounting policies. Recent accounting pronouncements In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, “Disclosure Update and Simplification,” amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders' equity for interim financial statements. Under the amendments, an analysis of changes in each caption of stockholders' equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. This final rule is effective on November 5, 2018. We anticipate our first presentation of the expanded disclosure requirements on changes in stockholders’ equity will be included in our Form 10-Q for the quarter ended March 31, 2019. Management does not believe that any other recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements.

<s>[INST] All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forwardlooking statements. When used in this Form 10K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forwardlooking statements. Such forwardlooking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on August 28, 2017 in Delaware and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our Business Combination using cash from the proceeds of our Initial Public Offering and the Private Placement, the proceeds from the sale of our shares in connection with a Business Combination (pursuant to the forward purchase agreement we entered into with our sponsor or backstop agreements we may enter into in connection with our initial Business Combination), our securities, debt or a combination of cash, securities and debt. The issuance of additional shares of common stock or preferred stock: · may significantly dilute the equity interest of investors, which dilution would increase if the antidilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than onetoone basis upon conversion of the Class B common stock; · may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; · could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; · may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and · may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: · default and foreclosure on our assets if our operating revenues after an initial business combination are insufficient to repay our debt obligations; · acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; · our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; · our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; · our inability to pay dividends on our common stock; · using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; · limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; · increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; · limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of [/INST] Negative. </s>

Mudrick Capital Acquisition Corp

2020-03-12

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Special Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. When used in this Form 10-K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on August 28, 2017 in Delaware and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our Initial Public Offering and the Private Placement, the proceeds from the sale of our shares in connection with a business combination (pursuant to the forward purchase agreement we entered into with our sponsor or backstop agreements we may enter into in connection with our initial business combination), our securities, debt or a combination of cash, securities and debt. The issuance of additional shares of common stock or preferred stock: · may significantly dilute the equity interest of investors, which dilution would increase if the anti-dilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than one-to-one basis upon conversion of the Class B common stock; · may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; · could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; · may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and · may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: · default and foreclosure on our assets if our operating revenues after an initial business combination are insufficient to repay our debt obligations; · acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; · our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; · our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; · our inability to pay dividends on our common stock; · using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; · limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; · increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; · limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and · other purposes and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to raise capital or to complete a business combination will be successful. Recent Developments On January 2, 2020, we issued an unsecured promissory note (the “Promissory Note”) to the Sponsor in the aggregate amount of $1,500,000 in order to finance transaction costs in connection with a business combination. The Promissory Note is non-interest bearing and repayable by us to the Sponsor upon consummation of a business combination. The Promissory Note will be forgiven if we are unable to consummate a business combination except to the extent of any funds held outside of the Trust Account. The Promissory Note may be convertible into warrants of the post Business Combination entity at a price of $1.00 per warrant, other than in connection with the Hycroft Business Combination. The warrants would be identical to the Private Placement Warrants. On January 13, 2020, we entered into a purchase agreement (as amended on February 26, 2020, and as may be further amended from time to time, the “Purchase Agreement”) with Hycroft Mining Corporation, a Delaware corporation (“Hycroft”), pursuant to which we will purchase from Hycroft, all of the issued and outstanding equity interests of Hycroft’s subsidiaries and substantially all of Hycroft’s other assets (the “Hycroft Business Combination”). The Hycroft Business Combination will be consummated subject to the deliverables and provisions as further described in the Purchase Agreement. On February 10, 2020, we held a special meeting of the stockholders of the Company at which the stockholders approved, among other things, a proposal to amend our amended and restated certificate of incorporation (the “Extension Amendment”) to extend the deadline to complete a business combination from February 12, 2020 to August 12, 2020 (the “Extended Termination Date”). In connection with the Extension Amendment, stockholders elected to redeem an aggregate of 13,890,713 shares of our Class A common stock. As a result, an aggregate of approximately $144,218,760 (or approximately $10.38 per share) was removed from the Trust Account to pay such stockholders. On February 12, 2020, we entered into an amendment (the “UA Amendment”) to our underwriting agreement with Cantor, pursuant to which the deferred underwriting fees provided for by the underwriting agreement, which were originally payable by us to the underwriters in cash upon completion of our initial business combination, shall be payable upon completion of the Hycroft Business Combination through a combination of (i) $2,500,000, payable in cash and directly from the Trust Account, (ii) $2,000,000, payable in shares of Class A common stock, valued for these purposes at $10.00 per share and (iii) an amount up to $2,780,000, determined as follows: (A) if Third Party Equity Value (as defined in the UA Amendment) is less than or equal to $75,000,000, an amount payable in Class A common stock, valued for these purposes at $10.00 per share, equal to the product of (x) 2,780,000 and (y) a fraction, the numerator of which is the Third Party Equity Value and the denominator of which is $75,000,000 or (B) if Third Party Equity Value is greater than $75,000,000, $2,780,000 payable in cash and directly from the Trust Account (collectively, the “Deferred Underwriting Commission”); provided, however, to the extent Cantor continues to beneficially own and hold for its own account the Specified Shares (as defined in the UA Amendment) on the date of the consummation of the Hycroft Business Combination (the “Acquisition Closing Date”), (1) the Deferred Underwriting Commission payable in Class A common stock pursuant to clauses (ii) and (iii) above shall be reduced by an amount equal to the product of (x) $10.00 and (y) the number of Specified Shares beneficially owned and held by Cantor for its own account on the Acquisition Closing Date and (2) the Deferred Underwriting Commission payable in cash and directly from the Trust Account pursuant to this sentence shall be increased by such same and equal amount. The UA Amendment does not amend, modify or supplement any other terms of the underwriting agreement. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from August 28, 2017 (date of inception) through December 31, 2019 were organizational activities, those necessary to prepare for the Initial Public Offering, which was consummated on February 12, 2018, and identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination. We generate non-operating income in the form of interest income on investments held in the Trust Account. We are incurring expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2019, we had net income of $2,610,824, which consists of interest income on investments held in the Trust Account of $4,379,894 and other interest income of $6,634, offset by operating costs of $875,900 and a provision for income taxes of $899,804. For the year ended December 31, 2018, we had net income of $1,679,963, which consists of interest income on securities held in the Trust Account of $2,836,691 and other interest income of $8,302, offset by operating costs of $609,581 and a provision for income taxes of $555,449. Liquidity and Capital Resources The completion of the Initial Public Offering and simultaneous Private Placement Warrants, inclusive of the underwriters’ partial exercise of their over-allotment option, generated gross proceeds to the Company of $215,740,000. Related transaction costs amounted to $11,974,088, consisting of $4,160,000 of underwriting fees, $7,280,000 of deferred underwriting commissions payable (which are held in the Trust Account) and $534,088 of other costs. As of December 31, 2019, we had investments held in the Trust Account of $215,385,757, substantially all of which is invested in U.S. treasury securities money market fund. Interest income earned on the balance in the Trust Account is available to us to pay taxes. During the year ended December 31, 2019, we withdrew approximately $1,911,000 of interest income to pay our franchise and income taxes. As of December 31, 2019, we had cash of $208,536 held outside the Trust Account, which is available for use by us to cover the costs associated with identifying a target business, negotiating a Business Combination, due diligence procedures and other general corporate uses. In addition, as of December 31, 2019, we had accounts payable and accrued expenses of $334,619. For the year ended December 31, 2019, cash used in operating activities amounted to $2,238,238. Net income of $2,610,824 was offset by interest earned on investments held in the Trust Account of $4,379,894 and changes in our operating assets and liabilities, which used $469,168 of cash. For the year ended December 31, 2018, cash used in operating activities amounted to $452,715. Net income of $1,679,963 was offset by interest earned on securities held in the Trust Account of $2,836,691. Changes in our operating assets and liabilities provided $704,013 of cash. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (which interest shall be net of taxes payable and excluding deferred underwriting commissions) to complete our Business Combination. We may withdraw interest to pay taxes and up to $100,000 for dissolution expenses, if any. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our Business Combination, the remaining proceeds held in the Trust Account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. Our Sponsor has committed, pursuant to the Forward Purchase Contract with us, to purchase, in a private placement for gross proceeds of $25,000,000 to occur concurrently with the consummation of a Business Combination, 2,500,000 Units on substantially the same terms as the sale of Units in Initial Public Offering at $10.00 per Unit, and 625,000 shares of Class A common stock. The funds from the sale will be used as part of the consideration to the sellers in a Business Combination; any excess funds from this private placement will be used for working capital purposes in the post-transaction company. This commitment is independent of the percentage of stockholders electing to redeem their Public Shares and provides us with a minimum funding level for a Business Combination. Going Concern We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (less taxes payable and deferred underwriting commissions) to complete our initial business combination. To the extent necessary, the Sponsor or an affiliate of the Sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required, up to $1,500,000. Such loans may be convertible into warrants of the post business combination entity at a price of $1.00 per warrant. The warrants would be identical to the Private Placement Warrants. On January 2, 2020, we issued the Promissory Note to the Sponsor in the aggregate amount of $1,500,000 in order to finance transaction costs in connection with a business combination. The Promissory Note is non-interest bearing and repayable by us to the Sponsor upon consummation of a business combination. The Promissory Note will be forgiven if we are unable to consummate a business combination except to the extent of any funds held outside of the Trust Account. The Promissory Note may be convertible into warrants of the post business combination entity at a price of $1.00 per warrant, other than in connection with the Hycroft Business Combination. The warrants would be identical to the Private Placement Warrants. If our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating a business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to a business combination. Moreover, we may need to obtain additional financing either to complete a business combination or because we become obligated to redeem a significant number of our Public Shares upon completion of a business combination, in which case we may issue additional securities or incur debt in connection with such business combination. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, suspending the pursuit of a potential transaction. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all. The liquidity condition and date for mandatory liquidation raise substantial doubt about our ability to continue as a going concern through August 12, 2020, our scheduled liquidation date. Off-balance sheet financing arrangements We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay the sponsor a monthly fee of $10,000 for office space, utilities and secretarial and administrative support provided to the Company. We began incurring these fees on February 8, 2018 and will continue to incur these fees monthly until the earlier of the completion of the business combination or the Company’s liquidation. The underwriters are entitled to deferred underwriting fee of $0.35 per Unit, or $7,280,000 in the aggregate. The deferred underwriting fee will become payable to the underwriters from the amounts held in the Trust Account solely in the event that the Company completes a business combination, subject to the terms of the underwriting agreement (see Recent Developments above). On January 24, 2018, we entered into the Forward Purchase Contract with the Sponsor, pursuant to which the Sponsor committed to purchase, in a private placement for gross proceeds of $25,000,000 to occur concurrently with the consummation of a business combination, 2,500,000 Units (the “Forward Units”) on substantially the same terms as the sale of Units in Initial Public Offering at $10.00 per Unit, and 625,000 shares of Class A common stock. The funds from the sale of Forward Units will be used as part of the consideration to the sellers in a business combination; any excess funds from this private placement will be used for working capital purposes in the post-transaction company. This commitment is independent of the percentage of stockholders electing to redeem their Public Shares and provides us with a minimum funding level for a business combination. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have not identified any critical accounting policies. Recent accounting pronouncements In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, “Disclosure Update and Simplification,” amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders' equity for interim financial statements. Under the amendments, an analysis of changes in each caption of stockholders' equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. This final rule is effective on November 5, 2018. We anticipate our first presentation of the expanded disclosure requirements on changes in stockholders’ equity will be included in our Form 10-Q for the quarter ended March 31, 2019. Management does not believe that any other recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements.

<s>[INST] All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forwardlooking statements. When used in this Form 10K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forwardlooking statements. Such forwardlooking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on August 28, 2017 in Delaware and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our Initial Public Offering and the Private Placement, the proceeds from the sale of our shares in connection with a business combination (pursuant to the forward purchase agreement we entered into with our sponsor or backstop agreements we may enter into in connection with our initial business combination), our securities, debt or a combination of cash, securities and debt. The issuance of additional shares of common stock or preferred stock: · may significantly dilute the equity interest of investors, which dilution would increase if the antidilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than onetoone basis upon conversion of the Class B common stock; · may subordinate the rights of holders of our common stock if preferred stock is issued with rights senior to those afforded our common stock; · could cause a change in control if a substantial number of shares of our common stock is issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; · may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and · may adversely affect prevailing market prices for our Class A common stock and/or warrants. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: · default and foreclosure on our assets if our operating revenues after an initial business combination are insufficient to repay our debt obligations; · acceleration of our obligations to repay the indebtedness even if we make all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; · our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; · our inability to obtain necessary additional financing if the debt security contains covenants restricting our ability to obtain such financing while the debt security is outstanding; · our inability to pay dividends on our common stock; · using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, our ability to pay expenses, make capital expenditures and acquisitions, and fund other general corporate purposes; · limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; · increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; · limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, and execution of our strategy; and · [/INST] Positive. </s>

Kezar Life Sciences, Inc.

2019-03-26

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion of our financial condition and results of operations in conjunction with the financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report on Form 10-K, particularly in “Special Note Regarding Forward-Looking Statements” and “Risk Factors.” Overview We are a clinical-stage biotechnology company, discovering and developing novel small molecule therapeutics to treat unmet needs in autoimmunity and cancer. Our lead product candidate, KZR-616, a first-in-class selective immunoproteasome inhibitor, has completed testing in healthy volunteers and is now enrolling a Phase 1b/2 clinical trial in lupus and lupus nephritis. We believe that the immunoproteasome is a validated target for the treatment of a wide variety of autoimmune diseases, given the compelling published activity seen with proteasome inhibitors administered to patients with severe autoimmune diseases. Our Phase 1a clinical trial results provide evidence that KZR-616 avoids the side effects caused by non-selective proteasome inhibitors, side effects that prevent them from being developed as a treatment in autoimmunity. Initial top-line results from the Phase 1b portion of our trial are expected in the second quarter of 2019. In January 2019, we began enrolling healthy female patients in a Phase 1 trial, and we plan to initiate Phase 2 trials in up to four additional autoimmune indications in 2019. We are also leveraging our protein secretion pathway research platform to discover and develop small molecule therapies targeting cancer including immuno-oncology. Since the commencement of our operations in mid-2015, we have devoted substantially all our resources to performing research and development activities in support of our product development efforts, hiring personnel, raising capital to support and expand such activities and providing general and administrative support for these operations. We do not have any products approved for sale and have not generated any revenue from product sales. We have funded our operations to date primarily from the issuance and sale of convertible preferred stock and from our initial public offering as described below. On June 8, 2018, we effected a 1-for-5.62 reverse stock split of our issued and outstanding shares of common stock and redeemable convertible preferred stock. Accordingly, all share and per share amounts for all periods presented in the accompanying consolidated financial statements and notes thereto have been adjusted retroactively, where applicable, to reflect this reverse stock split. On June 25, 2018, we completed our initial public offering, or IPO, whereby we sold 5,750,000 shares of our common stock, which included 750,000 shares issued as a result of the underwriters exercising their over-allotment option in full. We received cash proceeds of approximately $77.7 million from the IPO, net of underwriting discounts and commissions and other offering expenses paid by us. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates and programs. Our net losses were $23.2 million and $8.5 million for the years ended December 31, 2018 and 2017, respectively, and we expect to continue to incur significant losses for the foreseeable future. As of December 31, 2018, we had an accumulated deficit of $49.2 million. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on discovering, completing the necessary development, obtaining regulatory approval and preparing for potential commercialization of our product candidates. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Our net losses may fluctuate significantly from period to period, depending on the timing of our planned clinical trials and expenditures on other research and development activities. We expect our expenses will increase substantially over time as we: ▪ continue the ongoing and planned development of KZR-616; ▪ seek to discover and develop additional product candidates; ▪ initiate preclinical studies and clinical trials for any additional product candidates that we may pursue in the future; ▪ establish a sales, marketing, manufacturing and distribution infrastructure to commercialize any product candidate for which we may obtain marketing approval; ▪ continue to build a portfolio of product candidates through the acquisition or in-license of drugs, product candidates or technologies; ▪ seek marketing approvals for KZR-616 and any future product candidates that successfully complete clinical trials; ▪ maintain, protect and expand our portfolio of intellectual property rights, including patents, trade secrets and know-how; ▪ implement operational, financial and management systems; and ▪ attract, hire and retain additional administrative, clinical, regulatory and scientific personnel. Critical Accounting Polices and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Accrued Research and Development Costs We record accrued expenses for estimated costs of our research and development activities conducted by third-party service providers, which include the conduct of clinical studies, contract manufacturing activities and preclinical studies. We record the estimated costs of research and development activities based upon the estimated amount of services provided but not yet invoiced and include these costs in accrued liabilities in the consolidated balance sheets and within research and development expense in the consolidated statements of operations. These costs are a significant component of our research and development expenses. We record accrued expenses for these costs based on factors such as estimates of the work completed and in accordance with agreements established with these third-party service providers. Any payments made in advance of services provided are recorded as prepaid assets, which are expensed as the contracted services are performed. We estimate the amount of work completed through discussions with internal personnel and external service providers as to the progress or stage of completion of the services and the agreed-upon fee to be paid for such services. We make judgments and estimates in determining the accrued balance in each reporting period. As actual costs become known, we adjust our accrued estimates. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed, the number of patients enrolled and the rate of patient enrollment may vary from our estimates and could result in us reporting amounts that are too high or too low in any particular period. Our accrued expenses are dependent, in part, upon the receipt of timely and accurate reporting from clinical research organizations and other third-party service providers. For the periods presented, we have experienced no material differences between our accrued expenses and actual expenses. Stock-Based Compensation We recognize compensation costs related to stock options granted to employees and directors based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. The grant date fair value of the stock-based awards is recognized on a straight-line basis over the requisite service periods, which are generally the vesting period of the respective awards. The Black-Scholes option-pricing model requires the use of subjective assumptions which determine the fair value of stock-based awards, including the expected term and the price volatility of the underlying stock. These assumptions include: ▪ Expected term-The expected term represents the period that the stock-based awards are expected to be outstanding. We used the simplified method, which calculates the expected term as the average of the time to vesting and the contractual life of the options. For non-employees, we use the contractual term. ▪ Expected volatility- The expected volatility was estimated based on the average historical volatilities of common stock of comparable publicly traded entities over a period equal to the expected term of the stock option grants as we do not have significant trading history for our common stock. The comparable companies were chosen based on their size, stage in the life cycle or area of specialty. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. ▪ Risk-free interest rate-The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of grant for zero-coupon U.S. Treasury notes with maturities approximately equal to the expected term of the awards. ▪ Expected dividend-We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we used an expected dividend yield of zero. We will continue to use judgment in evaluating the expected term and expected volatility utilized for our stock-based compensation calculations on a prospective basis. Historically, for all periods prior to our IPO, the fair value of the shares of common stock underlying our share-based awards were estimated on each grant date by our board of directors. In order to determine the fair value of our common stock underlying option grants, our board of directors considered, among other things, timely valuations of our common stock prepared by unrelated third-party valuation firms in accordance with the guidance provided by the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, and a number of objective and subjective factors including important developments in our operations, sales of convertible preferred stock, actual operating results and financial performance, the conditions in the biotechnology industry and the economy in general, the stock price performance and volatility of comparable public companies, and the lack of liquidity of our common stock, among other factors. For the options granted subsequent to our June 2018 IPO, our board of directors will determine the fair value of each share of underlying common stock based on the closing price of our common stock as reported on the date of grant. Recent Accounting Pronouncements See Note 2 to our Consolidated Financial Statements “Summary of Significant Accounting Policies-Recently Accounting Pronouncements” for more information. Financial Operations Overview Research and Development Expenses Research and development expenses consist primarily of costs incurred for the development of our product candidates, which include: ▪ employee-related expenses, which include salaries, benefits and stock-based compensation; ▪ fees paid to consultants for services directly related to our product development and regulatory effort; ▪ expenses incurred under agreements with third-party contract organizations, investigative clinical trial sites and consultants that conduct research and development activities on our behalf; ▪ costs associated with preclinical studies and clinical trials; ▪ costs associated with technology and intellectual property licenses; ▪ the costs related to production of clinical supplies; and ▪ facilities and other allocated expenses, which include expenses for rent and other facility related costs and other supplies. We expense all research and development costs in the periods in which they are incurred. Costs for certain development activities are recognized based on an evaluation of the progress to completion of specific tasks using information and data provided to us by our vendors, collaborators and third-party service providers. We are eligible under the AusIndustry Research and Tax Development Tax Incentive Program to obtain a cash amount from the Australian Taxation Office. The tax incentive is available to us on the basis of specific criteria with which we must comply related to research and development expenditures in Australia. These research and development tax incentives are recognized as contra research and development expense when the right to receive has been attained and funds are considered to be collectible. The amounts are determined based on a cost-reimbursement basis, and the incentive is related to our research and development expenditures and is due to us regardless of whether any Australian tax is owed. Amounts related to the AusIndustry Research and Development Tax Incentive Program are recognized when there is reasonable assurance that the incentive will be received, the relevant expenditure has been incurred by our Australian subsidiary, Kezar Life Sciences Australia Pty Ltd, a proprietary company limited by shares, and the amount of the consideration can be reliably measured. The following table summarizes our research and development expenses for the years ended: We expect our research and development expenses to increase substantially for the foreseeable future as we continue to invest in research and development activities related to developing our product candidate and our preclinical programs and as they advance into later stages of development. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming, and the successful development of our product candidates is highly uncertain. As a result, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of any of our product candidates. General and Administrative Expenses Our general and administrative expenses consist primarily of personnel costs, allocated facilities costs and other expenses for outside professional services, including legal, human resource, IT and audit services. Personnel costs consist of salaries, benefits and stock-based compensation. We expect to incur additional expenses as a result of operating as a public company, including expenses related to compliance with the rules and regulations of the SEC, The Nasdaq Stock Market LLC and any other securities exchange on which our securities are traded, additional insurance expenses, investor relations activities and other administrative and professional services. We also expect to increase the size of our administrative function to support the growth of our business. Interest Income Our interest income consists of interest income earned on our cash and cash equivalents and marketable securities. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 Research and Development Expenses Research and development expenses increased by $11.7 million in 2018 compared to 2017. The increase was due to an increase of $2.7 million in toxicology and other preclinical studies, an increase of $1.8 million in clinical trial costs for the Phase 1b clinical trial of KZR-616, an increase of $1.4 million related to manufacturing, an increase of $1.0 million in medicinal chemistry efforts related to our protein secretion discovery program, an increase of $0.8 million in stock-based compensation, an increase of $1.7 million in personnel expenses due to an increase in headcount and an increase of $1.8 million in facility-related expense due to the move to our new corporate office. In addition, the Australian Research and Development Tax Incentive credit earned for the year ended December 31, 2018 decreased by $0.5 million compared to the same period in 2017, which is recorded as a reduction in our research and development expenses. General and Administrative Expenses General and administrative expenses increased by $4.3 million in 2018 compared to 2017. The increase was primarily due to an increase of $1.1 million in stock-based compensation, an increase of $1.0 million in personnel expenses related to an increase in headcount and increased salaries, an increase of $1.8 million in consulting and professional fees related to being a public company and an increase of $0.4 million in facility-related expenses due to the move to our new corporate office. Interest Income Interest income increased by $1.3 million in 2018 compared to 2017. The increase was attributable to interest income earned on higher balances of cash equivalents and marketable securities resulting from our IPO in June 2018. Comparison of the Years Ended December 31, 2017 and 2016 Research and Development Expenses Research and development expenses decreased by $0.9 million for the year ended December 31, 2017, compared to the year ended December 31, 2016. The decrease was due to a reduction of $1.9 million in the costs of GLP toxicology studies, which were mostly completed in 2016, and a reduction of $0.5 million in contract manufacturing related process development costs. These decreases were partially offset by an increase of $0.9 million in clinical trial costs due to the initiation of the Phase 1 clinical trial of KZR-616, an increase of $0.5 million in personnel expenses due to an increase in headcount and an increase of $0.3 million in medicinal chemistry efforts related to our protein secretion discovery program. In addition, the amount of our Australian Research and Development Tax Incentive increased by $0.1 million for the year ended December 31, 2017. General and Administrative Expenses General and administrative expenses increased by $0.7 million for the year ended December 31, 2017, compared to the year ended December 31, 2016. The increase was primarily due to an increase of $0.3 million in payroll expenses related to an increase in headcount and increased salaries and bonuses and an increase of $0.2 million in legal and professional fees related to our intellectual property activities and preparation to become a public company. Interest Income Interest income increased by $0.2 million for the year ended December 31, 2017, compared to the year ended December 31, 2016. The increase was attributable to interest income earned on cash equivalents due to additional funds received from our Series B redeemable convertible preferred stock financing in June and July 2017. Liquidity and Capital Resources Overview As of December 31, 2018, we had $24.2 million in cash and cash equivalents and $83.3 million of marketable securities invested in a U.S. Treasury money market fund, U.S. Treasury securities, U.S. Agency bonds and corporate debt securities with maturities of eight months or less. In June 2018, we completed an IPO whereby we sold 5,750,000 shares of our common stock at a price of $15.00 per share, which included 750,000 shares as a result of the underwriters exercising their over-allotment option exercised in full. We received net proceeds of $77.7 million from the IPO, after deducting underwriting discounts and commissions and other offering expenses paid by us. Prior to the IPO, we raised an aggregate of $72.6 million from the sale of convertible preferred stock, which automatically converted to common stock on a one-for-one ratio upon completion of the IPO. We have incurred operating losses and experienced negative operating cash flows since our inception and anticipate that we will continue to incur losses for at least the foreseeable future. Our net loss was $23.2 million for the year ended December 31, 2018, and we had an accumulated deficit of $49.2 million as of December 31, 2018. We believe that our cash, cash equivalents and marketable securities as of December 31, 2018 will be sufficient to meet our projected operating requirements through at least the next 12 months from the date these financial statements are issued. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Funding Requirements Our primary use of cash is to fund operating expenses, primarily research and development expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable, accrued expenses and prepaid expenses. We will require additional financing to fund working capital and pay our obligations. We may pursue financing opportunities through the issuance of debt or equity. There can be no assurance that we will be successful in acquiring additional funding at levels sufficient to fund our operations or on terms favorable to us or at all. Our future funding requirements will depend on many factors, including the following: ▪ the progress, timing, scope, results and costs of our clinical trials and preclinical studies for our product candidates, including the ability to enroll patients in a timely manner for our clinical trials; ▪ the costs of obtaining clinical and commercial supplies for KZR-616 and any other product candidates we may identify and develop; ▪ the cost, timing and outcomes of regulatory approvals; ▪ the extent to which we may acquire or in-license other product candidates and technologies; ▪ the cost of attracting, hiring and retaining qualified personnel; ▪ our ability to successfully commercialize any product candidates for which we obtain regulatory approval; and ▪ the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for clinical trials and other research and development expenditures. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies. If we need to raise additional capital to fund our operations, funding may not be available to us on acceptable terms, or at all. If we are unable to obtain adequate financing when needed, we may have to delay, reduce the scope of or suspend one or more of our preclinical studies, clinical trials, research and development programs or commercialization efforts. We may seek to raise any necessary additional capital through a combination of public or private equity offerings, debt financings, collaborations and other licensing arrangements. If we raise additional capital through debt financing, we may be subject to covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Cash Flows The following summarizes our cash flows for the periods indicated: Cash Flows from Operating Activities During the year ended December 31, 2018, cash used in operating activities was $20.8 million, which consisted of a net loss of $23.2 million, adjusted by non-cash charges of $2.3 million and a net change of $0.1 million in our net operating assets and liabilities. The non-cash charges consisted of $0.2 million for depreciation and amortization, $2.0 million for stock-based compensation expense and $0.1 million for loss on disposal of property and equipment. The change in our net operating assets and liabilities was primarily due to an increase of $1.0 million in prepaid expenses, including upfront payments for insurance premiums, clinical and toxicology activities, offset by an increase of $1.4 million in accounts payable, accrued expenses and other liabilities due to professional services, manufacturing and clinical expenditures as well as an increase of $0.3 million related to deferred rent. During the year ended December 31, 2017, cash used in operating activities was $8.1 million, which consisted of a net loss of $8.5 million, adjusted by non-cash charges of $0.4 million. The non-cash charges are primarily comprised of $0.2 million for depreciation and amortization and of $0.2 million for stock-based compensation expense. The change in our net operating assets and liabilities was primarily due to an increase in payroll-related accruals of $0.4 million and clinical expenditures of $0.3 million and an increase in prepaid expenses of $0.6 million, including advance payments for clinical activities. During the year ended December 31, 2016, cash used in operating activities was $9.8 million, which consisted of a net loss of $9.0 million, adjusted by non-cash charges of $0.3 million and a net change of $1.1 million in our net operating assets and liabilities. The non-cash charges are primarily comprised of $0.2 million for depreciation and amortization and $0.1 million for stock-based compensation expense. The change in our net operating assets and liabilities was primarily due to a decrease of $0.5 million in accounts payable primarily related to clinical development expenditures and an increase of $0.4 million for research and development tax incentive receivable. Cash Flows from Investing Activities During the year ended December 31, 2018, cash used in investing activities primarily consisted of $119.2 million in purchases of marketable securities offset by $36.5 million of maturities of such marketable securities. Purchases of property and equipment was $1.1 million, $0.4 million and $0.1 million during the years ended December 31, 2018, 2017 and 2016, respectively. Cash Flows from Financing Activities During the year ended December 31, 2018, cash provided by financing activities was $77.9 million, which consisted of $77.7 million in net proceeds from our IPO and $0.2 million from the issuance of common stock upon the exercise of stock options. During the year ended December 31, 2017, cash provided by financing activities consisted of $49.8 million in net proceeds from the issuance of Series B redeemable convertible preferred stock. During the year ended December 31, 2016, cash provided by financing activities consisted of $36,000 in net proceeds from the issuance of common stock upon the exercise of stock options. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2018 (in thousands): (1) Amounts in the table represent the operating lease obligations of office and laboratory space at 4000 Shoreline Court, South San Francisco, California. The minimum lease payments above do not include common area maintenance charges or real estate taxes. Except as disclosed in the table above, we have no long-term debt or capital leases and no material non-cancelable purchase commitments with service providers, as we have generally contracted on a cancelable, purchase order basis. The contractual obligations table does not include any potential contingent payments upon the achievement by us of clinical, regulatory and commercial events, as applicable, or royalty payments that we may be required to make under license agreements we have entered into or may enter into with various entities pursuant to which we have in-licensed certain intellectual property, including our license agreement with Onyx. Under the Onyx license agreement, we are obligated to pay Onyx milestone payments of up to $172.5 million in the aggregate upon the achievement of certain development, regulatory and sales milestones. We excluded the contingent payments given that the timing and amount (if any) of any such payments cannot be reasonably estimated at this time. See the section titled “Business-License Agreement with Onyx” for additional information. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have holdings in any variable interest entities. JOBS Act Accounting Election We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards and, therefore, will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. In addition, we intend to rely on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if as an “emerging growth company” we intend to rely on such exemptions, we are not required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act of 2002, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation-related items such as the correlation between executive compensation and performance and comparisons of the Chief Executive Officer’s compensation to median employee compensation. These exemptions will apply until December 31, 2023 or until we no longer meet the requirements of being an emerging growth company, whichever is earlier.

<s>[INST] Overview We are a clinicalstage biotechnology company, discovering and developing novel small molecule therapeutics to treat unmet needs in autoimmunity and cancer. Our lead product candidate, KZR616, a firstinclass selective immunoproteasome inhibitor, has completed testing in healthy volunteers and is now enrolling a Phase 1b/2 clinical trial in lupus and lupus nephritis. We believe that the immunoproteasome is a validated target for the treatment of a wide variety of autoimmune diseases, given the compelling published activity seen with proteasome inhibitors administered to patients with severe autoimmune diseases. Our Phase 1a clinical trial results provide evidence that KZR616 avoids the side effects caused by nonselective proteasome inhibitors, side effects that prevent them from being developed as a treatment in autoimmunity. Initial topline results from the Phase 1b portion of our trial are expected in the second quarter of 2019. In January 2019, we began enrolling healthy female patients in a Phase 1 trial, and we plan to initiate Phase 2 trials in up to four additional autoimmune indications in 2019. We are also leveraging our protein secretion pathway research platform to discover and develop small molecule therapies targeting cancer including immunooncology. Since the commencement of our operations in mid2015, we have devoted substantially all our resources to performing research and development activities in support of our product development efforts, hiring personnel, raising capital to support and expand such activities and providing general and administrative support for these operations. We do not have any products approved for sale and have not generated any revenue from product sales. We have funded our operations to date primarily from the issuance and sale of convertible preferred stock and from our initial public offering as described below. On June 8, 2018, we effected a 1for5.62 reverse stock split of our issued and outstanding shares of common stock and redeemable convertible preferred stock. Accordingly, all share and per share amounts for all periods presented in the accompanying consolidated financial statements and notes thereto have been adjusted retroactively, where applicable, to reflect this reverse stock split. On June 25, 2018, we completed our initial public offering, or IPO, whereby we sold 5,750,000 shares of our common stock, which included 750,000 shares issued as a result of the underwriters exercising their overallotment option in full. We received cash proceeds of approximately $77.7 million from the IPO, net of underwriting discounts and commissions and other offering expenses paid by us. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates and programs. Our net losses were $23.2 million and $8.5 million for the years ended December 31, 2018 and 2017, respectively, and we expect to continue to incur significant losses for the foreseeable future. As of December 31, 2018, we had an accumulated deficit of $49.2 million. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on discovering, completing the necessary development, obtaining regulatory approval and preparing for potential commercialization of our product candidates. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Our net losses may fluctuate significantly from period to period, depending on the timing of our planned clinical trials and expenditures on other research and development activities. We expect our expenses will increase substantially over time as we: ▪ continue the ongoing and planned development of KZR616; ▪ seek to discover and develop additional product candidates; ▪ initiate preclinical studies and clinical trials for any additional product candidates that we may pursue in the future; ▪ establish a sales, marketing, manufacturing and distribution infrastructure to commercialize any product candidate for which we may obtain marketing approval; [/INST] Negative. </s>

Kezar Life Sciences, Inc.

2020-03-12

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion of our financial condition and results of operations in conjunction with the financial statements and the related notes included elsewhere in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report on Form 10-K, particularly in “Special Note Regarding Forward-Looking Statements” and “Risk Factors.” Overview We are a clinical-stage biotechnology company, discovering and developing novel small molecule therapeutics to treat unmet needs in autoimmunity and cancer. We are developing our lead product candidate, KZR-616, a first-in-class selective immunoproteasome inhibitor, in severe autoimmune diseases where limited treatment options exist. We are conducting three Phase 2 clinical trials of KZR-616 across five separate autoimmune diseases of high unmet need: the MISSION trial in patients with lupus nephritis; the PRESIDIO trial in patients with dermatomyositis or polymyositis; and the MARINA trial in patients with autoimmune hemolytic anemia or immune thrombocytopenia. We believe that the immunoproteasome is a validated target for the treatment of a wide variety of autoimmune diseases given the compelling published activity seen with non-selective proteasome inhibitors administered to patients with severe autoimmune diseases. Based on results from our Phase 1a studies in healthy volunteers and the preliminary results from the Phase 1b portion of the MISSION trial in patients with systemic lupus erythematosus, also known as lupus or SLE, KZR-616 has largely avoided adverse effects associated with currently marketed non-selective proteasome inhibitors, as exhibited in clinical studies conducted by third parties, including side effects which we believe prevent them from being utilized as a chronic treatment in autoimmune disorders. In addition, we have seen encouraging clinical activity and biomarker data in SLE patients. Additionally, we are advancing our novel research platform targeting the Sec61 translocon and the protein secretion pathway to discover and develop small molecule therapeutics targeting oncology indications. Our first clinical candidate in this program, KZR-261, has demonstrated broad anti-tumor activity in preclinical models of both solid and hematologic malignancies. KZR-261 is undergoing laboratory studies and manufacturing activities in support of an investigational new drug application, which we anticipate submitting to the U.S. Food and Drug Administration in the first quarter of 2021 for a Phase 1 clinical trial in solid tumors. We believe this discovery platform has the potential to yield oral small molecule candidates that, if successfully developed and approved, could serve as alternatives to currently marketed biologic therapeutics to act as cytotoxic anti-cancer agents or to block the secretion of novel targets of interest in immuno-oncology or inflammation. Since the commencement of our operations in 2015, we have devoted substantially all our resources to performing research and development activities in support of our product development efforts, hiring personnel, raising capital to support and expand such activities and providing general and administrative support for these operations. We do not have any products approved for sale and have not generated any revenue from product sales. We have funded our operations to date primarily from the issuance and sale of convertible preferred stock and from public offerings of common stock and pre-funded warrants to purchase common stock as described below. We acquired exclusive worldwide rights to KZR-616 and an accompanying library of similar molecules pursuant to a license agreement, or the Onyx License Agreement, with Onyx Therapeutics, Inc., or Onyx, a wholly owned subsidiary of Amgen, Inc. in June 2015. Patent coverage for KZR-616 extends to at least 2034. In July 2019, we filed a shelf registration statement on Form S-3 (Registration No. 333-232542) that allows us to sell up to an aggregate of $150 million of our securities, which includes up to $50.0 million designated in a prospectus supplement for an at-the-market offering program, or ATM program. As of December 31, 2019, we sold no shares of common stock under the ATM program. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates and programs. Our net losses were $35.1 million, $23.2 million and $8.5 million for the years ended December 31, 2019, 2018 and 2017, respectively, and we expect to continue to incur significant losses for the foreseeable future. As of December 31, 2019, we had an accumulated deficit of $84.3 million. We anticipate that a substantial portion of our capital resources and efforts in the foreseeable future will be focused on discovering, completing the necessary development, obtaining regulatory approval and preparing for potential commercialization of our product candidates. We expect to continue to incur significant expenses and increasing operating losses for at least the next several years. Our net losses may fluctuate significantly from period to period, depending on the timing of our planned clinical trials and expenditures on other research and development activities. We expect our expenses will increase substantially over time as we: ● continue the ongoing and planned development of KZR-616 and KZR-261; ● seek to discover and develop additional product candidates, including preclinical studies and clinical trials for such product candidates; ● maintain, protect and expand our portfolio of intellectual property rights, including patents, trade secrets and know-how; ● seek marketing approvals for KZR-616, KZR-261 and any future product candidates that successfully complete clinical trials; ● establish a sales, marketing, manufacturing and distribution infrastructure to commercialize any product candidate for which we may obtain marketing approval; ● continue to build a portfolio of product candidates through the acquisition or in-license of drugs, product candidates or technologies; ● implement operational, financial, management and compliance systems; and ● attract, hire and retain additional administrative, clinical, regulatory and scientific personnel; and ● incur additional legal, accounting and other expenses associate with operating as a public company. Recent Highlights On February 4, 2020, we completed an underwritten public offering of 18,965,385 shares of our common stock, which includes the full exercise of the underwriters’ option to purchase additional shares of common stock, and, to certain investors in lieu thereof, pre-funded warrants to purchase 2,884,615 shares of our common stock at an exercise price of $0.001 per share, or the February Offering. The public offering price of our common stock was $2.60 per share and the public offering price of each pre-funded warrant was $2.599 per underlying share. The net proceeds from the public offering were approximately $53.3 million, after deducting underwriting discounts and commissions and other offering expenses paid by us. Our existing stockholder, Morningside Ventures, together with its affiliate, and certain of our officers and directors purchased an aggregate amount of approximately $22.9 million of common stock in the offering. Critical Accounting Polices and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our consolidated financial statements appearing elsewhere in this Annual Report on Form 10-K, we believe that the following accounting policies are those most critical to the judgments and estimates used in the preparation of our consolidated financial statements. Accrued Research and Development Costs We record accrued expenses for estimated costs of our research and development activities conducted by third-party service providers, which include the conduct of clinical studies, contract manufacturing activities and preclinical studies. We record the estimated costs of research and development activities based upon the estimated amount of services provided but not yet invoiced and include these costs in accrued liabilities in the consolidated balance sheets and within research and development expense in the consolidated statements of operations. These costs are a significant component of our research and development expenses. We record accrued expenses for these costs based on factors such as estimates of the work completed and in accordance with agreements established with these third-party service providers. Any payments made in advance of services provided are recorded as prepaid assets, which are expensed as the contracted services are performed. We estimate the amount of work completed through discussions with internal personnel and external service providers as to the progress or stage of completion of the services and the agreed-upon fee to be paid for such services. We make judgments and estimates in determining the accrued balance in each reporting period. As actual costs become known, we adjust our accrued estimates. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed, the number of patients enrolled and the rate of patient enrollment may vary from our estimates and could result in us reporting amounts that are too high or too low in any particular period. Our accrued expenses are dependent, in part, upon the receipt of timely and accurate reporting from clinical research organizations and other third-party service providers. For the periods presented, we have experienced no material differences between our accrued expenses and actual expenses. Stock-Based Compensation We recognize compensation costs related to stock options granted to employees and directors based on the estimated fair value of the awards on the date of grant. We estimate the grant date fair value, and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. The grant date fair value of the stock-based awards is recognized on a straight-line basis over the requisite service periods, which are generally the vesting period of the respective awards. The Black-Scholes option-pricing model requires the use of subjective assumptions which determine the fair value of stock-based awards, including the expected term and the price volatility of the underlying stock. These assumptions include: ● Expected term-The expected term represents the period that the stock-based awards are expected to be outstanding. We used the simplified method, which calculates the expected term as the average of the time to vesting and the contractual life of the options. For non-employees, we use the contractual term. ● Expected volatility- The expected volatility was estimated based on the average historical volatilities of common stock of comparable publicly traded entities over a period equal to the expected term of the stock option grants as we do not have significant trading history for our common stock. The comparable companies were chosen based on their size, stage in the life cycle or area of specialty. We will continue to apply this process until a sufficient amount of historical information regarding the volatility of our own stock price becomes available. ● Risk-free interest rate-The risk-free interest rate is based on the U.S. Treasury yield in effect at the time of grant for zero-coupon U.S. Treasury notes with maturities approximately equal to the expected term of the awards. ● Expected dividend-We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we used an expected dividend yield of zero. We will continue to use judgment in evaluating the expected term and expected volatility utilized for our stock-based compensation calculations on a prospective basis. Historically, for all periods prior to our IPO, the fair value of the shares of common stock underlying our share-based awards were estimated on each grant date by our board of directors. In order to determine the fair value of our common stock underlying option grants, our board of directors considered, among other things, timely valuations of our common stock prepared by unrelated third-party valuation firms in accordance with the guidance provided by the American Institute of Certified Public Accountants Practice Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, and a number of objective and subjective factors including important developments in our operations, sales of convertible preferred stock, actual operating results and financial performance, the conditions in the biotechnology industry and the economy in general, the stock price performance and volatility of comparable public companies, and the lack of liquidity of our common stock, among other factors. For the options granted subsequent to our IPO, our board of directors will determine the fair value of each share of underlying common stock based on the closing price of our common stock as reported on the date of grant. Recent Accounting Pronouncements See Note 2 to our Consolidated Financial Statements “Summary of Significant Accounting Policies-Accounting Pronouncements Adopted in 2019” for more information. Financial Operations Overview Research and Development Expenses Research and development expenses consist primarily of costs incurred for the development of our product candidates, which include: ● employee-related expenses, which include salaries, benefits and stock-based compensation; ● fees paid to consultants for services directly related to our product development and regulatory effort; ● expenses incurred under agreements with third-party contract organizations, investigative clinical trial sites and consultants that conduct research and development activities on our behalf; ● costs associated with preclinical studies and clinical trials; ● costs associated with technology and intellectual property licenses; ● the costs related to production of clinical supplies; and ● facilities and other allocated expenses, which include expenses for rent and other facility related costs and other supplies. We expense all research and development costs in the periods in which they are incurred. Costs for certain development activities are recognized based on an evaluation of the progress to completion of specific tasks using information and data provided to us by our vendors, collaborators and third-party service providers. We are eligible under the AusIndustry Research and Tax Development Tax Incentive Program to obtain a cash amount from the Australian Taxation Office. The tax incentive is available to us on the basis of specific criteria with which we must comply related to research and development expenditures in Australia. These research and development tax incentives are recognized as contra research and development expense when the right to receive the tax incentive has been attained and funds are considered to be collectible. The amounts are determined based on a cost-reimbursement basis, and the incentive is related to our research and development expenditures and is due to us regardless of whether any Australian tax is owed. Amounts related to the AusIndustry Research and Development Tax Incentive Program are recognized when there is reasonable assurance that the incentive will be received, the relevant expenditure has been incurred by our Australian subsidiary, Kezar Life Sciences Australia Pty Ltd, a proprietary company limited by shares, and the amount of the consideration can be reliably measured. The following table summarizes our research and development expenses for the years ended: We expect our research and development expenses to increase substantially for the foreseeable future as our product candidates advance into later stages of development. The process of conducting the necessary clinical research to obtain regulatory approval is costly and time-consuming, and the successful development of our product candidates is highly uncertain. As a result, we are unable to determine the duration and completion costs of our research and development projects or when and to what extent we will generate revenue from the commercialization and sale of any of our product candidates. General and Administrative Expenses Our general and administrative expenses consist primarily of personnel costs, allocated facilities costs and expenses for outside professional services, including legal, human resource, information technology and audit services. Personnel costs consist of salaries, benefits and stock-based compensation. We incur additional expenses as we increase the size of our administrative function to support the growth of our business. Interest Income Our interest income consists of interest income earned on our cash, cash equivalents and marketable securities. Results of Operations A discussion regarding our financial condition and results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017 is included in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on March 26, 2019. Comparison of the Years Ended December 31, 2019 and 2018 Research and Development Expenses Research and development expenses increased by $9.2 million in 2019 compared to 2018. The increase was primarily due to an increase of $3.6 million in clinical trial related costs for KZR-616, an increase of $1.5 million in manufacturing expenses, an increase of $3.3 million in personnel expenses due to an increase in headcount, an increase of $0.9 million in stock-based compensation and an increase of $0.5 million in facility-related expenses. In addition, the Australian Research and Development Tax Incentive credit earned for the year ended December 31, 2019 increased by $0.6 million compared to the same period in 2018, which is recorded as a reduction in our research and development expenses. General and Administrative Expenses General and administrative expenses increased by $3.4 million in 2019 compared to 2018. The increase was primarily due to an increase of $1.3 million in personnel expenses due to an increase in headcount and salaries, an increase of $1.1 million in stock-based compensation, an increase of $0.9 million in consulting and professional fees related to operating as a public company and an increase of $0.1 million in facility-related expenses. Interest Income Interest income increased by $0.7 million in 2019 compared to 2018. The increase was attributable to interest income earned on higher balances of cash equivalents and marketable securities resulting from our IPO. Liquidity and Capital Resources Overview As of December 31, 2019, we had $15.0 million in cash and cash equivalents and $63.2 million of marketable securities invested in a U.S. Treasury money market fund, U.S. Treasury securities, U.S. agency bonds, commercial paper and corporate debt securities. As of December 31, 2019, our cash equivalents and marketable securities had an average maturity of approximately three months and the longest maturity was twelve months. In June 2018, we completed an IPO whereby we sold 5,750,000 shares of our common stock at a price of $15.00 per share, which included 750,000 shares as a result of the underwriters exercising their over-allotment option in full. We received net proceeds of $77.7 million from the IPO, after deducting underwriting discounts and commissions and other offering expenses paid by us. Prior to the IPO, we raised an aggregate of $72.6 million from the sale of convertible preferred stock, which automatically converted to common stock on a one-for-one ratio upon completion of the IPO. We have incurred operating losses and experienced negative operating cash flows since our inception and anticipate that we will continue to incur losses for at least the foreseeable future. Our net loss was $35.1 million for the year ended December 31, 2019, and we had an accumulated deficit of $84.3 million as of December 31, 2019. We believe that our cash, cash equivalents and marketable securities as of December 31, 2019, as adjusted to give effect to the $53.3 million in net proceeds we received from the February Offering, will be sufficient to meet our projected operating requirements through at least the next 12 months from the date these financial statements are issued. We have based this estimate on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect. Funding Requirements Our primary use of cash is to fund operating expenses, primarily research and development expenditures. Cash used to fund operating expenses is impacted by the timing of when we pay these expenses, as reflected in the change in our outstanding accounts payable, accrued expenses and prepaid expenses. We will require additional financing to fund working capital and pay our obligations. We may pursue financing opportunities through the issuance of debt or equity. There can be no assurance that we will be successful in acquiring additional funding at levels sufficient to fund our operations or on terms favorable to us or at all. Our future funding requirements will depend on many factors, including the following: ● the progress, timing, scope, results and costs of our clinical trials and preclinical studies for our product candidates, including the ability to enroll patients in a timely manner for our clinical trials; ● the costs of obtaining clinical and commercial supplies for KZR-616, KZR-261 and any other product candidates we may identify and develop; ● the cost, timing and outcomes of regulatory approvals; ● the extent to which we may acquire or in-license other product candidates and technologies; ● the cost of attracting, hiring and retaining qualified personnel; ● our ability to successfully commercialize any product candidates for which we obtain regulatory approval; and ● the cost of preparing, filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for clinical trials and other research and development expenditures. Because of the numerous risks and uncertainties associated with the development and commercialization of our product candidates, we are unable to estimate the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical studies. If we need to raise additional capital to fund our operations, funding may not be available to us on acceptable terms, or at all. If we are unable to obtain adequate financing when needed, we may have to delay, reduce the scope of or suspend one or more of our preclinical studies, clinical trials, research and development programs or commercialization efforts. We may seek to raise any necessary additional capital through a combination of public or private equity offerings, debt financings, collaborations and other licensing arrangements. If we raise additional capital through debt financing, we may be subject to covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. Cash Flows The following summarizes our cash flows for the periods indicated: Cash Flows from Operating Activities During the year ended December 31, 2019, cash used in operating activities was $29.9 million, which consisted of a net loss of $35.1 million, adjusted by a net change of $0.9 million in our net operating assets and liabilities and non-cash charges of $4.3 million. The non-cash charges consisted of $1.3 million for depreciation and amortization and $4.0 million for stock-based compensation expense, offset by $1.0 million of amortization of premium and discounts on marketable securities. The change in our net operating assets and liabilities was primarily due to an increase of $0.5 million in prepaid expenses and other current assets and a decrease of $0.8 million in operating lease liabilities, offset by an increase of $2.2 million in accounts payable and accrued expenses due to timing of payments and increased clinical and manufacturing expenditures. During the year ended December 31, 2018, cash used in operating activities was $20.8 million, which consisted of a net loss of $23.2 million, adjusted by non-cash charges of $2.3 million and a net change of $0.1 million in our net operating assets and liabilities. The non-cash charges consisted of $0.2 million for depreciation and amortization, $2.0 million for stock-based compensation expense and $0.1 million for loss on disposal of property and equipment. The change in our net operating assets and liabilities was primarily due to an increase of $1.0 million in prepaid expenses, including upfront payments for insurance premiums, clinical and toxicology activities, offset by an increase of $1.4 million in accounts payable, accrued expenses and other liabilities due to professional services, manufacturing and clinical expenditures as well as an increase of $0.3 million related to deferred rent. During the year ended December 31, 2017, cash used in operating activities was $8.1 million, which consisted of a net loss of $8.5 million, adjusted by non-cash charges of $0.4 million. The non-cash charges are primarily comprised of $0.2 million for depreciation and amortization and of $0.2 million for stock-based compensation expense. The change in our net operating assets and liabilities was primarily due to an increase in payroll-related accruals of $0.4 million and clinical expenditures of $0.3 million and an increase in prepaid expenses of $0.6 million, including advance payments for clinical activities. Cash Flows from Investing Activities During the year ended December 31, 2019, cash provided by investing activities was $20.4 million primarily relating to the maturities of marketable securities $123.3 million exceeding purchases of such marketable securities $102.3 million. During the year ended December 31, 2018, cash used in investing activities was $83.9 million primarily consisted of $119.2 million in purchases of marketable securities offset by $36.5 million of maturities of such marketable securities. Payments for the purchases of property and equipment was $0.6 million, $1.1 million and $0.4 million during the years ended December 31, 2019, 2018 and 2017, respectively. Cash Flows from Financing Activities During the year ended December 31, 2019, cash provided by financing activities was $0.3 million, consisting of proceeds from the issuance of common stock pursuant to our employee equity plans. During the year ended December 31, 2018, cash provided by financing activities was $77.9 million consisting of $77.7 million in net proceeds from our IPO and $0.2 million from the issuance of common stock pursuant to our employee equity plans. During the year ended December 31, 2017, cash provided by financing activities consisted of $49.8 million in net proceeds from the issuance of Series B redeemable convertible preferred stock. Contractual Obligations and Other Commitments The following table summarizes our contractual obligations as of December 31, 2019 (in millions): (1) Amounts in the table represent the operating lease obligations of office and laboratory space at 4000 Shoreline Court, South San Francisco, California. The minimum lease payments above do not include common area maintenance charges or real estate taxes. Except as disclosed in the table above, we have no long-term debt or capital leases and no material non-cancelable purchase commitments with service providers, as we have generally contracted on a cancelable, purchase order basis. The contractual obligations table does not include any potential contingent payments upon the achievement by us of clinical, regulatory and commercial events, as applicable, or royalty payments that we may be required to make under license agreements we have entered into or may enter into with various entities pursuant to which we have in-licensed certain intellectual property, including our Onyx License Agreement. Under the Onyx License Agreement, we are obligated to pay Onyx milestone payments of up to $172.5 million in the aggregate upon the achievement of certain development, regulatory and sales milestones. We excluded the contingent payments given that the timing and amount (if any) of any such payments cannot be reasonably estimated at this time. See the section titled “Business-License Agreement with Onyx” for additional information. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements and do not have holdings in any variable interest entities. JOBS Act Accounting Election We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards and, therefore, will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. In addition, we intend to rely on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if as an “emerging growth company” we intend to rely on such exemptions, we are not required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404(b) of the Sarbanes-Oxley Act of 2002, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the Public Company Accounting Oversight Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation-related items such as the correlation between executive compensation and performance and comparisons of the Chief Executive Officer’s compensation to median employee compensation. These exemptions will apply until December 31, 2023 or until we no longer meet the requirements of being an emerging growth company, whichever is earlier.

<s>[INST] Overview We are a clinicalstage biotechnology company, discovering and developing novel small molecule therapeutics to treat unmet needs in autoimmunity and cancer. We are developing our lead product candidate, KZR616, a firstinclass selective immunoproteasome inhibitor, in severe autoimmune diseases where limited treatment options exist. We are conducting three Phase 2 clinical trials of KZR616 across five separate autoimmune diseases of high unmet need: the MISSION trial in patients with lupus nephritis; the PRESIDIO trial in patients with dermatomyositis or polymyositis; and the MARINA trial in patients with autoimmune hemolytic anemia or immune thrombocytopenia. We believe that the immunoproteasome is a validated target for the treatment of a wide variety of autoimmune diseases given the compelling published activity seen with nonselective proteasome inhibitors administered to patients with severe autoimmune diseases. Based on results from our Phase 1a studies in healthy volunteers and the preliminary results from the Phase 1b portion of the MISSION trial in patients with systemic lupus erythematosus, also known as lupus or SLE, KZR616 has largely avoided adverse effects associated with currently marketed nonselective proteasome inhibitors, as exhibited in clinical studies conducted by third parties, including side effects which we believe prevent them from being utilized as a chronic treatment in autoimmune disorders. In addition, we have seen encouraging clinical activity and biomarker data in SLE patients. Additionally, we are advancing our novel research platform targeting the Sec61 translocon and the protein secretion pathway to discover and develop small molecule therapeutics targeting oncology indications. Our first clinical candidate in this program, KZR261, has demonstrated broad antitumor activity in preclinical models of both solid and hematologic malignancies. KZR261 is undergoing laboratory studies and manufacturing activities in support of an investigational new drug application, which we anticipate submitting to the U.S. Food and Drug Administration in the first quarter of 2021 for a Phase 1 clinical trial in solid tumors. We believe this discovery platform has the potential to yield oral small molecule candidates that, if successfully developed and approved, could serve as alternatives to currently marketed biologic therapeutics to act as cytotoxic anticancer agents or to block the secretion of novel targets of interest in immunooncology or inflammation. Since the commencement of our operations in 2015, we have devoted substantially all our resources to performing research and development activities in support of our product development efforts, hiring personnel, raising capital to support and expand such activities and providing general and administrative support for these operations. We do not have any products approved for sale and have not generated any revenue from product sales. We have funded our operations to date primarily from the issuance and sale of convertible preferred stock and from public offerings of common stock and prefunded warrants to purchase common stock as described below. We acquired exclusive worldwide rights to KZR616 and an accompanying library of similar molecules pursuant to a license agreement, or the Onyx License Agreement, with Onyx Therapeutics, Inc., or Onyx, a wholly owned subsidiary of Amgen, Inc. in June 2015. Patent coverage for KZR616 extends to at least 2034. In July 2019, we filed a shelf registration statement on Form S3 (Registration No. 333232542) that allows us to sell up to an aggregate of $150 million of our securities, which includes up to $50.0 million designated in a prospectus supplement for an atthemarket offering program, or ATM program. As of December 31, 2019, we sold no shares of common stock under the ATM program. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the successful development and eventual commercialization of one or more of our current or future product candidates and [/INST] Negative. </s>

Union Acquisition Corp.

2018-04-30

2018-01-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Certain information contained in the discussion and analysis set forth below includes forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. Overview We are a blank check company formed on November 14, 2017 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more target businesses. We intend to effectuate our initial business combination using cash from the proceeds of the IPO and the sale of the Private Placement Warrants, our capital stock, debt or a combination of cash, stock and debt. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our IPO, which was consummated on March 2, 2018. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from November 14, 2017 (inception) to January 31, 2018 were organizational activities and those necessary to consummate the IPO, described below. Following the IPO, we do not expect to generate any operating revenues until after the completion of our business combination. We expect to generate non-operating income in the form of interest income on cash and marketable securities held after the IPO. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the period from November 14, 2017 (inception) through January 31, 2018, we had a net loss of $12,765 which consists of operating and formation costs. Liquidity and Capital Resources As of January 31, 2018, we had cash of $112,067. Until the consummation of the IPO, our liquidity needs were satisfied through the receipt of $25,000 from our sale of the Founder Shares, and unsecured loans from our sponsor. On March 2, 2018, we consummated the IPO of 11,500,000 Units, which includes the full exercise by the underwriters of their over-allotment option in the amount of 1,500,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $115,000,000. Simultaneously with the closing of the IPO, we consummated the sale of 5,200,000 Private Placement Warrants to our sponsor at a price of $1.00 per warrant, generating gross proceeds of $5,200,000. Following the IPO and the sale of the Private Placement Warrants, a total of $116,150,000 was placed in the Trust Account and, following the payment of certain transaction expenses, we had approximately $1,377,000 of cash held outside of the Trust Account and available for working capital purposes. We incurred $2,724,997 in IPO related costs, including $2,300,000 of underwriting fees and $424,997 of other costs. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account (less taxes payable) to complete our initial Business Combination. We may withdraw interest from the trust account to pay franchise and income taxes. To the extent that our equity or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a business combination. In order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, our sponsor or an affiliate of our sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant at the option of the lender. The warrants would be identical to the Private Placement Warrants. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business prior to our initial business combination. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. Moreover, we may need to obtain additional financing either to complete our business combination or because we become obligated to redeem a significant number of our public shares upon completion of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. Off-Balance Sheet Arrangements; Commitments and Contractual Obligations We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of January 31, 2018. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities other than an agreement to pay an affiliate of our sponsor a monthly fee of $10,000 for office space, utilities and administrative support provided to the Company. We began incurring these fees on February 27, 2018 and will continue to incur these fees monthly until the earlier of the completion of the business combination and the Company’s liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. The Company has not identified any critical accounting policies. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements.

<s>[INST] Overview We are a blank check company formed on November 14, 2017 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more target businesses. We intend to effectuate our initial business combination using cash from the proceeds of the IPO and the sale of the Private Placement Warrants, our capital stock, debt or a combination of cash, stock and debt. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our IPO, which was consummated on March 2, 2018. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from November 14, 2017 (inception) to January 31, 2018 were organizational activities and those necessary to consummate the IPO, described below. Following the IPO, we do not expect to generate any operating revenues until after the completion of our business combination. We expect to generate nonoperating income in the form of interest income on cash and marketable securities held after the IPO. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the period from November 14, 2017 (inception) through January 31, 2018, we had a net loss of $12,765 which consists of operating and formation costs. Liquidity and Capital Resources As of January 31, 2018, we had cash of $112,067. Until the consummation of the IPO, our liquidity needs were satisfied through the receipt of $25,000 from our sale of the Founder Shares, and unsecured loans from our sponsor. On March 2, 2018, we consummated the IPO of 11,500,000 Units, which includes the full exercise by the underwriters of their overallotment option in the amount of 1,500,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $115,000,000. Simultaneously with the closing of the IPO, we consummated the sale of 5,200,000 Private Placement Warrants to our sponsor at a price of $1.00 per warrant, generating gross proceeds of $5,200,000. Following the IPO and the sale of the Private Placement Warrants, a total of $116,150,000 was placed in the Trust Account and, following the payment of certain transaction expenses, we had approximately $1,377,000 of cash held outside of the Trust Account and available for working capital purposes. We incurred $2,724,997 in IPO related costs, including $2,300,000 of underwriting fees and $424,997 of other costs. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account (less taxes payable) to complete our initial Business Combination. We may withdraw interest from the trust account to pay franchise and income taxes. To the extent that our equity or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a business combination. In order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, our sponsor or an affiliate of our sponsor or certain of our officers and directors may [/INST] Positive. </s>

Union Acquisition Corp.

2019-03-05

2019-01-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Certain information contained in the discussion and analysis set forth below includes forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. Recent Developments On November 8, 2018, we entered into the Exchange Agreement. Pursuant to the Exchange Agreement, among other things, (i) Bioceres S.A., an Argentine corporation and the parent company of Bioceres, Inc., will form a new entity, New Bioceres Inc., a Delaware corporation (“Bioceres”), and Bioceres, Inc. will contribute all of its assets and liabilities to Bioceres, in exchange for all of the Bioceres stock; (ii) Bioceres, Inc. will convert into a Delaware limited liability company, Bioceres LLC; and (iii) Bioceres S.A. will contribute all of its equity interest in its majority owned subsidiary, Bioceres Semillas to Bioceres LLC. Following the Reorganization, Bioceres LLC will contribute all if its equity interest in Bioceres and Bioceres Semillas to our company in exchange for 27,116,174 UAC Shares and 7,500,000 warrants. In addition, the consideration payable in connection with the minority ownership of Bioceres Semillas, if the minority holders exercise their tag-along rights in connection with the consummation of the Business Combination, will be in the form of UAC Shares and/or cash and shall be equal to an amount not to exceed $2,000,000 to be payable to the minority holders of Bioceres Semillas by Bioceres S.A. The number of UAC Shares exchanged for Bioceres stock and all of the issued and outstanding stock of Bioceres Semillas owned by Bioceres LLC shall not exceed 27,116,174. Upon the consummation of the Business Combination, all of the Bioceres stock outstanding immediately prior to the effective time of the Exchange shall be automatically cancelled, extinguished and converted into 27,116,174 UAC Shares and 7,500,000 UAC Warrants. The consummation of the Business Combination is subject to (a) the Company having at least $5,000,001 of net tangible assets upon closing of the Business Combination, (b) the listing of the combined company’s shares on the New York Stock Exchange upon the closing of the Business Combination, (c) the consummation of the transactions contemplated by the Exchange Agreement, (d) the exercise of the Rizobacter option (as such term is defined in the Exchange Agreement); (e) the indebtedness of the Group Companies (as such term is defined in the Exchange Agreement) not to exceed $101 million; and (f) no Bioceres Material Adverse Effect (as such term is defined in the Exchange Agreement) having occurred. Overview We are a Cayman Islands exempted company incorporated on November 14, 2017 for the purpose of entering into a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization, or other similar business combination with one or more businesses or entities. On March 2, 2018, we consummated our initial public offering (“IPO”) of 11,500,000 units, including 1,500,000 units which were subject to the over-allotment option granted to the underwriters of the IPO, with each unit consisting of one ordinary share, one right, and one redeemable warrant. Each right is exchangeable for one-tenth (1/10) of one ordinary share upon the consummation of our initial business combination. Each warrant will become exercisable on the later of the completion of an initial business combination or March 2, 2019 and will expire on the fifth anniversary of our completion of an initial business combination, or earlier upon redemption or liquidation. The ordinary shares, rights, and warrants included in the units traded as a unit until March 19, 2018 when separate trading of ordinary shares, rights, and warrants began. Holders now have the option to continue to hold units or separate their units into the component pieces. The units were sold at an offering price of $10.00 per unit, generating gross proceeds of $115,000,000. Simultaneously with the consummation of the IPO, we consummated the private placement of 5,200,000 Private Placement Warrants at a price of $1.00 per warrant, generating total proceeds of $5,200,000. The Private Placement Warrants were purchased by certain of our initial shareholders. The Private Placement Warrants are identical to the warrants included in the units sold in the IPO and are exercisable on a cashless basis only. Additionally, the purchasers of the Private Placement Warrants have agreed not to transfer, assign, or sell any of the Private Placement Warrants (except to certain permitted transferees) until the completion of the Company’s initial business combination. All activity through January 31, 2019 related to our formation, the IPO, our search for a target business with which to complete an initial business combination and activities in connection with the proposed Business Combination with Bioceres, Inc. Results of Operations We will not generate any operating revenues until the closing and completion of our initial business combination. We are incurring expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended January 31, 2019, we had a net income of $742,351, which consists of dividend income on marketable securities held in the Trust Account of $1,714,549, offset by operating costs of $972,198. For the period from November 14, 2017 (inception) through January 31, 2018, we had a net loss of $12,765 which consists of operating and formation costs. Liquidity and Capital Resources On March 2, 2018, we consummated the IPO of 11,500,000 Units, which includes the full exercise by the underwriters of their over-allotment option in the amount of 1,500,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $115,000,000. Simultaneously with the closing of the IPO, we consummated the sale of 5,200,000 Private Placement Warrants to our Initial Shareholders at a price of $1.00 per warrant, generating gross proceeds of $5,200,000. Following the IPO and the sale of the Private Placement Warrants, a total of $116,150,000 was placed in the Trust Account. We incurred $2,724,997 in IPO related costs, consisting of $2,300,000 of underwriting fees and $424,997 of other costs. For the year ended January 31, 2019, cash used in operating activities was $1,000,234. Net income of $742,351 was offset by dividend income earned on marketable securities held in the Trust Account of $1,714,549 and changes in operating assets and liabilities, which used $28,036 of cash. At January 31, 2019, we had marketable securities held in the Trust Account of $117,864,549. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing income earned on the Trust Account (less taxes payable) to complete our initial business combination. We may withdraw income from the Trust Account to pay franchise and income taxes. To the extent that our equity or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. At January 31, 2019, we had cash and cash equivalents of $337,004 held outside the Trust Account. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a business combination. In order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, our Initial Shareholders or an affiliate of our Initial Shareholders or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant at the option of the lender. The warrants would be identical to the Private Placement Warrants. As of December 31, 2018, we had cash and cash equivalents of $337,004 held outside of the Trust Account and working capital of $365,040. Until the consummation of an initial business combination, we will be using the funds not held in the Trust Account for primarily to identify a target business, undertake in-depth due diligence and negotiate an initial business combination. Our Initial Shareholders, officers, directors or their affiliates are not under any obligation to advance us funds, or to invest in us. Accordingly, we may not be able to obtain additional financing. If we are unable to raise additional capital, we may be required to take additional measures to conserve liquidity, which could include, but not necessarily be limited to, curtailing operations, suspending the pursuit of a potential transaction, and reducing overhead expenses. We cannot provide any assurance that new financing will be available to us on commercially acceptable terms, if at all. These conditions raise substantial doubt about our ability to continue as a going concern. Off-Balance Sheet Arrangements; Commitments and Contractual Obligations We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of January 31, 2019. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities other than an agreement to pay two affiliates of certain of the Company's officers and directors a monthly fee of $10,000 for office space, utilities and administrative support provided to the Company. We began incurring these fees on February 27, 2018 and will continue to incur these fees monthly until the earlier of the completion of the business combination and the Company’s liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policy: Ordinary shares subject to possible redemption We account for our ordinary shares subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Ordinary shares subject to mandatory redemption are classified as a liability instrument and are measured at fair value. Conditionally redeemable ordinary shares (including ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. Our ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, at January 31, 2019, the ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of our balance sheet. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements.

<s>[INST] Recent Developments On November 8, 2018, we entered into the Exchange Agreement. Pursuant to the Exchange Agreement, among other things, (i) Bioceres S.A., an Argentine corporation and the parent company of Bioceres, Inc., will form a new entity, New Bioceres Inc., a Delaware corporation (“Bioceres”), and Bioceres, Inc. will contribute all of its assets and liabilities to Bioceres, in exchange for all of the Bioceres stock; (ii) Bioceres, Inc. will convert into a Delaware limited liability company, Bioceres LLC; and (iii) Bioceres S.A. will contribute all of its equity interest in its majority owned subsidiary, Bioceres Semillas to Bioceres LLC. Following the Reorganization, Bioceres LLC will contribute all if its equity interest in Bioceres and Bioceres Semillas to our company in exchange for 27,116,174 UAC Shares and 7,500,000 warrants. In addition, the consideration payable in connection with the minority ownership of Bioceres Semillas, if the minority holders exercise their tagalong rights in connection with the consummation of the Business Combination, will be in the form of UAC Shares and/or cash and shall be equal to an amount not to exceed $2,000,000 to be payable to the minority holders of Bioceres Semillas by Bioceres S.A. The number of UAC Shares exchanged for Bioceres stock and all of the issued and outstanding stock of Bioceres Semillas owned by Bioceres LLC shall not exceed 27,116,174. Upon the consummation of the Business Combination, all of the Bioceres stock outstanding immediately prior to the effective time of the Exchange shall be automatically cancelled, extinguished and converted into 27,116,174 UAC Shares and 7,500,000 UAC Warrants. The consummation of the Business Combination is subject to (a) the Company having at least $5,000,001 of net tangible assets upon closing of the Business Combination, (b) the listing of the combined company’s shares on the New York Stock Exchange upon the closing of the Business Combination, (c) the consummation of the transactions contemplated by the Exchange Agreement, (d) the exercise of the Rizobacter option (as such term is defined in the Exchange Agreement); (e) the indebtedness of the Group Companies (as such term is defined in the Exchange Agreement) not to exceed $101 million; and (f) no Bioceres Material Adverse Effect (as such term is defined in the Exchange Agreement) having occurred. Overview We are a Cayman Islands exempted company incorporated on November 14, 2017 for the purpose of entering into a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization, or other similar business combination with one or more businesses or entities. On March 2, 2018, we consummated our initial public offering (“IPO”) of 11,500,000 units, including 1,500,000 units which were subject to the overallotment option granted to the underwriters of the IPO, with each unit consisting of one ordinary share, one right, and one redeemable warrant. Each right is exchangeable for onetenth (1/10) of one ordinary share upon the consummation of our initial business combination. Each warrant will become exercisable on the later of the completion of an initial business combination or March 2, 2019 and will expire on the fifth anniversary of our completion of an initial business combination, or earlier upon redemption or liquidation. The ordinary shares, rights, and warrants included in the units traded as a unit until March 19, 2018 when separate trading of ordinary shares, rights, and warrants began. Holders now have the option to continue to hold units or separate their units into the component pieces. The units were sold at an offering price of $10.00 per unit, generating gross proceeds of [/INST] Positive. </s>

Bank First National Corp

2019-03-26

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our consolidated financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes. Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods. We are a bank holding company and we conduct all of our material business operations through the Bank. As a result, the discussion and analysis above relates to activities primarily conducted at the Bank level. We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this Annual Report. OVERVIEW Bank First National Corporation is a Wisconsin corporation that was organized primarily to serve as the holding company for Bank First, N.A. Bank First, N.A., which was incorporated in 1894, is a nationally-chartered bank headquartered in Manitowoc, Wisconsin. It is a member of the Federal Reserve, and is regulated by the OCC. Including its headquarters in Manitowoc, Wisconsin, the Bank has 18 banking locations in Manitowoc, Outagamie, Brown, Winnebago, Sheboygan, Waupaca and Barron counties in Wisconsin. The Bank offers loan, deposit and treasury management products at each of its banking locations. As with most community banks, the Bank derives a significant portion of its income from interest received on loans and investments. The Bank’s primary source of funding is deposits, both interest-bearing and noninterest-bearing. In order to maximize the Bank’s net interest income, or the difference between the income on interest-earning assets and the expense of interest-bearing liabilities, the Bank must not only manage the volume of these balance sheet items, but also the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities. To account for credit risk inherent in all loans, the Bank maintains an Allowance for Loan and Lease Losses (“ALLL”) to absorb possible losses on existing loans that may become uncollectible. The Bank establishes and maintains this allowance by charging a provision for loan losses against operating earnings. Beyond its net interest income, the Bank further receives income through the net gain on sale of loans held for sale as well as servicing income which is retained on those sold loans. In order to maintain its operations and bank locations, the Bank incurs various operating expenses which are further described within the “Results of Operations” later in this section. The Bank is a 49.8% member of a data processing subsidiary, UFS, LLC, which provides core data processing, endpoint management cloud services, cyber security and digital banking solutions for over 60 Midwest banks. The Bank, through its 100% owned subsidiary TVG Holdings, Inc., also holds a 30% ownership interest in Ansay & Associates, LLC, an insurance agency providing clients primarily located in Wisconsin with insurance and risk management solutions. These unconsolidated subsidiary interests contribute noninterest income to the Bank through their underlying annual earnings. As of December 31, 2018, the Company had total consolidated assets of  $1.79 billion, total loans of  $1.43 billion, total deposits of  $1.56 billion and total stockholders’ equity of  $174.3 million. The Company employs approximately 253 full-time equivalent employees and has an assets-to-FTE ratio of approximately $7.1 million. For more information, see the Company’s website at www.bankfirstwi.bank. Recent acquisitions On October 27, 2017, the Company completed a merger with Waupaca Bancorporation, Inc. (“Waupaca”), a bank holding company headquartered in Waupaca, Wisconsin, pursuant to an Agreement and Plan of Merger, dated as of May 11, 2017 and as amended on July 20, 2017, by and among the Company, BFNC Merger Sub, LLC, a wholly-owned subsidiary of the Company, and Waupaca, whereby Waupaca merged with and into the Company, and First National Bank, Waupaca’s wholly-owned banking subsidiary, was merged with and into the Bank. Waupaca’s principal activity was the ownership and operation of First National Bank, a national banking institution that operated eight (8) branches in Wisconsin at the time of closing. The merger consideration totaled approximately $78,060,000, 70% of which was distributed in cash and 30% of which was distributed in the form of Company common stock. On January 22, 2019, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Partnership Community Bancshares, Inc., a Wisconsin Corporation (“PCB”), pursuant to which PCB will merge with and into the Company, and Partnership Bank, PCB’s wholly-owned banking subsidiary, will merge with and into the Bank. On the terms and subject to the conditions set forth in the Merger Agreement, the Company has committed to purchase from PCB all of the issued and outstanding shares of PCB common stock in a combined stock-and-cash transaction, pursuant to which each PCB shareholder will receive either $17.3832 in cash or 0.35047 of a share of the Company’s common stock in exchange for each share of PCB common stock. The acquisition is valued at approximately $41.0 million at the date of announcement, and the merger consideration will consist of 65% in common stock of the Company and 35% in cash. As of December 31, 2018, PCB had approximately $306.8 million in consolidated assets, $267.1 million in net loans, $261.6 million in deposits and $21.6 million in consolidated stockholders’ equity. Consummation of the merger is subject to, among other things, the receipt of approval by regulatory authorities and PCB shareholders. The acquisition is expected to be completed sometime in the third quarter of 2019. CRITICAL ACCOUNTING POLICIES The accounting and reporting policies of the Company conform to GAAP in the United States and general practices within the financial institution industry. Significant accounting and reporting policies are summarized below. Business Combinations We account for business combinations under the acquisition method of accounting in accordance with Accounting Standards Codification (ASC) 805, Business Combinations (ASC 805). We recognize the full fair value of the assets acquired and liabilities assumed and immediately expense transaction costs. There is no separate recognition of the acquired ALLL on the acquirer’s balance sheet as credit related factors are incorporated directly into the fair value of the net tangible and intangible assets acquired. If the amount of consideration exceeds the fair value of assets purchased less the fair value of liabilities assumed, goodwill is recorded. Alternatively, if the amount by which the fair value of assets purchased exceeds the fair value of liabilities assumed and consideration paid, a gain (bargain purchase gain) is recorded. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available. Results of operations of the acquired business are included in the statement of income from the effective date of the acquisition. Allowance for Loan and Lease Losses-Originated The ALLL is established through a provision for loan losses charged to expense as losses are estimated to have occurred. Loan losses are charged against the allowance when management believes that the collectability of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance. Management regularly evaluates the ALLL using general economic conditions, our past loan loss experience, composition of the portfolio, credit worthiness of the borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses and other relevant factors. This evaluation is inherently subjective since it requires material estimates that may be susceptible to significant change. The ALLL consists of specific reserves for certain impaired loans and general reserves for non-impaired loans. Specific reserves reflect estimated losses on impaired loans from management’s analyses developed through specific credit allocations. The specific credit reserves are based on regular analyses of impaired non-homogenous loans. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general reserve is based on our historical loss experience which is updated quarterly. The general reserve portion of the ALLL also includes consideration of certain qualitative factors such as (1) changes in lending policies and/or underwriting practices, (2) national and local economic conditions, (3) changes in portfolio volume and nature, (4) experience, ability and depth of lending management and other relevant staff, (5) levels of and trends in past-due and nonaccrual loans and quality, (6) changes in loan review and oversight, (7) impact and effects of concentrations and (8) other issues deemed relevant. Management believes that the current ALLL is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the ALLL. Such agencies may require us to recognize additions to the allowance based on their judgments of information available to them at the time of their examination. Allowance for Loan and Lease Losses-Acquired The ALLL for acquired loans is calculated using a methodology similar to that described for originated loans. Performing acquired loans are subsequently evaluated for any required allowance at each reporting date. Such required allowance for each loan pool is compared to the remaining fair value discount for that pool. If greater, the excess is recognized as an addition to the allowance through a provision for loan losses. If less than the discount, no additional allowance is recorded. Charge-offs and losses first reduce any remaining fair value discount for the loan pool and once the discount is depleted, losses are applied against the allowance established for that pool. For purchase credit impaired loans after an acquisition, cash flows expected to be collected are recast for each loan periodically as determined appropriate by management. If the present value of expected cash flows for a loan is less than its carrying value, impairment is reflected by an increase in the ALLL and a charge to the provision for loan losses. If the present value of the expected cash flows for a loan is greater than its carrying value, any previously established ALLL is reversed and any remaining difference increases the accretable yield which will be taken into income over the remaining life of the loan. Loans which were considered troubled debt restructurings (“TDRs”) by the acquired institution prior to the acquisition are not required to be classified as TDRs in our consolidated financial statements unless or until such loans would subsequently meet our criteria to be classified as such, since acquired loans were recorded at their estimated fair values at the time of the acquisition. Impaired Investment Securities Unrealized gains or losses considered temporary and the noncredit portion of unrealized losses deemed other-than-temporary are reported as an increase or decrease in accumulated other comprehensive income. The credit related portion of unrealized losses deemed other-than-temporary is recorded in current period earnings. Realized gains or losses, determined on the basis of the cost of specific securities sold, are included in earnings. We evaluate securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. As part of such monitoring, the credit quality of individual securities and their issuers are assessed. In addition, management considers the length of time and extent that fair value has been less than cost, the financial condition and near-term prospects of the issuer, and that the Company does not have the intent to sell the security and it is more likely than not that it will not have to sell the security before recovery of its cost basis. Adjustments to market value that are considered temporary are recorded as a separate component of equity, net of tax. If an impairment of security is identified as other-than-temporary based on information available such as the decline in the credit worthiness of the issuer, external market ratings or the anticipated or realized elimination of associated dividends, such impairments are further analyzed to determine if a credit loss exists. If there is a credit loss, it will be recorded in the consolidated statement of income in the period of identification. Intangible Assets and Goodwill Intangible assets consist of the value of core deposits and mortgage servicing assets and the excess of purchase price over fair value of net assets (“goodwill”). The value of core deposits is stated at cost less accumulated amortization and is amortized on a sum of the years digits basis over a period of one to ten years. Mortgage servicing rights are recognized as separate assets when rights are acquired through purchase or through sale of mortgage loans with servicing retained. Servicing rights acquired through sale of financial assets are recorded based on the fair value of the servicing right. The determination of fair value is based on a valuation model and includes stratifying the mortgage servicing rights by predominant characteristics, such as interest rates and terms, and estimating the fair value of each stratum based on the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as costs to service, a discount rate, and prepayment speeds. Changes in fair value are recorded as an adjustment to earnings. We perform a “qualitative” assessment of goodwill to determine whether further impairment testing of indefinite-lived intangible assets is necessary on at least an annual basis. If it is determined, as a result of performing a qualitative assessment over goodwill, that it is more likely than not that goodwill is impaired, management will perform an impairment test to determine if the carrying value of goodwill is realizable. Deferred Tax Assets Deferred tax assets (“DTA”) and liabilities are determined using the liability method. DTAs and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities and the current enacted tax rates which will be in effect when these differences are expected to reverse. Provision (benefit) for deferred taxes is the result of changes in the DTAs and liabilities. Deferred taxes are reviewed quarterly and would be reduced by a valuation allowance if, based upon the information available, it is more likely than not that some or all of the DTAs will not be realized. Recent Accounting Developments In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (ASU 2014-09). ASU 2014-09 implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract and (v) recognize revenue when (or as) the entity satisfies a performance obligation. ASU 2015-14, Revenue from Contracts with Customers (Topic 606) (ASU 2015-14) was issued in August 2015 which deferred adoption to annual reporting periods beginning after December 15, 2017 and interim reporting periods within those annual periods. The timing of the Company’s revenue recognition did not materially change. Our largest portions of revenue, interest and fees on loans and gain on sales of loans, are specifically excluded from the scope of the guidance, and we currently recognize the majority of the remaining revenue sources in a manner that management believes is consistent with the new guidance. An unconsolidated subsidiary of the Bank did have a material impact as a result of this ASU, and implementation resulted in an increase of  $1,588,000 to retained earnings during 2018. In January 2016, the FASB issued ASU 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01). This guidance changes how entities account for equity investments that do not result in consolidation and are not accounted for under the equity method of accounting. Entities will be required to measure these investments at fair value at the end of each reporting period and recognize changes in fair value in net income. A practicability exception will be available for equity investments that do not have readily determinable fair values; however, the exception requires the Company to adjust the carrying amount for impairment and observable price changes in orderly transactions for the identical or a similar investment of the same issuer. This guidance also changes certain disclosure requirements and other aspects of current GAAP. This guidance was effective for fiscal years beginning after December 15, 2017 including interim reporting periods within those fiscal years. The adoption of this ASU did not have a material impact on our consolidated financial statements. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (ASU 2016-02). Certain aspects of this ASU were updated in July 2018 by the issuance of ASU 2018-10, Codification Improvements to Topic 842, Leases. The new guidance establishes the principles to report transparent and economically neutral information about the assets and liabilities that arise from leases. Entities will be required to recognize the lease assets and lease liabilities that arise from leases in the statement of financial position and to disclose qualitative and quantitative information about lease transactions, such as information about variable lease payments and options to renew and terminate leases. This guidance is effective for fiscal years beginning after December 15, 2018 including interim reporting periods within those fiscal years. Our assets and liabilities will increase based on the present value of the remaining lease payments for leases in place at the adoption date; however, this is not expected to be material to our results of operations due to the immaterial nature of lease agreements in existence. In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. Certain aspects of this ASU were updated in November 2018 by the issuance of ASU 2018-19, Codification Improvements to Topic 326, Financial Instruments-Credit Losses. The main objective of the ASU is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in the ASU replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. This ASU is effective for the Company for the fiscal year beginning after December 15, 2019, including interim periods within those fiscal years. Early adoption is permitted for the fiscal year beginning after December 15, 2018, including interim periods within this fiscal year. We are currently evaluating the impact of ASU 2016-13 on the consolidated financial statements, although the general expectation in the banking industry is that the implementation of this standard will result in higher required balances in the ALLL. In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this ASU were issued to address concerns over the cost and complexity of the two-step goodwill impairment test and resulted in the removal of the second step of the test. The amendments require an entity to apply a one-step quantitative test and record the amount of goodwill impairment as the excess of a reporting unit’s carrying amount over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit. The new guidance does not amend the optional qualitative assessment of goodwill impairment. This ASU is intended to reduce the cost and complexity of the two-step goodwill impairment test and is effective for annual and interim goodwill impairment tests in fiscal years beginning after December 15, 2019, with early adoption permitted for testing performed after January 1, 2017. Upon adoption, the amendments should be applied on a prospective basis and the entity is required to disclose the nature of and reason for the change in accounting principle upon transition. The adoption of this guidance is not expected to have a significant impact on our consolidated financial statements. In March 2017, the FASB issued ASU 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The amendments in this ASU shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount as discounts continue to be accreted to maturity. This ASU is intended to more closely align the amortization period of premiums and discounts to expectations incorporated in market pricing on the underlying securities. In most cases, market participants price securities to the call date that produces the worst yield when the coupon is above current market rates and prices securities to maturity when the coupon is below market rates. As a result, the amendments more closely align interest income recorded on bonds held at a premium or a discount with the economics of the underlying instrument. This ASU is intended to reduce diversity in practice and is effective for fiscal years beginning after December 15, 2018, with early adoption permitted. Upon adoption, the amendments should be applied using a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. Additionally, in the period of adoption, an entity should provide disclosures about a change in accounting principles. The adoption of this guidance is not expected to have a significant impact on our consolidated financial statements. In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. The amendments of this ASU better align an entity’s accounting and financial reporting for hedging activities with the economic objectives of those activities. The ASU is effective for fiscal years beginning after December 15, 2018 and interim reporting periods within those fiscal years, with early adoption permitted. The adoption of this guidance is not expected to have a significant impact on our consolidated financial statements. In February 2018, the FASB issued ASU 2018-02, Certain Income Tax Effects within Accumulated Other Comprehensive Income. The amendments in this ASU allow entities to release the income tax effects from other comprehensive income that resulted from H.R.1, An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018 (“Tax Cuts and Jobs Act”). We have elected, as allowed under this amendment, to reclassify the effects of the Tax Cuts and Jobs Act, totaling $161,000, from accumulated other comprehensive income to retained earnings during the year ended December 31, 2017. In June 2018, the FASB issued ASU 2018-07, Stock Compensation-Improvements to Nonemployee Share-Based Payment Accounting, which simplifies several aspects of the account for nonemployee share-based payment transactions for acquiring goods or services from nonemployees. The amendment is effective for the fiscal years beginning after December 15, 2018, including interim reporting periods within those fiscal years, with early adoption permitted. The adoption of this guidance is not expected to have a significant impact on our consolidated financial statements. PUBLIC COMPANY COSTS On September 24, 2018, the Company filed a Registration Statement on Form 10 with the SEC, and filed the Amendment No.1 to the Registration Statement on Form 10 on October 17, 2018. That Registration Statement was declared effective by the SEC on October 23, 2018. The Company qualifies as an “emerging growth company” as defined by the Jumpstart Our Business Startups Act (“JOBS Act”). There are additional costs associated with operating as a public company including hiring additional personnel, enhancing technology and expanding our capabilities. We expect that these costs will include legal, regulatory, accounting, investor relations and other expenses that we did not incur as a private company. Sarbanes-Oxley, as well as rules adopted by the SEC, the FDIC and national securities exchanges also requires public companies to implement specified corporate governance practices. In addition, due to regulatory changes in the banking industry and the implementation of new laws, rules and regulations, we are now subject to higher regulatory compliance costs. These additional rules and regulations also increase our legal, regulatory, accounting and financial compliance costs and make some activities more time-consuming. TAX LEGISLATION CHANGES On December 22, 2017, the Tax Cuts and Jobs Act was enacted into law. The Tax Cuts and Jobs Act provides for significant changes to the U.S. tax code that impact businesses. Effective January 1, 2018, the Tax Cuts and Jobs Act reduced the U.S. federal tax rate for corporations from 35% to 21% for U.S. taxable income and required a one-time remeasurement of deferred taxes to reflect their value at a lower tax rate of 21%. The Tax Cuts and Jobs Act included other changes, including, but not limited to, immediate deductions for certain new investments instead of deductions for depreciation expense over time, additional limitations on the deductibility of executive compensation and limitations on the deductibility of interest. For more information regarding the impact of the Tax Cuts and Jobs Act on the Company, see Note 16 “Income Taxes” in the notes to our consolidated financial statements. RESULTS OF OPERATIONS Results of Operations for the Years Ended December 31, 2018 and 2017 General. Net income increased $10.1 million, or 66.2%, to $25.5 million for the year ended December 31, 2018, from $15.3 million for the year ended December 31, 2017. The primary reason for the increase in profitability was increased net interest income from the added scale as a result of the acquisition of Waupaca, which impacted all twelve months of 2018 compared to a little more than two months of 2017. This was offset by larger provisions for loan losses during 2018, which were required to establish an allowance for loans which were purchased in that acquisition at fair value, and required reserves in the ALLL when they renewed during 2018. In addition, the reduced corporate tax rate from 35% to 21% pursuant to the Tax Cuts and Jobs Act had a significantly positive impact on net income for 2018. Net Interest Income. The management of interest income and expense is fundamental to our financial performance. Net interest income, the difference between interest income and interest expense, is the largest component of the Company’s total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets). We seek to maximize net interest income without exposing the Company to an excessive level of interest rate risk through our asset and liability policies. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest-bearing assets and liabilities. Our net interest margin can also be adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short-term investments. Net interest income after provision for loan losses increased by $15.5 million to $60.2 million for the year ended December 31, 2018, from $44.7 million for the year ended December 31, 2017. The increase in net interest income was due to loan growth primarily from the acquisition of loans from Waupaca in the fourth quarter of 2017. Interest income on loans increased by $23.2 million, or 47.6%, from 2017 to 2018. Total average interest-earning assets increased to $1.66 billion for the year ended December 31, 2018 from $1.38 billion for the year ended December 31, 2017. The Bank’s net interest margin increased 44 basis points to 3.89% for the year ended December 31, 2018, up from 3.45% for the year ended December 31, 2017. Interest Income. Total interest income increased $24.5 million, or 45.8%, to $77.9 million for the year ended December 31, 2018, up from $53.5 million for the year ended December 31, 2017. As noted, the increase was primarily due to loan growth from the acquisition of Waupaca. The average balance of loans increased by $295.8 million during 2018. Interest Expense. Interest expense increased $7.1 million, or 92.0%, to $14.8 million for the year ended December 31, 2018, up from $7.7 million for the year ended December 31, 2017. The increase was driven by a $212.7 million increase in the average balance of interest-bearing liabilities as well as an increase in the average cost of interest-bearing liabilities, rising 46 basis points from 0.79% to 1.25%. Interest expense from other borrowed funds increased $1.2 million from 2017 to 2018, primarily due to an increase of 1.18% in the average borrowing cost year-over-year. Interest expense on interest-bearing deposits increased by $5.9 million to $12.4 million for the year ended December 31, 2018, from $6.4 million for the year ended December 31, 2017. This increase was primarily due to a higher interest rate environment along with elevated levels of interest-bearing deposits from the acquisition of Waupaca, which impacted the full year 2018 versus two months of 2017. The average cost of interest-bearing deposits was 1.15% for the year ended December 31, 2018, compared to 0.76% for the year ended December 31, 2017. The average cost of all deposit types increased for the year ended December 31, 2018 as compared to the year ended December 31, 2017 due to a generally higher interest rate environment. Provision for Loan Losses. Credit risk is inherent in the business of making loans. We establish an ALLL through charges to earnings, which are shown in the statements of operations as the provision for loan losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for loan losses is determined by conducting a quarterly evaluation of the adequacy of our ALLL and charging the shortfall or excess, if any, to the current quarter’s expense. This has the effect of creating variability in the amount and frequency of charges to earnings. The provision for loan losses and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in our market area. The determination of the amount is complex and involves a high degree of judgment and subjectivity. We recorded a provision for loan losses of  $2.9 million for the year ended December 31, 2018, compared to $1.1 million for the year ended December 31, 2017. The elevated level of provision for loan losses during 2018 was the result of several significant charged off loans during 2018 along with the need to establish an allowance on the loans which were acquired in connection with the Waupaca acquisition near the end of 2017 and renewed during 2018. These loans were recorded at fair value when purchased, with no related ALLL, but required an ALLL once they renewed. The ALLL was $12.2 million, or 0.86% of total loans, at December 31, 2018 compared to $11.6 million, or 0.83% of total loans at December 31, 2017. Noninterest Income. Noninterest income is an important component of our total revenues. A significant portion of our noninterest income is associated with service charges and income from the Bank’s unconsolidated subsidiaries, Ansay and UFS. Other sources of noninterest income include loan servicing fees, gains on sales of mortgage loans, and other income from strategic alliances. Noninterest income increased $1.7 million to $11.5 million in 2018 compared to $9.8 million in 2017. Due to the increased customer base from the Waupaca acquisition in late 2017, service charge income increased by $0.5 million to $3.5 million for 2018, from $3.0 million for 2017. Income from the minority-owned subsidiaries Ansay and UFS increased by $0.6 million from 2017 to 2018. Loan servicing income increased by $0.3 million from 2017 to 2018 primarily due to the revaluation of our mortgage servicing rights asset. Offsetting this, however, was a reduction of  $0.3 million in net gain on sales of mortgage loans from 2017 to 2018 as we experienced the effects of an overall slowdown in mortgage originations throughout 2018. Finally, other noninterest income benefited during 2018 from rent received on other real estate owned properties which were acquired through the Waupaca acquisition late in 2017. The major components of our noninterest income are listed in the table below: Noninterest Expense. Noninterest expense increased $9.2 million to $39.6 million for the year ended December 31, 2018, up from $30.4 million for the year ended December 31, 2017. The primary cause of increases in most areas within noninterest expense from 2017 to 2018 was due to the acquisition of Waupaca during late 2017 which impacted the full year 2018 versus two months of 2017. Salaries, commissions and employee benefits expense for the year ended December 31, 2018 was $21.5 million compared to $16.6 million for the year ended December 31, 2017, an increase of  $4.9 million, or 29.6%. This increase was attributable to an increase in the overall number of employees due to the Waupaca acquisition and also what is consistent and necessary to support our continued growth, annual salary adjustments, increased bonus and incentives and increased benefit costs. 2018 also experienced elevated expenses in the areas of occupancy, equipment and office as well as postage, stationery and supplies as a result of significant improvements to facilities and equipment in the offices acquired near the end of 2017 and the need to stock them all with supplies. The increase in customers as a result of this acquisition led to higher data processing costs, which have a significant component calculated on a per-customer basis. Net losses on sales of ORE increased significantly during 2018 as a result of many problem loans and ORE which were a part of the Waupaca acquisition. As part of the accounting for the acquisition, a core deposit intangible of $3.1 million was established. 2018 saw twelve months of amortization of this core deposit intangible versus two during 2017, causing an increase in amortization expense. Finally, other noninterest expense increased significantly due to the costs to repossess and maintain a significant amount of collateral on defaulted loans. The major components of our noninterest expense are listed in the table below. Income Tax Expense. We recorded a provision for income taxes of  $6.6 million for the year ended December 31, 2018, compared to $8.8 million for the year ended December 31, 2017, reflecting effective tax rates of 20.6% and 36.6%, respectively. As a result of the Tax Cuts and Jobs Act, we recorded a write down to our net DTAs of approximately $0.6 million, resulting in an equivalent increase in tax expense for 2017. In addition, the provision for 2018 was lower due to the lower federal rates. Results of Operations for the Years Ended December 31, 2017 and 2016 General. Net income increased $0.4 million, or 2.7%, to $15.3 million for the year ended December 31, 2017, from $14.9 million for the year ended December 31, 2016. There was an increase in net interest income due to the acquisition of Waupaca, offset by costs as a result of the acquisition. Also, the provision for loan losses increased from $0.3 million to $1.1 million from 2016 to 2017. Net Interest Income. Net interest income after provision for loan losses increased by $6.2 million to $44.7 million for the year ended December 31, 2017, from $38.5 million for the year ended December 31, 2016. The increase in net interest income was due to loan growth primarily from the acquisition of loans from Waupaca. Interest income on loans increased by $8.0 million, or 19.6%, from 2016 to 2017. Total average interest-earning assets increased to $1.38 billion for the year ended December 31, 2017 from $1.24 billion for the year ended December 31, 2016. The Bank’s net interest margin increased 19 basis points to 3.45% for the year ended December 31, 2017, up from 3.26% for the year ended December 31, 2016. Interest Income. Total interest income increased $8.8 million, or 19.6%, to $53.5 million for the year ended December 31, 2017, up from $44.7 million for the year ended December 31, 2016. As noted, the increase was primarily due to loan growth from the acquisition of Waupaca. The average balance of loans increased by $134.4 million during 2017. Interest income from Fed Funds Sold increased $0.6 million, increasing from $0.5 million in the year ended December 31, 2016, to $1.1 million for the year ended December 31, 2017. Interest Expense. Interest expense increased $1.8 million, or 30.3%, to $7.7 million for the year ended December 31, 2017, up from $5.9 million for the year ended December 31, 2016. The increase was driven by an $80.9 million increase in the average balance of interest-bearing liabilities as well as an increase in the average cost of interest-bearing liabilities, rising 13 basis points from 0.66% to 0.79%. Interest expense from sweep repurchase agreements and borrowed funds increased $202,000 and $617,000 from 2016 to 2017, respectively. Interest expense on interest-bearing deposits increased by $0.9 million to $6.4 million for the year ended December 31, 2017, from $5.5 million for the year ended December 31, 2016. This increase was primarily due to a higher interest rate environment along with elevated levels of interest-bearing deposits for the last two months of 2017 as a result of the acquisition of Waupaca. The average cost of interest-bearing deposits was 0.76% for the year ended December 31, 2017, compared to 0.71% for the year ended December 31, 2016. The average cost of certificates of deposits decreased during the year ended December 31, 2017 as compared to the year ended December 31, 2016 due to a significant change in duration mix of the certificates acquired in the Waupaca acquisition, leading to a shorter overall duration of lower interest-bearing deposits. We experienced an increase in the average cost of checking, savings and money market accounts for the year ended December 31, 2017 as compared to the year ended December 31, 2016 due to a generally higher interest rate environment. Provision for Loan Losses. We recorded a provision for loan losses of $1.1 million for the year ended December 31, 2017, compared to $0.3 million for the year ended December 31, 2016. A significant recovery of a previously charged off commercial loan during 2016 led to a net recovery of   $0.4 million during 2016, compared to a net charge-off of   $0.2 million during 2017. The net recovery during 2016 reduced the need to record a provision for loan losses during that year. The provision for loan losses recorded during 2017 was primarily due to the need to establish a reserve against the organic loan growth during that year. The ALLL was $11.6 million, or 0.83% of total loans, at December 31, 2017 compared to $10.7 million, or 1.05% of total loans at December 31, 2016. The reduction in the ALLL to total loans ratio during 2017 was a result of loans acquired from Waupaca being recorded at fair value at the time of acquisition, with no related allowance recorded. If these acquired loans are removed from total loans in the calculation of this ratio, the ALLL to total loans ratio comes to 1.03% at December 31, 2017. Noninterest Income. Noninterest income increased $0.6 million to $9.8 million in 2017 compared to $9.2 million in 2016. The main driver was income from the minority-owned subsidiaries Ansay and UFS, which increased by $0.3 million from 2016 to 2017. Service charge income also increased by $0.2 million from 2016 to 2017. Much of this increase occurred in the final two months of 2017 as a result of adding significant new customer relationships through the Waupaca acquisition. Loan servicing income increased by $0.2 million from 2016 to 2017 primarily due to the revaluation of our mortgage servicing rights asset. Offsetting this, however, was a reduction of  $0.1 million in net gain on sales of mortgage loans from 2016 to 2017 as we experienced the effects of an overall slowdown in mortgage originations during the second half of 2017. The major components of our noninterest income are listed in the table below: Noninterest Expense. Noninterest expense increased $5.3 million to $30.4 million for the year ended December 31, 2017, up from $25.1 million for the year ended December 31, 2016. The primary cause of increases in most areas within noninterest expense from 2016 to 2017 was due to the acquisition of Waupaca which occurred during the fourth quarter of 2017. Salaries, commissions and employee benefits expense for the year ended December 31, 2017 was $16.6 million compared to $13.3 million for the year ended December 31, 2016, an increase of  $3.3 million, or 24.6%. This increase was attributable to an increase in the overall number of employees due to the Waupaca acquisition and also what is consistent and necessary to support our continued growth, annual salary adjustments, increased bonus and incentives and increased benefit costs. One-time costs such as significant severance payments to terminated employees of Waupaca ($0.8 million), outside service fees ($1.2 million), data processing costs ($0.3 million) and marketing and customer communications in the new market ($0.2 million) also caused most noninterest expense categories to increase. Many of the offices which were obtained in this acquisition had aging technology requiring significant equipment replacement, leading to an increase of  $0.5 million in occupancy expense from 2016 to 2017. As part of the accounting for the acquisition, a core deposit intangible of  $3.1 million was established. Two months of amortization of this intangible led to the increase in amortization of intangibles from 2016 to 2017. The remainder of the increases are due to the added scale of bank operations from adding six new offices through the acquisition. We did experience a positive variance of  $0.1 million in net gains (losses) on sales of ORE due to several sales of ORE during the first half of 2017 at higher than anticipated values. The major components of our noninterest expense are listed in the table below. Income Tax Expense. We recorded a provision for income taxes of $8.8 million for the year ended December 31, 2017, compared to $7.7 million for the year ended December 31, 2016, reflecting effective tax rates of 36.56% and 34.07%, respectively. As a result of the Tax Cuts and Jobs Act, we recorded a write down to our net DTAs of approximately $0.6 million, resulting in an equivalent increase in tax expense for 2017. NET INTEREST MARGIN Net interest income represents the difference between interest earned, primarily on loans and investments, and interest paid on funding sources, primarily deposits and borrowings. Interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate paid on total interest-bearing liabilities. Net interest margin is the amount of net interest income, on a fully taxable-equivalent basis, expressed as a percentage of average interest-earning assets. The average rate earned on earning assets is the amount of annualized taxable equivalent interest income expressed as a percentage of average earning assets. The average rate paid on interest-bearing liabilities is equal to annualized interest expense as a percentage of average interest-bearing liabilities. The following tables set forth the distribution of our average assets, liabilities and shareholders’ equity, and average rates earned or paid on a fully taxable equivalent basis for each of the periods indicated: (1) Annualized on a fully taxable equivalent basis calculated using a federal tax rate of 21% for year ended December 31, 2018 and 35% for years ended December 31, 2017 and 2016. (2) Nonaccrual loans are included in average amounts outstanding. (3) Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities. (4) Net interest margin represents net interest income on a fully tax equivalent basis as a percentage of average interest-earning assets. Rate/Volume Analysis The following tables describe the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volumes (changes in average balance multiplied by prior year average rate) and (ii) changes attributable to changes in rates (change in average interest rate multiplied by prior year average balance), while (iii) changes attributable to the combined impact of volumes and rates have been allocated proportionately to separate volume and rate categories. CHANGES IN FINANCIAL CONDITION Total Assets. Total assets increased $39.8 million, or 2.3%, to $1.79 billion at December 31, 2018 from $1.75 billion at December 31, 2017. Cash and Cash Equivalents. Cash and cash equivalents increased by $5.7 million, or 5.6%, to $107.7 million at December 31 2018 from $102.0 million at December 31, 2017. Investment Securities. The carrying value of total investment securities increased by $0.7 million to $159.7 million at December 31, 2018 from $159.0 million at December 31, 2017. Loans. Net loans increased by $30.3 million, or 2.2%, to $1.42 billion at December 31, 2018 from $1.39 billion at December 31, 2017. Bank-Owned Life Insurance. At December 31, 2018, our investment in bank-owned life insurance was $24.2 million, an increase of  $0.5 million from $23.7 million at December 31, 2017. Deposits. Deposits increased $50.5 million, or 3.4%, to $1.56 billion at December 31, 2018 from $1.51 billion at December 31, 2017. Borrowings. At December 31, 2018, borrowings consisted of subordinated debt to other banks. Notes payable decreased $8.5 million from December 31, 2017 to December 31, 2018, as all of these notes were paid in full during 2018. Subordinated debt remained at $11.5 million at December 31, 2018, the same balance as at December 31, 2017. From time to time the Bank utilized short-term FHLB advances during 2017 and 2018 to fund liquidity, but there were no outstanding FHLB advances at either year end. Stockholders’ Equity. Total stockholders’ equity increased $12.6 million, or 7.8%, to $174.3 million at December 31, 2018 from $161.7 million at December 31, 2017. LOANS Our lending activities are conducted principally in Wisconsin. The Bank makes commercial and industrial loans, commercial real estate loans, construction and development loans, residential real estate loans, and a variety of consumer loans and other loans. Much of the loans made by the Bank are secured by real estate collateral. The Bank’s commercial business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower, with liquidation of the underlying real estate collateral typically being viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are also often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment. Repayment of the Bank’s residential loans is generally dependent on the health of the employment market in the borrowers’ geographic areas and that of the general economy with liquidation of the underlying real estate collateral being typically viewed as the primary source of repayment in the event of borrower default. Our loan portfolio is our most significant earning asset, comprising 79.7%, 79.7% and 78.0% of our total assets as of December 31, 2018, 2017 and 2016, respectively. Our strategy is to grow our loan portfolio by originating quality commercial and consumer loans that comply with our credit policies and that produce revenues consistent with our financial objectives. We believe our loan portfolio is well-balanced, which provides us with the opportunity to grow while monitoring our loan concentrations. Total loans increased $30.9 million, or 2.2%, to $1.43 billion as of December 31, 2018 as compared to $1.40 billion as of December 31, 2017. Our loan growth during the year ended December 31, 2018 has been comprised of an increase of   $33.8 million or 12.8% in commercial and industrial loans, an increase of  $24.5 million or 3.8% in commercial real estate loans, a decrease of  $15.0 million or 19.8% in construction and development loans, a decrease of  $8.6 million or 2.3% in residential 1-4 family loans and a decrease of  $3.7 million or 10.1% in consumer and other loans. The increase in loans during the year ended December 31, 2018 is attributable to modest organic loan growth, which was offset by a planned reduction of a portion of the loan portfolio acquired from Waupaca. The reduction of a portion of the loan portfolio acquired from Waupaca focused on out of market loans as well as loans of poor asset quality. This reduction occurred without incurring significant losses. Total loans increased $371.3 million, or 36.2%, to $1.40 billion as of December 31, 2017 as compared to $1.03 billion as of December 31, 2016. Our loan growth during the year ended December 31, 2017 has been comprised of an increase of   $61.3 million or 30.3% in commercial and industrial loans, an increase of  $192.4 million or 42.6% in commercial real estate loans, an increase of  $24.0 million or 46.3% in construction and development loans, an increase of  $93.9 million or 33.1% in residential 1-4 family loans and a decrease of  $0.3 million or 0.8% in consumer and other loans. The increase in loans during the year ended December 31, 2017 is primarily attributable to the Waupaca acquisition as well as modest organic loan growth. The following table presents the balance and associated percentage of each major category in our loan portfolio at December 31, 2018, 2017, 2016, 2015 and 2014: Our directors and officers and their associates are customers of, and have other transactions with, the Bank in the normal course of business. All loans and commitments included in such transactions were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risk of collection or present other unfavorable features. At December 31, 2018 and December 31, 2017, total loans outstanding to such directors and officers and their associates were $84.1 million and $65.7 million, respectively. During the year ended December 31, 2018, $59.7 million of additions and $41.3 million of repayments were made to these loans, compared to $28.5 million of additions and $13.0 million of repayments during the year ended December 31, 2017. At December 31, 2018 and December 31, 2017, all of the loans to directors and officers were performing according to their original terms. Loan categories The principal categories of our loan portfolio are discussed below: Commercial and Industrial (C&I). Our C&I portfolio totaled $297.3 million, $263.5 million and $202.3 million at December 31, 2018, 2017 and 2016, respectively, and represented 21%, 19% and 20% of our total loans, respectively. C&I loans increased 12.8% during 2018 due to the increased business needs of customers in our markets in response to strong economic conditions in those markets. C&I loans increased 30.3% during 2017 due primarily to the Waupaca acquisition. C&I loans decreased by 7.8% during 2016 due to changing needs of our customers, highlighted by several significant sales of businesses where the acquiring parties did not retain their banking relationship with the Bank. Our C&I loan customers represent various small and middle-market established businesses involved in professional services, accommodation and food services, health care, financial services, wholesale trade, manufacturing, distribution, retailing and non-profits. Most clients are privately owned with markets that range from local to national in scope. Many of the loans to this segment are secured by liens on corporate assets and the personal guarantees of the principals. The regional economic strength or weakness impacts the relative risks in this loan category. There is little concentration in any one business sector, and loan risks are generally diversified among many borrowers. Commercial Real Estate (CRE). Our CRE loan portfolio totaled $668.3 million, $643.8 million and $451.4 million at December 31, 2018, 2017 and 2016, respectively, and represented 47%, 46% and 44% of our total loans, respectively. Our CRE loans increased 3.8% during 2018 due to modest organic loan growth spurred by the business needs of customers in our markets, offset by a planned reduction in out-of-market CRE loans acquired in the Waupaca acquisition that was planned at the time of acquisition. Our CRE loans increased 42.6% during 2017 due primarily to the Waupaca acquisition. Our CRE loans are secured by a variety of property types including multifamily dwellings, retail facilities, office buildings, commercial mixed use, lodging and industrial and warehouse properties. We do not have any specific industry or customer concentrations in our CRE portfolio. Our commercial real estate loans are generally for terms up to twenty years, with loan-to-values that generally do not exceed 85%. Amortization schedules are long term and thus a balloon payment is generally due at maturity. Under most circumstances, the Bank will offer to rewrite or otherwise extend the loan at prevailing interest rates. Construction and Development (C&D). Our C&D loan portfolio totaled $60.8 million, $75.8 million and $51.9 million at December 31, 2018, 2017 and 2016, respectively, and represented 4%, 5% and 5% of our total loans, respectively. C&D loans decreased 19.8% during 2018 as a result of targeted efforts to reduce this type of lending as it had approached an internally set maximum allowable percentage to regulatory capital during 2017. C&D loans increased 46.3% during 2017 due primarily to the Waupaca acquisition. Our C&D loans are generally for the purpose of creating value out of real estate through construction and development work, and also include loans used to purchase recreational use land. Borrowers typically provide a copy of a construction or development contract which is subject to bank acceptance prior to loan approval. Disbursements are handled by a title company. Borrowers are required to inject their own equity into the project prior to any note proceeds being disbursed. These loans are, by their nature, intended to be short term and are refinanced into other loan types at the end of the construction and development period. Residential 1-4 Family. Our residential 1-4 family loan portfolio totaled $368.7 million, $377.3 million and $283.4 million at December 31, 2018, 2017 and 2016, respectively, and represented 26%, 27% and 28% of our total loans, respectively. Residential 1-4 family loans decreased 2.3% during 2018 as a result of an overall slowdown in the residential mortgage lending environment. Residential 1-4 family loans increased 33.1% during 2017 due primarily to the Waupaca acquisition. We offer fixed and adjustable rate residential mortgage loans with maturities up to 30 years. One-to-four family residential mortgage loans are generally underwritten according to Fannie Mae guidelines, and we refer to loans that conform to such guidelines as “conforming loans.” We generally originate both fixed and adjustable rate mortgage loans in amounts up to the maximum conforming loan limits as established by the Federal Housing Finance Agency. In addition, we also offer loans above conforming lending limits typically referred to as “jumbo” loans. These loans are typically underwritten to the same guidelines as conforming loans; however, we may choose to hold a jumbo loan within our portfolio with underwriting criteria that does not exactly match conforming guidelines. We do not offer reverse mortgages nor do we offer loans that provide for negative amortization of principal, such as “Option ARM” loans, where the borrower can pay less than the interest owed on his loan, resulting in an increased principal balance during the life of the loan. We also do not offer “subprime loans” (loans that are made with low down payments to borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios) or Alt-A loans (defined as loans having less than full documentation). Residential real estate loans are originated both for sale to the secondary market as well as for retention in the Bank’s loan portfolio. The decision to sell a loan to the secondary market or retain within the portfolio is determined based on a variety of factors including but not limited to our asset/liability position, the current interest rate environment, and customer preference. Servicing rights are retained on all loans sold to the secondary market. We were servicing mortgage loans sold to others without recourse of approximately $316.5 million, $316.3 million and $305.6 million at December 31, 2018, 2017 and 2016, respectively. Loans sold with the retention of servicing assets result in the capitalization of servicing rights. Loan servicing rights are included in intangible assets and are subsequently amortized as an offset to other income over the estimated period of servicing. The net balance of capitalized servicing rights amounted to $3.1 million, $2.6 million and $2.4 million at December 31, 2018, 2017 and 2016, respectively. Consumer Loans. Our consumer loan portfolio totaled $27.0 million, $33.6 million and $28.5 million at December 31, 2018, 2017 and 2016, respectively, and represented 2%, 2% and 3% of our total loans, respectively. Consumer loans include secured and unsecured loans, lines of credit and personal installment loans. Our consumer loans decreased by 19.7% during 2018 due to one loan totaling $7.6 million, secured by a trust, which was paid in full when the trust grantor passed away. Our consumer loans increased 17.8% during 2017 primarily due to the Waupaca acquisition. Consumer loans generally have greater risk compared to longer-term loans secured by improved, owner-occupied real estate, particularly consumer loans that are secured by rapidly depreciable assets. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. As a result, consumer loan repayments are dependent on the borrower’s continuing financial stability and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Other Loans. Our other loans totaled $6.4 million, $3.5 million and $8.9 million at December 31, 2018, 2017 and 2016, respectively, and are immaterial to the overall loan portfolio. The other loans category consists primarily of overdrawn depository accounts, loans utilized to purchase or carry securities and loans to nonprofit organizations. Loan Portfolio Maturities. The following tables summarize the dollar amount of loans maturing in our portfolio based on their loan type and contractual terms to maturity at December 31, 2018 and 2017, respectively. The tables do not include any estimate of prepayments, which can significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. The following tables summarize the dollar amount of loans maturing in our portfolio based on whether the loan has a fixed or variable rate of interest and their contractual terms to maturity at December 31, 2018 and 2017, respectively. The tables do not include any estimate of prepayments, which can significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. NONPERFORMING LOANS AND TROUBLED DEBT RESTRUCTURINGS In order to operate with a sound risk profile, we focus on originating loans that we believe to be of high quality. We have established loan approval policies and procedures to assist us in maintaining the overall quality of our loan portfolio. When delinquencies in our loans exist, we rigorously monitor the levels of such delinquencies for any negative or adverse trends. From time to time, we may modify loans to extend the term or make other concessions to help a borrower with a deteriorating financial condition stay current on their loan and to avoid foreclosure. We generally do not forgive principal or interest on loans or modify the interest rates on loans to rates that are below market rates. Furthermore, we are committed to collecting on all of our loans and, as a result, at times have lower net charge-offs compared to many of our peer banks. We believe that our commitment to collecting on all of our loans results in higher loan recoveries. Our nonperforming assets consist of nonperforming loans and foreclosed real estate. Nonperforming loans are those on which the accrual of interest has stopped, as well as loans that are contractually 90 days past due on which interest continues to accrue. The composition of our nonperforming assets is as follows: At December 31, 2018, 2017, 2016, 2015 and 2014, impaired loans had specific reserves of  $1,079,000, $281,000, $225,000, $360,000 and $400,000, respectively. Levels of specific reserves are dependent on the specific underlying impaired loans at any given time, and the increase in specific reserves as of December 31, 2018 is due to management’s determination of the collectability of loans considered impaired at that time. Management has evaluated the aforementioned loans and other loans classified as nonperforming and believes that all nonperforming loans have been adequately reserved for in the allowance for loan losses at December 31, 2018. Until 2017, the steady decline in our nonperforming assets was the result of the consistent improvement in our overall credit quality as economic conditions in our markets have continued to improve. Our nonperforming assets have increased during the years ended December 31, 2018 and 2017, primarily due to the Waupaca acquisition, which included $19.4 million of loans which were considered nonperforming. This increase in nonperforming assets was anticipated in conjunction with the Waupaca acquisition, and management has and will continue to actively manage these relationships out of the Bank through pay downs, refinances with or sales of loans to other institutions, or foreclosure actions. Nonaccrual Loans Loans are typically placed on nonaccrual status when any payment of principal and/or interest is 90 days or more past due, unless the collateral is sufficient to cover both principal and interest and the loan is in the process of collection. Loans are also placed on nonaccrual status when management believes, after considering economic and business conditions, that the principal or interest will not be collectible in the normal course of business. We monitor closely the performance of our loan portfolio. In addition to the monitoring and review of loan performance internally, we have also contracted with an independent organization to review our commercial and retail loan portfolios. The status of delinquent loans, as well as situations identified as potential problems, is reviewed on a regular basis by senior management. Troubled Debt Restructurings A troubled debt restructuring includes a loan modification where a borrower is experiencing financial difficulty and we grant a concession to that borrower that we would not otherwise consider except for the borrower’s financial difficulties. These concessions may include modifications of the terms of the debt such as deferral of payments, extension of maturity, reduction of principal balance, reduction of the stated interest rate other than normal market rate adjustments, or a combination of these concessions. Debt may be bifurcated with separate terms for each tranche of the restructured debt. Restructuring a loan in lieu of aggressively enforcing the collection of the loan may benefit the Company by increasing the ultimate probability of collection. A TDR may be either on accrual or nonaccrual status based upon the performance of the borrower and management’s assessment of collectability. If a TDR is placed on nonaccrual status, which would occur based on the same criteria as non-TDR loans, it remains there until a sufficient period of performance under the restructured terms has occurred at which it returned to accrual status, generally 6 months. As of December 31, 2018 and 2017, the Company had specific reserves of  $353,000 and $0 for TDRs, respectively, and none of them have subsequently defaulted. Classified loans Accounting standards require the Company to identify loans, where full repayment of principal and interest is doubtful, as impaired loans. These standards require that impaired loans be valued at the present value of expected future cash flows, discounted at the loan’s effective interest rate, or using one of the following methods: the observable market price of the loan or the fair value of the underlying collateral if the loan is collateral dependent. We have implemented these standards in our quarterly review of the adequacy of the ALLL, and identify and value impaired loans in accordance with guidance on these standards. As part of the review process, we also identify loans classified as watch, which have a potential weakness that deserves management’s close attention. Loans totaling $67.6 million and $79.0 million were classified substandard under the Bank’s policy as of December 31, 2018 and 2017, respectively. Approximately 48.5% and 65.6% of loans classified as substandard were acquired loans as of December 31, 2018 and 2017, respectively. The following table sets forth information related to the credit quality of our loan portfolio at December 31, 2018 and 2017. Allowance for Loan AND LEASE Losses ALLL represents management’s estimate of probable and inherent credit losses in the loan portfolio. Estimating the amount of the ALLL requires the exercise of significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogenous loans based on historical loss experience, and consideration of other qualitative factors such as current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset on the consolidated balance sheets. Loan losses are charged off against the ALLL, while recoveries of amounts previously charged off are credited to the ALLL. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors. The ALLL consists of specific reserves for certain individually evaluated impaired loans and general reserves for collectively evaluated non-impaired loans. Specific reserves reflect estimated losses on impaired loans from management’s analyses developed through specific credit allocations. The specific reserves are based on regular analyses of impaired, non-homogenous loans greater than $250,000. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general reserve is based in part on the Bank’s historical loss experience which is updated quarterly. The general reserve portion of the ALLL also includes consideration of certain qualitative factors such as: (1) changes in lending policies and/or underwriting practices, (2) national and local economic conditions, (3) changes in portfolio volume and nature, (4) experience, ability and depth of lending management and other relevant staff, (5) levels of and trends in past-due and nonaccrual loans and quality, (6) changes in loan review and oversight, (7) impact and effects of concentrations and (8) other issues deemed relevant. There are many factors affecting the ALLL; some are quantitative while others require qualitative judgment. The process for determining the ALLL (which management believes adequately considers potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for loan losses could be required that could adversely affect our earnings or financial position in future periods. Allocations of the ALLL may be made for specific loans but the entire ALLL is available for any loan that, in management’s judgment, should be charged off or for which an actual loss is realized. As an integral part of their examination process, various regulatory agencies review the ALLL as well. Such agencies may require that changes in the ALLL be recognized when such regulators’ credit evaluations differ from those of management based on information available to the regulators at the time of their examinations. The following table summarizes the changes in our ALLL for the years indicated: The level of charge-offs depends on many factors, including the national and regional economy. Cyclical lagging factors may result in charge-offs being higher than historical levels. The dollar amount of the ALLL increased primarily as a result of loan growth and changes in the portfolio composition. Although the allowance is allocated between categories, the entire allowance is available to absorb losses attributable to all loan categories. Management believes that the ALLL is adequate. The following table summarizes an allocation of the ALLL and the related percentage of loans outstanding in each category for the periods below. Sources of Funds General. Deposits traditionally have been our primary source of funds for our investment and lending activities. We continue to focus on growing core deposits through our relationship driven banking philosophy and community-focused marketing programs. We also borrow from the FHLB of Chicago to supplement cash needs, to lengthen the maturities of liabilities for interest rate risk management purposes and to manage our cost of funds. Our additional sources of funds are scheduled payments and prepayments of principal and interest on loans and investment securities and fee income and proceeds from the sales of loans and securities. Deposits. Our current deposit products include non-interest bearing and interest-bearing checking accounts, savings accounts, money market accounts, and certificates of deposit. As of December 31, 2018, deposit liabilities accounted for approximately 86.8% of our total liabilities and equity. We accept deposits primarily from customers in the communities in which our branches and offices are located, as well as from small businesses and other customers throughout our lending area. We rely on our competitive pricing and products, quality customer service, and convenient locations and hours to attract and retain deposits. Deposit rates and terms are based primarily on current business strategies, market interest rates, liquidity requirements and our deposit growth goals. Total deposits were $1.56 billion, $1.51 billion and $1.13 billion as of December 31, 2018, 2017 and 2016, respectively. Noninterest-bearing deposits at December 31, 2018, 2017 and 2016 were $448.8 million, $436.6 million and $326.2 million, respectively, while interest-bearing deposits were $1.11 billion, $1.07 billion and $800.9 million at December 31, 2018, 2017 and 2016, respectively. Our acquisition of Waupaca contributed $325.3 million to the increase in total deposits for the year ended December 31, 2017, $74.7 million to the increase in noninterest-bearing deposits and $250.6 million to the increase in interest-bearing deposits. In addition to the acquisition of Waupaca, the increase in our deposits over the past two years and as of December 31, 2018 can be attributed to strong growth in our Sheboygan and Fox Valley markets as we continue to develop new customer relationships. At December 31, 2018, we had a total of  $400.2 million in certificates of deposit, including $17.7 million of brokered deposits, of which $2.6 million had remaining maturities of one year or less. Based on historical experience and our current pricing strategy, we believe we will retain a large portion of these accounts upon maturity. The following tables set forth the average balances of our deposits for the periods indicated: Certificates of deposit of  $100,000 or greater by maturity are as follows: Retail certificates of deposit of  $100,000 or greater totaled $198.4 million, $176.7 million and $87.1 million at December 31, 2018, 2017 and 2016, respectively. Interest expense on retail certificates of deposit of  $100,000 or greater was $2.5 million, $1.4 million and $1.3 million for the years ended December 31, 2018, 2017 and 2016, respectively. The following table sets forth certificates of deposit (including brokered deposits) classified by interest rate as of the dates indicated: Borrowings Deposits and investment securities for sale are the primary source of funds for our lending activities and general business purposes. However, we may also obtain advances from the FHLB, purchase federal funds and engage in overnight borrowing from the Federal Reserve, correspondent banks, or enter into repurchase agreements. Securities sold under repurchase agreements The Company has securities sold under repurchase agreements which have contractual maturities up to one year from the transaction date with variable and fixed rate terms. The agreements to repurchase require that the Company (seller) repurchase identical securities as those that are sold. The securities underlying the agreements are under the Company’s control. The following table summarizes securities sold under repurchase agreements, and the weighted average interest rates paid: Short-term borrowings The Company’s short-term borrowings consist primarily of short-term FHLB of Chicago advances collateralized by blanket pledge agreement on the Company’s FHLB capital stock and retail and commercial loans held in the Company’s portfolio. There were no advances outstanding from the FHLB at December 31, 2018, 2017 or 2016. From time to time the Company utilized short-term FHLB advances to fund liquidity during these years. The total loans pledged as collateral were $697.3 million, $564.4 million and $525.8 million at December 31, 2018, 2017 and 2016, respectively. Outstanding letters of credit from the FHLB totaled $55.0 million, $20.7 million and $21.5 million at December 31, 2018, 2017 and 2016, respectively. The following table summarizes short-term borrowings (borrowings with maturities of one year or less), which consist of borrowings from the FHLB, and the weighted average interest rates paid: Lines of credit and other borrowings. We maintain a $5.0 million line of credit with a commercial bank. At December 31, 2018, 2017 and 2016, we had outstanding balances on this note of -0-, $5.0 million and $-0-, respectively. Any future borrowings under this note would carry interest at a variable rate with a floor of 3.50% and will be due in full on May 25, 2019. We also maintain another $5.0 million line of credit with another commercial bank. There were no outstanding balances on this note at December 31, 2018, 2017 or 2016. Any future borrowings under this note would carry interest at a variable rate with a floor of 3.25% and will be due in full on May 19, 2019. During September 2017, the Company entered into a term loan agreement with a commercial bank. The Company had up to twelve months from entering this agreement to borrow funds up to a maximum availability of $5.0 million. As of December 31, 2017, the Company had borrowed $3.5 million under this agreement. This note was repaid in full during July 2018. During September 2017, the Company entered into subordinated note agreements with three separate commercial banks. The Company had up to twelve months from entering these agreements to borrow funds up to a maximum availability of $22.5 million. As of December 31, 2018 and 2017, the Company had borrowed $11.5 million under these agreements. These notes were all issued with 10-year maturities, carry interest at a variable rate payable quarterly, are callable on or after the sixth anniversary of their issuance dates, and qualify for Tier 2 capital for regulatory purposes. INVESTMENT SECURITIES Our securities portfolio consists of securities available for sale and securities held to maturity. Securities are classified as held to maturity or available for sale at the time of purchase. Obligations of states and political subdivisions and mortgage-backed securities, all of which are issued by U.S. government agencies or U.S. government-sponsored enterprises, make up the largest components of the securities portfolio. We manage our investment portfolio to provide an adequate level of liquidity as well as to maintain neutral interest rate-sensitive positions, while earning an adequate level of investment income without taking undue or excessive risk. Securities available for sale consist of U.S. Treasury securities, obligations of states and political subdivision, mortgage-backed securities, and corporate notes. Securities classified as available for sale, which management has the intent and ability to hold for an indefinite period of time, but not necessarily to maturity, are carried at fair value, with unrealized gains and losses, net of related deferred income taxes, included in stockholders’ equity as a separate component of other comprehensive income. The fair value of securities available for sale totaled $118.9 million and included gross unrealized gains of  $0.8 million and gross unrealized losses of  $1.4 million at December 31, 2018. At December, 31 2017, the fair value of securities available for sale totaled $119.0 million and included gross unrealized gains of  $1.6 million and gross unrealized losses of $0.5 million. Securities classified as held to maturity consist of U.S. Treasury securities and obligations of states and political subdivisions. These securities, which management has the intent and ability to hold to maturity, are reported at amortized cost. Securities held to maturity as of December 31, 2018 are carried at their amortized cost of  $40.8 million. At December 31, 2017, securities held to maturity totaled $40.0 million. The Company recognized a net loss on sale of investment securities of  $31,000, $32,000 and $225,000 for the years ended December 31, 2018, 2017 and 2016, respectively. The following table sets forth the fair value of available for sale investment securities, the amortized costs of held to maturity and the percentage distribution at the dates indicated: The following tables set forth the composition and maturities of investment securities as of December 31, 2018 and December 31, 2017. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. (1) Weighted Average Yield is shown on a fully taxable equivalent basis using a federal tax rate of 21% and 35% at December 31, 2018 and December 31, 2017, respectively. The Company evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. Consideration is given to (1) credit quality of individual securities and their issuers are assessed; (2) the length of time and the extent to which the fair value has been less than cost; (3) the financial condition and near-term prospects of the issuer; and (4) that the Company does not have the intent to sell the security and it is more likely than not that it will not have to sell the security before recovery of its cost basis. As of December 31, 2018, 64 debt securities had gross unrealized losses, with an aggregate depreciation of 1.11% from our amortized cost basis. The largest unrealized loss percentage of any single security was 4.98% (or $148,000) of its amortized cost. This was also the largest unrealized dollar loss of any single security. As of December 31, 2017, 52 debt securities had gross unrealized losses, with an aggregate depreciation of 0.44% from our amortized cost basis. The largest unrealized loss percentage of any single security was 5.36% (or $55,000) of its amortized cost. This was also the largest unrealized dollar loss of any security. The unrealized losses on these debt securities arose primarily due to changing interest rates and are considered to be temporary. RETURN ON AVERAGE EQUITY AND ASSETS Over the past five years, we have consistently improved our profitability as a result of the success of our growth strategies to grow quality loans and low-cost deposits as well as the improving economic conditions in our markets during the periods indicated in the table below. The following table sets forth our ROAA, ROAE, dividend payout ratio and average shareholders’ equity to average assets ratio for the periods indicated: LIQUIDITY AND CAPITAL RESOURCES Impact of Inflation and Changing Prices. Our consolidated financial statements and related notes have been prepared in accordance with GAAP. GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration of changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on our performance than they would on industrial companies. Liquidity. Liquidity is defined as the Company’s ability to generate adequate cash to meet its needs for day-to-day operations and material long and short-term commitments. Liquidity is the risk of potential loss if we were unable to meet our funding requirements at a reasonable cost. We are expected to maintain adequate liquidity at the Bank to meet the cash flow requirements of customers who may be either depositors wishing to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Our asset and liability management policy is intended to cause the Bank to maintain adequate liquidity and, therefore, enhance our ability to raise funds to support asset growth, meet deposit withdrawals and lending needs, maintain reserve requirements and otherwise sustain our operations. We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all of our short-term and long-term cash requirements. We manage our liquidity based on demand and specific events and uncertainties to meet current and future financial obligations of a short-term nature. We also monitor our liquidity requirements in light of interest rate trends, changes in the economy and the scheduled maturity and interest rate sensitivity of the investment and loan portfolios and deposits. Our objective in managing liquidity is to respond to the needs of depositors and borrowers as well as to increase earnings enhancement opportunities in a changing marketplace. Our liquidity is maintained through investment portfolio, deposits, borrowings from the FHLB, and lines available from correspondent banks. Our highest priority is placed on growing noninterest bearing deposits through strong community involvement in the markets that we serve. Borrowings and brokered deposits are considered short-term supplements to our overall liquidity but are not intended to be relied upon for long-term needs. We believe that our present position is adequate to meet our current and future liquidity needs, and management knows of no trend or event that will have a material impact on the Company’s ability to maintain liquidity at satisfactory levels. Capital Adequacy. Total shareholders’ equity was $174.3 million at December 31, 2018, compared to $161.7 million at December 31, 2017, and $127.5 million at December 31, 2016. Our total shareholders’ equity increased during 2018 as a result of our profitability, reduced by dividends paid and common stock repurchases. Our total shareholders’ equity increased during 2017 primarily as a result of the Waupaca acquisition, and to a lesser extent due to our profitability, reduced by dividends paid and common share repurchases. Our capital management consists of providing adequate equity to support our current and future operations. We are subject to various regulatory capital requirements administered by state and federal banking agencies, including the Federal Reserve and the OCC. Failure to meet minimum capital requirements may prompt certain actions by regulators that, if undertaken, could have a direct material adverse effect on our financial condition and results of operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measure of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and the classifications are also subject to qualitative judgment by the regulator in regards to risk weighting and other factors. See “Business-Supervision and Regulation-Capital Requirements.” The following table reflects capital ratios computed pursuant to the regulatory capital rules as applicable to the Company and the Bank. As a result of the Economic Growth Act, the Company is no longer required to comply with its risk-based capital rules. For more information, see “Business-Supervision and Regulation-Capital Requirements.” As previously mentioned, the Company carried $11.5 million of subordinated debt as of December 31, 2018 and 2017 which is included in total capital in the tables above. CONTRACTUAL OBLIGATIONS, COMMITMENTS, AND CONTINGENCIES The Company has entered into contractual obligations and commitments. The following tables summarize the Company’s contractual cash obligations and other commitments by maturity at December 31, 2018: We believe that we will be able to meet our contractual obligations as they come due through the maintenance of adequate cash levels. We expect to maintain adequate cash levels through profitability, loan and securities repayment and maturity activity and continued deposit gathering activities. We have in place various borrowing mechanisms for both short-term and long-term liquidity needs. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK We are party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to originate and sell loans, standby and direct pay letters of credit, unused lines of credit and unadvanced portions of construction and development loans. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in these particular classes of financial instruments. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments, standby and direct pay letters of credit and unadvanced portions of construction and development loans is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Off-Balance Sheet Arrangements. Our significant off-balance-sheet arrangements consist of the following: • Unused lines of credit • Standby and direct pay letters of credit • Credit card arrangements Off-balance sheet arrangement means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with the registrant is a party, under which the registrant has (1) any obligation under a guarantee contract, (2) retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement, (3) any obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument, or (4) any obligation, including a contingent obligation, arising out of a variable interest. Loan commitments are made to accommodate the financial needs of our customers. Standby and direct pay letters of credit commit us to make payments on behalf of customers when certain specified future events occur. Both arrangements have credit risk essentially the same as that involved in extending loans to clients and are subject to our normal credit policies. Collateral (e.g., securities, receivables, inventory, equipment, etc.) is obtained based on management’s credit assessment of the customer. Loan commitments and standby and direct pay letters of credit do not necessarily represent our future cash requirements because while the borrower has the ability to draw upon these commitments at anytime, these commitments occasionally expire without being drawn upon. Our off-balance sheet arrangements as of December 31, 2018 were as follows: We closely monitor the amount of our remaining future commitments to borrowers in light of prevailing economic conditions and adjust these commitments as necessary. We will continue this process as new commitments are entered into or existing commitments are renewed. Effects of Inflation The effect of inflation on a financial institution differs significantly from the effect on an industrial company. While a financial institution’s operating expenses, particularly salary and employee benefits, are affected by general inflation, the asset and liability structure of a financial institution consists largely of monetary items. Monetary items, such as cash, investments, loans, deposits and other borrowings, are those assets and liabilities which are or will be converted into a fixed number of dollars regardless of changes in prices. As a result, changes in interest rates have a more significant impact on a financial institution’s performance than does general inflation. For additional information regarding interest rates and changes in net interest income see “Quantitative and Qualitative Disclosures About Market Risk-Interest Rate Sensitivity.” Inflation may have impacts on the Bank’s customers, on businesses and consumers and their ability or willingness to invest, save or spend, and perhaps on their ability to repay loans. As such, there would likely be impacts on the general appetite of banking products and the credit health of the Bank’s customer base. Selected Quarterly Financial Data The following is selected financial data summarizing the results of operations for each quarter in the years ended December 31, 2018 and 2017. * Cumulative quarterly per share performance may not equal annual per share totals due to the effects of the amount and timing of capital increases. When computing earnings per share for an interim period, the denominator is based on the weighted average shares outstanding during the interim period, and not on an annualized weighted average basis. Accordingly, the sum of the quarters’ earnings per share data will not necessarily equal the year to date earnings per share data.

<s>[INST] The following discussion and analysis of our consolidated financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes. Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods. We are a bank holding company and we conduct all of our material business operations through the Bank. As a result, the discussion and analysis above relates to activities primarily conducted at the Bank level. We have made, and will continue to make, various forwardlooking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forwardlooking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forwardlooking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding ForwardLooking Statements” at the beginning of this Annual Report. OVERVIEW Bank First National Corporation is a Wisconsin corporation that was organized primarily to serve as the holding company for Bank First, N.A. Bank First, N.A., which was incorporated in 1894, is a nationallychartered bank headquartered in Manitowoc, Wisconsin. It is a member of the Federal Reserve, and is regulated by the OCC. Including its headquarters in Manitowoc, Wisconsin, the Bank has 18 banking locations in Manitowoc, Outagamie, Brown, Winnebago, Sheboygan, Waupaca and Barron counties in Wisconsin. The Bank offers loan, deposit and treasury management products at each of its banking locations. As with most community banks, the Bank derives a significant portion of its income from interest received on loans and investments. The Bank’s primary source of funding is deposits, both interestbearing and noninterestbearing. In order to maximize the Bank’s net interest income, or the difference between the income on interestearning assets and the expense of interestbearing liabilities, the Bank must not only manage the volume of these balance sheet items, but also the yields earned on interestearning assets and the rates paid on interestbearing liabilities. To account for credit risk inherent in all loans, the Bank maintains an Allowance for Loan and Lease Losses (“ALLL”) to absorb possible losses on existing loans that may become uncollectible. The Bank establishes and maintains this allowance by charging a provision for loan losses against operating earnings. Beyond its net interest income, the Bank further receives income through the net gain on sale of loans held for sale as well as servicing income which is retained on those sold loans. In order to maintain its operations and bank locations, the Bank incurs various operating expenses which are further described within the “Results of Operations” later in this section. The Bank is a 49.8% member of a data processing subsidiary, UFS, LLC, which provides core data processing, endpoint management cloud services, cyber security and digital banking solutions for over 60 Midwest banks. The Bank, through its 100% owned subsidiary TVG Holdings, Inc., also holds a 30% ownership interest in Ansay & Associates, LLC, an insurance agency providing clients primarily located in Wisconsin with insurance and risk management solutions. These unconsolidated subsidiary interests contribute noninterest income to the Bank through their underlying annual earnings. As of December 31, 2018, the Company had total consolidated assets of  $1.79 billion, total loans of  $1.43 billion, total deposits of  $1.56 billion and total stockholders’ equity of  $174.3 million. The Company employs approximately 253 fulltime equivalent employees and has an assetstoFTE ratio of approximately $7.1 million. For more information, see the Company’s website at www.bankfirstwi.bank. Recent acquisitions On October 27, 2017, the Company completed a merger with Waupaca Bancorporation, Inc. (“Waupaca”), a bank holding company headquartered in Waupaca, Wisconsin, pursuant to an Agreement and Plan of Merger, dated as of May 11, 2017 and as amended on July 20, [/INST] Negative. </s>

Bank First Corp

2020-03-11

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our consolidated financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes. Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods. We are a bank holding company and we conduct all of our material business operations through the Bank. As a result, the discussion and analysis above relates to activities primarily conducted at the Bank level. We have made, and will continue to make, various forward-looking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forward-looking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding Forward-Looking Statements” at the beginning of this Annual Report. OVERVIEW Bank First Corporation is a Wisconsin corporation that was organized primarily to serve as the holding company for Bank First, N.A. Bank First, N.A., which was incorporated in 1894, is a nationally-chartered bank headquartered in Manitowoc, Wisconsin. It is a member of the Federal Reserve, and is regulated by the OCC. Including its headquarters in Manitowoc, Wisconsin, the Bank has 23 banking locations in Manitowoc, Outagamie, Brown, Winnebago, Sheboygan, Waupaca, Ozaukee, Monroe, Jefferson and Barron counties in Wisconsin. The Bank offers loan, deposit and treasury management products at each of its banking locations. As with most community banks, the Bank derives a significant portion of its income from interest received on loans and investments. The Bank’s primary source of funding is deposits, both interest-bearing and noninterest-bearing. In order to maximize the Bank’s net interest income, or the difference between the income on interest-earning assets and the expense of interest-bearing liabilities, the Bank must not only manage the volume of these balance sheet items, but also the yields earned on interest-earning assets and the rates paid on interest-bearing liabilities. To account for credit risk inherent in all loans, the Bank maintains an Allowance for Loan and Lease Losses (“ALLL”) to absorb possible losses on existing loans that may become uncollectible. The Bank establishes and maintains this allowance by charging a provision for loan losses against operating earnings. Beyond its net interest income, the Bank further receives income through the net gain on sale of loans held for sale as well as servicing income which is retained on those sold loans. In order to maintain its operations and bank locations, the Bank incurs various operating expenses which are further described within the “Results of Operations” later in this section. The Bank is a 49.8% member of a data processing subsidiary, UFS, LLC, which provides core data processing, endpoint management cloud services, cyber security and digital banking solutions for over 60 Midwest banks. The Bank, through its 100% owned subsidiary TVG Holdings, Inc., also holds a 40% (up from 30% due to a purchase of member interest on October 1, 2019) ownership interest in Ansay & Associates, LLC, an insurance agency providing clients primarily located in Wisconsin with insurance and risk management solutions. These unconsolidated subsidiary interests contribute noninterest income to the Bank through their underlying annual earnings. As of December 31, 2019, the Company had total consolidated assets of  $2.21 billion, total loans of  $1.74 billion, total deposits of  $1.84 billion and total stockholders’ equity of  $230.2 million. The Company employs approximately 284 full-time equivalent employees and has an assets-to-FTE ratio of approximately $7.8 million. For more information, see the Company’s website at www.bankfirstwi.bank. Recent acquisitions On October 27, 2017, the Company completed a merger with Waupaca Bancorporation, Inc. (“Waupaca”), a bank holding company headquartered in Waupaca, Wisconsin, pursuant to the Agreement and Plan of Bank Merger, dated as of May 11, 2017 and as amended on July 20, 2017, by and among the Company, BFNC Merger Sub, LLC, a wholly-owned subsidiary of the Company, and Waupaca, whereby Waupaca merged with and into the Company, and First National Bank, Waupaca’s wholly-owned banking subsidiary, was merged with and into the Bank. Waupaca’s principal activity was the ownership and operation of First National Bank, a national banking institution that operated eight (8) branches in Wisconsin at the time of closing. The merger consideration totaled approximately $78.1 million, 70% of which was distributed in cash and 30% of which was distributed in the form of Company common stock. On July 12, 2019, the Company completed a merger with Partnership Community Bancshares, Inc. (“Partnership”), a bank holding company headquartered in Cedarburg, Wisconsin, pursuant to the Agreement and Plan of Bank Merger, dated as of January 22, 2019 and as amended on April 30, 2019, by and among the Company and Partnership, whereby Partnership merged with and into the Company, and Partnership Bank, Partnership’s wholly-owned banking subsidiary, merged with and into the Bank. Partnership’s principal activity was the ownership and operation of Partnership Bank, a state-chartered banking institution that operated four (4) branches in Wisconsin at the time of closing. The merger consideration totaled approximately $49.6 million. Pursuant to the terms of the Merger Agreement, Partnership shareholders had the option to receive either 0.34879 shares of the Company’s common stock or $17.3001 in cash for each outstanding share of Partnership common stock, and cash in lieu of any remaining fractional share. The stock versus cash elections by the Partnership shareholders were subject to final consideration being made up of approximately $14.3 million in cash and 534,731 shares of Company common stock, valued at approximately $35.3 million (based on a value of  $66.03 per share on the closing date). The Company accounted for the transaction under the acquisition method of accounting, and thus, the financial position and results of operations of Partnership prior to the consummation date were not included in the accompanying consolidated financial statements. The accounting required assets purchased and liabilities assumed to be recorded at their respective fair values at the date of acquisition. The Company determined the fair value of core deposit intangibles, securities, premises and equipment, loans, other assets and liabilities, deposits and borrowings with the assistance of third party valuations, appraisals, and third party advisors. The estimated fair values will be subject to refinement for up to one year after the consummation as additional information becomes available relative to the closing date fair values. On November 20, 2019, the Company entered into an Agreement and Plan of Merger with Tomah Bancshares, Inc. (Timberwood), a Wisconsin Corporation, under which Timberwood will merge with and into the Company and Timberwood’s banking subsidiary, Timberwood Bank, will merge with and into the Bank. The transaction is expected to close in the second quarter of 2020 and is subject to, among other items, approval by the shareholders of Timberwood and regulatory agencies. Merger consideration consists of 100% common stock of the Company, and will total roughly $32.6 million, subject to the fair market valuation of the Company’s common stock on the date of closing. Based on results as of December 31, 2019, the combined company would have total assets of approximately $2.40 billion, loans of approximately $1.80 billion and deposits of approximately $2.00 billion. CRITICAL ACCOUNTING POLICIES The accounting and reporting policies of the Company conform to GAAP in the United States and general practices within the financial institution industry. Significant accounting and reporting policies are summarized below. Business Combinations We account for business combinations under the acquisition method of accounting in accordance with Accounting Standards Codification (ASC) 805, Business Combinations (ASC 805). We recognize the full fair value of the assets acquired and liabilities assumed and immediately expense transaction costs. There is no separate recognition of the acquired ALLL on the acquirer’s balance sheet as credit related factors are incorporated directly into the fair value of the net tangible and intangible assets acquired. If the amount of consideration exceeds the fair value of assets purchased less the fair value of liabilities assumed, goodwill is recorded. Alternatively, if the amount by which the fair value of assets purchased exceeds the fair value of liabilities assumed and consideration paid, a gain (bargain purchase gain) is recorded. Fair values are subject to refinement for up to one year after the closing date of an acquisition as information relative to closing date fair values becomes available. Results of operations of the acquired business are included in the statement of income from the effective date of the acquisition. Allowance for Loan and Lease Losses-Originated The ALLL is established through a provision for loan losses charged to expense as losses are estimated to have occurred. Loan losses are charged against the allowance when management believes that the collectability of the principal is unlikely. Subsequent recoveries, if any, are credited to the allowance. Management regularly evaluates the ALLL using general economic conditions, our past loan loss experience, composition of the portfolio, credit worthiness of the borrowers, the estimated value of the underlying collateral, the assumptions about cash flow, determination of loss factors for estimating credit losses and other relevant factors. This evaluation is inherently subjective since it requires material estimates that may be susceptible to significant change. The ALLL consists of specific reserves for certain impaired loans and general reserves for non-impaired loans. Specific reserves reflect estimated losses on impaired loans from management’s analyses developed through specific credit allocations. The specific credit reserves are based on regular analyses of impaired non-homogenous loans. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general reserve is based on our historical loss experience which is updated quarterly. The general reserve portion of the ALLL also includes consideration of certain qualitative factors such as (1) changes in lending policies and/or underwriting practices, (2) national and local economic conditions, (3) changes in portfolio volume and nature, (4) experience, ability and depth of lending management and other relevant staff, (5) levels of and trends in past-due and nonaccrual loans and quality, (6) changes in loan review and oversight, (7) impact and effects of concentrations and (8) other issues deemed relevant. Management believes that the current ALLL is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the ALLL. Such agencies may require us to recognize additions to the allowance based on their judgments of information available to them at the time of their examination. Allowance for Loan and Lease Losses-Acquired The ALLL for acquired loans is calculated using a methodology similar to that described for originated loans. Performing acquired loans are subsequently evaluated for any required allowance at each reporting date. Such required allowance for each loan pool is compared to the remaining fair value discount for that pool. If greater, the excess is recognized as an addition to the allowance through a provision for loan losses. If less than the discount, no additional allowance is recorded. Charge-offs and losses first reduce any remaining fair value discount for the loan pool and once the discount is depleted, losses are applied against the allowance established for that pool. For purchase credit impaired loans after an acquisition, cash flows expected to be collected are recast for each loan periodically as determined appropriate by management. If the present value of expected cash flows for a loan is less than its carrying value, impairment is reflected by an increase in the ALLL and a charge to the provision for loan losses. If the present value of the expected cash flows for a loan is greater than its carrying value, any previously established ALLL is reversed and any remaining difference increases the accretable yield which will be taken into income over the remaining life of the loan. Loans which were considered troubled debt restructurings (“TDRs”) by the acquired institution prior to the acquisition are not required to be classified as TDRs in our consolidated financial statements unless or until such loans would subsequently meet our criteria to be classified as such, since acquired loans were recorded at their estimated fair values at the time of the acquisition. Impaired Investment Securities Unrealized gains or losses considered temporary and the noncredit portion of unrealized losses deemed other-than-temporary are reported as an increase or decrease in accumulated other comprehensive income. The credit related portion of unrealized losses deemed other-than-temporary is recorded in current period earnings. Realized gains or losses, determined on the basis of the cost of specific securities sold, are included in earnings. We evaluate securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. As part of such monitoring, the credit quality of individual securities and their issuers are assessed. In addition, management considers the length of time and extent that fair value has been less than cost, the financial condition and near-term prospects of the issuer, and that the Company does not have the intent to sell the security and it is more likely than not that it will not have to sell the security before recovery of its cost basis. Adjustments to market value that are considered temporary are recorded as a separate component of equity, net of tax. If an impairment of security is identified as other-than-temporary based on information available such as the decline in the credit worthiness of the issuer, external market ratings or the anticipated or realized elimination of associated dividends, such impairments are further analyzed to determine if a credit loss exists. If there is a credit loss, it will be recorded in the consolidated statement of income in the period of identification. Intangible Assets and Goodwill Intangible assets consist of the value of core deposits and mortgage servicing assets and the excess of purchase price over fair value of net assets (“goodwill”). The value of core deposits is stated at cost less accumulated amortization and is amortized on a sum of the years digits basis over a period of one to ten years. Mortgage servicing rights are recognized as separate assets when rights are acquired through purchase or through sale of mortgage loans with servicing retained. Servicing rights acquired through sale of financial assets are recorded based on the fair value of the servicing right. The determination of fair value is based on a valuation model and includes stratifying the mortgage servicing rights by predominant characteristics, such as interest rates and terms, and estimating the fair value of each stratum based on the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as costs to service, a discount rate, and prepayment speeds. Changes in fair value are recorded as an adjustment to earnings. We perform a “qualitative” assessment of goodwill to determine whether further impairment testing of indefinite-lived intangible assets is necessary on at least an annual basis. If it is determined, as a result of performing a qualitative assessment over goodwill, that it is more likely than not that goodwill is impaired, management will perform an impairment test to determine if the carrying value of goodwill is realizable. Deferred Tax Assets Deferred tax assets (“DTA”) and liabilities are determined using the liability method. DTAs and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities and the current enacted tax rates which will be in effect when these differences are expected to reverse. Provision (benefit) for deferred taxes is the result of changes in the DTAs and liabilities. Deferred taxes are reviewed quarterly and would be reduced by a valuation allowance if, based upon the information available, it is more likely than not that some or all of the DTAs will not be realized. Recent Accounting Developments In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606) (ASU 2014-09). ASU 2014-09 implements a common revenue standard that clarifies the principles for recognizing revenue. The core principle of ASU 2014-09 is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity should apply the following steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract and (v) recognize revenue when (or as) the entity satisfies a performance obligation. ASU 2015-14, Revenue from Contracts with Customers (Topic 606) (ASU 2015-14) was issued in August 2015 which deferred adoption to annual reporting periods beginning after December 15, 2017 and interim reporting periods within those annual periods. The timing of the Company’s revenue recognition did not materially change. Our largest portions of revenue, interest and fees on loans and gain on sales of loans, are specifically excluded from the scope of the guidance, and we currently recognize the majority of the remaining revenue sources in a manner that management believes is consistent with the new guidance. Unconsolidated subsidiaries of the Bank did have a material impact as a result of this ASU, and implementation resulted in a decrease of  $100,000 to retained earnings during 2019 and an increase of  $1,588,000 to retained earnings during 2018. In January 2016, the FASB issued ASU 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (ASU 2016-01). This guidance changes how entities account for equity investments that do not result in consolidation and are not accounted for under the equity method of accounting. Entities will be required to measure these investments at fair value at the end of each reporting period and recognize changes in fair value in net income. A practicability exception will be available for equity investments that do not have readily determinable fair values; however, the exception requires the Company to adjust the carrying amount for impairment and observable price changes in orderly transactions for the identical or a similar investment of the same issuer. This guidance also changes certain disclosure requirements and other aspects of current GAAP. This guidance was effective for fiscal years beginning after December 15, 2017 including interim reporting periods within those fiscal years. The adoption of this ASU did not have a material impact on our consolidated financial statements. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) (ASU 2016-02). Certain aspects of this ASU were updated in July 2018 by the issuance of ASU 2018-10, Codification Improvements to Topic 842, Leases. The new guidance establishes the principles to report transparent and economically neutral information about the assets and liabilities that arise from leases. Entities will be required to recognize the lease assets and lease liabilities that arise from leases in the statement of financial position and to disclose qualitative and quantitative information about lease transactions, such as information about variable lease payments and options to renew and terminate leases. This guidance was effective for fiscal years beginning after December 15, 2018 including interim reporting periods within those fiscal years. The Company’s assets and liabilities increased by $1.7 million based on the present value of the remaining lease payments for leases in place at the adoption date. In June 2016, the FASB issued ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments. Certain aspects of this ASU were updated in November 2018 by the issuance of ASU 2018-19, Codification Improvements to Topic 326, Financial Instruments-Credit Losses. The main objective of the ASU is to provide financial statement users with more decision-useful information about the expected credit losses on financial instruments and other commitments to extend credit held by a reporting entity at each reporting date. To achieve this objective, the amendments in the ASU replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. During 2019 FASB issued ASU 2019-10 which delayed the effective date of ASU 2016-13 for smaller, publicly traded companies, until interim and annual periods beginning after December 15, 2022. This delay applies to the Company as it was classified as a “Smaller reporting company” as defined in Rule 12b-2 of the Exchange Act as of the date ASU 2019-10 was enacted. We are currently evaluating the impact of ASU 2016-13 on the consolidated financial statements, although the general expectation in the banking industry is that the implementation of this standard will result in higher required balances in the ALLL. In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The amendments in this ASU were issued to address concerns over the cost and complexity of the two-step goodwill impairment test and resulted in the removal of the second step of the test. The amendments require an entity to apply a one-step quantitative test and record the amount of goodwill impairment as the excess of a reporting unit’s carrying amount over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit. The new guidance does not amend the optional qualitative assessment of goodwill impairment. This ASU is intended to reduce the cost and complexity of the two-step goodwill impairment test and is effective for annual and interim goodwill impairment tests in fiscal years beginning after December 15, 2019, with early adoption permitted for testing performed after January 1, 2017. Upon adoption, the amendments should be applied on a prospective basis and the entity is required to disclose the nature of and reason for the change in accounting principle upon transition. The adoption of this guidance is not expected to have a significant impact on our consolidated financial statements. In March 2017, the FASB issued ASU 2017-08, Receivables-Nonrefundable Fees and Other Costs (Subtopic 310-20): Premium Amortization on Purchased Callable Debt Securities. The amendments in this ASU shorten the amortization period for certain callable debt securities held at a premium. Specifically, the amendments require the premium to be amortized to the earliest call date. The amendments do not require an accounting change for securities held at a discount as discounts continue to be accreted to maturity. This ASU was intended to more closely align the amortization period of premiums and discounts to expectations incorporated in market pricing on the underlying securities. In most cases, market participants price securities to the call date that produces the worst yield when the coupon is above current market rates and prices securities to maturity when the coupon is below market rates. As a result, the amendments more closely align interest income recorded on bonds held at a premium or a discount with the economics of the underlying instrument. This ASU was intended to reduce diversity in practice and was effective for fiscal years beginning after December 15, 2018, with early adoption permitted. Upon adoption, the amendments were applied using a modified retrospective basis through a cumulative-effect adjustment directly to retained earnings as of the beginning of the period of adoption. Additionally, in the period of adoption, an entity was to provide disclosures about a change in accounting principles. The adoption of this guidance did not have a significant impact on our consolidated financial statements as all premiums within our securities portfolio were already being amortized to the earliest call date prior to implementation. In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. The amendments of this ASU better align an entity’s accounting and financial reporting for hedging activities with the economic objectives of those activities. The ASU was effective for fiscal years beginning after December 15, 2018 and interim reporting periods within those fiscal years, with early adoption permitted. The adoption of this guidance did not have a significant impact on our consolidated financial statements. In June 2018, the FASB issued ASU 2018-07, Stock Compensation-Improvements to Nonemployee Share-Based Payment Accounting, which simplifies several aspects of the account for nonemployee share-based payment transactions for acquiring goods or services from nonemployees. The amendment was effective for the fiscal years beginning after December 15, 2018, including interim reporting periods within those fiscal years, with early adoption permitted. The adoption of this guidance did not have a significant impact on our consolidated financial statements. PUBLIC COMPANY COSTS On September 24, 2018, the Company filed a Registration Statement on Form 10 with the SEC, and filed the Amendment No.1 to the Registration Statement on Form 10 on October 17, 2018. That Registration Statement was declared effective by the SEC on October 23, 2018. The Company qualifies as an “emerging growth company” as defined by the Jumpstart Our Business Startups Act (“JOBS Act”). There are additional costs associated with operating as a public company including hiring additional personnel, enhancing technology and expanding our capabilities. We expect that these costs will include legal, regulatory, accounting, investor relations and other expenses that we did not incur as a private company. Sarbanes-Oxley, as well as rules adopted by the SEC, the FDIC and national securities exchanges also requires public companies to implement specified corporate governance practices. In addition, due to regulatory changes in the banking industry and the implementation of new laws, rules and regulations, we are now subject to higher regulatory compliance costs. These additional rules and regulations also increase our legal, regulatory, accounting and financial compliance costs and make some activities more time-consuming. RESULTS OF OPERATIONS Results of Operations for the Years Ended December 31, 2019 and 2018 General. Net income increased $1.2 million, or 4.9%, to $26.7 million for the year ended December 31, 2019, from $25.5 million for the year ended December 31, 2018. The primary reason for the increase in profitability was increased net interest income from the added scale as a result of the acquisition of Partnership, which impacted the second half of 2019. This was offset by larger provisions for loan losses during 2019, which were required due to significant charge-offs related to exiting certain relationships which were obtained through the Waupaca acquisition. Net Interest Income. The management of interest income and expense is fundamental to our financial performance. Net interest income, the difference between interest income and interest expense, is the largest component of the Company’s total revenue. Management closely monitors both total net interest income and the net interest margin (net interest income divided by average earning assets). We seek to maximize net interest income without exposing the Company to an excessive level of interest rate risk through our asset and liability policies. Interest rate risk is managed by monitoring the pricing, maturity and repricing options of all classes of interest-bearing assets and liabilities. Our net interest margin can also be adversely impacted by the reversal of interest on nonaccrual loans and the reinvestment of loan payoffs into lower yielding investment securities and other short-term investments. Net interest income after provision for loan losses increased by $4.2 million to $64.4 million for the year ended December 31, 2019, from $60.2 million for the year ended December 31, 2018. Interest income on loans increased by $10.8 million, or 15.0%, from 2018 to 2019. Total average interest-earning assets increased to $1.81 billion for the year ended December 31, 2019 from $1.66 billion for the year ended December 31, 2018. The Bank’s net interest margin increased 6 basis points to 3.95% for the year ended December 31, 2019, up from 3.89% for the year ended December 31, 2018. Interest Income. Total interest income increased $11.2 million, or 14.4%, to $89.1 million for the year ended December 31, 2019, up from $77.9 million for the year ended December 31, 2018. As noted, the increase was primarily due to loan growth from the acquisition of Partnership. The average balance of loans increased by $139.4 million during 2019. Interest income was also aided by a generally rising interest rate environment which occurred throughout 2018 and the first half of 2019. Interest Expense. Interest expense increased $4.7 million, or 31.3%, to $19.5 million for the year ended December 31, 2019, up from $14.8 million for the year ended December 31, 2018. The increase was driven by a $53.7 million increase in the average balance of interest-bearing liabilities as well as an increase in the average cost of interest-bearing liabilities, rising 32 basis points from 1.25% to 1.57%. As noted above, a generally rising interest rate environment occurred throughout 2018 and the first half of 2019. Interest expense from other borrowed funds decreased $0.9 million from 2018 to 2019, primarily due to a decrease of 57.8 million in the average balance of other borrowings year-over-year. Interest expense on interest-bearing deposits increased by $5.5 million to $17.9 million for the year ended December 31, 2019, from $12.4 million for the year ended December 31, 2018. This increase was primarily due to a higher interest rate environment along with elevated levels of interest-bearing deposits from the acquisition of Partnership, which impacted the second half of 2019. The average cost of interest-bearing deposits was 1.50% for the year ended December 31, 2019, compared to 1.15% for the year ended December 31, 2018. Provision for Loan Losses. Credit risk is inherent in the business of making loans. We establish an ALLL through charges to earnings, which are shown in the statements of operations as the provision for loan losses. Specifically identifiable and quantifiable known losses are promptly charged off against the allowance. The provision for loan losses is determined by conducting a quarterly evaluation of the adequacy of our ALLL and charging the shortfall or excess, if any, to the current quarter’s expense. This has the effect of creating variability in the amount and frequency of charges to earnings. The provision for loan losses and level of allowance for each period are dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management’s assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in our market area. The determination of the amount is complex and involves a high degree of judgment and subjectivity. We recorded a provision for loan losses of  $5.3 million for the year ended December 31, 2019, compared to $2.9 million for the year ended December 31, 2018. Significant charge-offs occurring during the third quarter of 2019 necessitated increased provisions for loan losses during 2019. These charge-offs were the result of exiting certain relationships during that quarter which were originally acquired as part of the Waupaca transaction. These relationships were never anticipated to be long-term relationships for the Company, and this action had been foreshadowed since the transaction occurred during 2017.The ALLL was $11.4 million, or 0.66% of total loans, at December 31, 2019 compared to $12.2 million, or 0.86% of total loans at December 31, 2018. Noninterest Income. Noninterest income is an important component of our total revenues. A significant portion of our noninterest income is associated with service charges and income from the Bank’s unconsolidated subsidiaries, Ansay and UFS. Other sources of noninterest income include loan servicing fees, gains on sales of mortgage loans, and other income from strategic alliances. Noninterest income increased $1.1 million to $12.6 million in 2019 compared to $11.5 million in 2018. Income from Ansay decreased by $0.3 million as a result of lower contingency income recorded during 2019 compared to 2018. As an insurance broker, Ansay’s profitability is subject to ongoing volatility due to variable claim history from year-to-year, which impacts the level of contingency income they receive. Income from UFS increased by $0.4 million from 2018 to 2019, the result of an increase in their customer base. Loan servicing income decreased by $0.9 million from 2018 to 2019. This decrease was the result of a negative valuation adjustment to the Bank’s mortgage servicing rights asset of  $0.7 million during 2019 versus a positive valuation adjustment of  $0.4 million during 2018. Offsetting this, however, was an increase of  $0.8 million in gains on sales of mortgage loans on the secondary market year-over-year. Finally, a restructuring of the Bank’s investment portfolio during 2019 led to a gain on sale of investments of  $0.9 million, an increase over a negligible loss during 2018. The major components of our noninterest income are listed in the table below: Noninterest Expense. Noninterest expense increased $3.1 million to $42.7 million for the year ended December 31, 2019, up from $39.6 million for the year ended December 31, 2018. Personnel expense increased $1.4 million, or 6.5%, year-over-year, the result of staffing four additional locations for the second half of 2019 after the Partnership acquisition. Equipment and data processing expense as well as amortization of intangibles also all increased significantly from 2018 to 2019 as a result of the Partnership acquisition. Outside service fees were also negatively impacted by the Partnership acquisition during 2019, but this impact was more than offset by the lack of expenses that were incurred during 2018 during the process of becoming an SEC registrant. Charitable contributions returned to normal levels during 2019 after seeing several large one-time contributions during 2018. The major components of our noninterest expense are listed in the table below. Income Tax Expense. We recorded a provision for income taxes of  $7.6 million for the year ended December 31, 2019, compared to $6.6 million for the year ended December 31, 2018, reflecting effective tax rates of 22.1% and 20.6%, respectively. The effective tax rate for 2019 increased due to certain nondeductible expenses incurred as part of the Partnership acquisition. Results of Operations for the Years Ended December 31, 2018 and 2017 General. Net income increased $10.1 million, or 66.2%, to $25.5 million for the year ended December 31, 2018, from $15.3 million for the year ended December 31, 2017. The primary reason for the increase in profitability was increased net interest income from the added scale as a result of the acquisition of Waupaca, which impacted all twelve months of 2018 compared to a little more than two months of 2017. This was offset by larger provisions for loan losses during 2018, which were required to establish an allowance for loans which were purchased in that acquisition at fair value, and required reserves in the ALLL when they renewed during 2018. In addition, the reduced corporate tax rate from 35% to 21% pursuant to the Tax Cuts and Jobs Act had a significantly positive impact on net income for 2018. Net Interest Income. Net interest income after provision for loan losses increased by $15.5 million to $60.2 million for the year ended December 31, 2018, from $44.7 million for the year ended December 31, 2017. The increase in net interest income was due to loan growth primarily from the acquisition of loans from Waupaca in the fourth quarter of 2017. Interest income on loans increased by $23.2 million, or 47.6%, from 2017 to 2018. Total average interest-earning assets increased to $1.66 billion for the year ended December 31, 2018 from $1.38 billion for the year ended December 31, 2017. The Bank’s net interest margin increased 44 basis points to 3.89% for the year ended December 31, 2018, up from 3.45% for the year ended December 31, 2017. Interest Income. Total interest income increased $24.5 million, or 45.8%, to $77.9 million for the year ended December 31, 2018, up from $53.5 million for the year ended December 31, 2017. As noted, the increase was primarily due to loan growth from the acquisition of Waupaca. The average balance of loans increased by $295.8 million during 2018. Interest Expense. Interest expense increased $7.1 million, or 92.0%, to $14.8 million for the year ended December 31, 2018, up from $7.7 million for the year ended December 31, 2017. The increase was driven by a $212.7 million increase in the average balance of interest-bearing liabilities as well as an increase in the average cost of interest-bearing liabilities, rising 46 basis points from 0.79% to 1.25%. Interest expense from other borrowed funds increased $1.2 million from 2017 to 2018, primarily due to an increase of 1.18% in the average borrowing cost year-over-year. Interest expense on interest-bearing deposits increased by $5.9 million to $12.4 million for the year ended December 31, 2018, from $6.4 million for the year ended December 31, 2017. This increase was primarily due to a higher interest rate environment along with elevated levels of interest-bearing deposits from the acquisition of Waupaca, which impacted the full year 2018 versus two months of 2017. The average cost of interest-bearing deposits was 1.15% for the year ended December 31, 2018, compared to 0.76% for the year ended December 31, 2017. The average cost of all deposit types increased for the year ended December 31, 2018 as compared to the year ended December 31, 2017 due to a generally higher interest rate environment. Provision for Loan Losses. We recorded a provision for loan losses of  $2.9 million for the year ended December 31, 2018, compared to $1.1 million for the year ended December 31, 2017. The elevated level of provision for loan losses during 2018 was the result of several significant charged off loans during 2018 along with the need to establish an allowance on the loans which were acquired in connection with the Waupaca acquisition near the end of 2017 and renewed during 2018. These loans were recorded at fair value when purchased, with no related ALLL, but required an ALLL once they renewed. The ALLL was $12.2 million, or 0.86% of total loans, at December 31, 2018 compared to $11.6 million, or 0.83% of total loans at December 31, 2017. Noninterest Income. Noninterest income increased $1.7 million to $11.5 million in 2018 compared to $9.8 million in 2017. Due to the increased customer base from the Waupaca acquisition in late 2017, service charge income increased by $0.5 million to $3.5 million for 2018, from $3.0 million for 2017. Income from the minority-owned subsidiaries Ansay and UFS increased by $0.6 million from 2017 to 2018. Loan servicing income increased by $0.3 million from 2017 to 2018 primarily due to the revaluation of our mortgage servicing rights asset. Offsetting this, however, was a reduction of  $0.3 million in net gain on sales of mortgage loans from 2017 to 2018 as we experienced the effects of an overall slowdown in mortgage originations throughout 2018. Finally, other noninterest income benefited during 2018 from rent received on other real estate owned properties which were acquired through the Waupaca acquisition late in 2017. The major components of our noninterest income are listed in the table below: Noninterest Expense. Noninterest expense increased $9.2 million to $39.6 million for the year ended December 31, 2018, up from $30.4 million for the year ended December 31, 2017. The primary cause of increases in most areas within noninterest expense from 2017 to 2018 was due to the acquisition of Waupaca during late 2017 which impacted the full year 2018 versus two months of 2017. Salaries, commissions and employee benefits expense for the year ended December 31, 2018 was $21.5 million compared to $16.6 million for the year ended December 31, 2017, an increase of  $4.9 million, or 29.6%. This increase was attributable to an increase in the overall number of employees due to the Waupaca acquisition and also what is consistent and necessary to support our continued growth, annual salary adjustments, increased bonus and incentives and increased benefit costs. 2018 also experienced elevated expenses in the areas of occupancy, equipment and office as well as postage, stationery and supplies as a result of significant improvements to facilities and equipment in the offices acquired near the end of 2017 and the need to stock them all with supplies. The increase in customers as a result of this acquisition led to higher data processing costs, which have a significant component calculated on a per-customer basis. Net losses on sales of ORE increased significantly during 2018 as a result of many problem loans and ORE which were a part of the Waupaca acquisition. As part of the accounting for the acquisition, a core deposit intangible of  $3.1 million was established. 2018 saw twelve months of amortization of this core deposit intangible versus two during 2017, causing an increase in amortization expense. Finally, other noninterest expense increased significantly due to the costs to repossess and maintain a significant amount of collateral on defaulted loans. The major components of our noninterest expense are listed in the table below. Income Tax Expense. We recorded a provision for income taxes of  $6.6 million for the year ended December 31, 2018, compared to $8.8 million for the year ended December 31, 2017, reflecting effective tax rates of 20.6% and 36.6%, respectively. As a result of the Tax Cuts and Jobs Act, we recorded a write down to our net DTAs of approximately $0.6 million, resulting in an equivalent increase in tax expense for 2017. In addition, the provision for 2018 was lower due to the lower federal rates. NET INTEREST MARGIN Net interest income represents the difference between interest earned, primarily on loans and investments, and interest paid on funding sources, primarily deposits and borrowings. Interest rate spread is the difference between the average rate earned on total interest-earning assets and the average rate paid on total interest-bearing liabilities. Net interest margin is the amount of net interest income, on a fully taxable-equivalent basis, expressed as a percentage of average interest-earning assets. The average rate earned on earning assets is the amount of annualized taxable equivalent interest income expressed as a percentage of average earning assets. The average rate paid on interest-bearing liabilities is equal to annualized interest expense as a percentage of average interest-bearing liabilities. The following tables set forth the distribution of our average assets, liabilities and shareholders’ equity, and average rates earned or paid on a fully taxable equivalent basis for each of the periods indicated: (1) Annualized on a fully taxable equivalent basis calculated using a federal tax rate of 21% for years ended December 31, 2019 and 2018, and 35% for year ended December 31, 2017. (2) Nonaccrual loans are included in average amounts outstanding. (3) Interest rate spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities. (4) Net interest margin represents net interest income on a fully tax equivalent basis as a percentage of average interest-earning assets. Rate/Volume Analysis The following tables describe the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volumes (changes in average balance multiplied by prior year average rate) and (ii) changes attributable to changes in rate (change in average interest rate multiplied by prior year average balance), while (iii) changes attributable to the combined impact of volumes and rates have been allocated proportionately to separate volume and rate categories. CHANGES IN FINANCIAL CONDITION Total Assets. Total assets increased $417.0 million, or 23.3%, to $2.2 billion at December 31, 2019 from $1.79 billion at December 31, 2018. Cash and Cash Equivalents. Cash and cash equivalents decreased by $21.3 million, or 19.8%, to $86.5 million at December 31 2019 from $107.7 million at December 31, 2018. Investment Securities. The carrying value of total investment securities increased by $65.6 million to $225.2 million at December 31, 2019 from $159.7 million at December 31, 2018. Loans. Net loans increased by $308.7 million, or 21.8%, to $1.72 billion at December 31, 2019 from $1.42 billion at December 31, 2018. Bank-Owned Life Insurance. At December 31, 2019, our investment in bank-owned life insurance was $24.9 million, an increase of  $0.8 million from $24.2 million at December 31, 2018. Deposits. Deposits increased $286.1 million, or 18.4%, to $1.84 billion at December 31, 2019 from $1.56 billion at December 31, 2018. Borrowings. At December 31, 2019, borrowings consisted of advances from the FHLB of Chicago, as well as notes payable and subordinated debt to other banks. FHLB borrowings and notes payable to other banks totaled $39.8 million and $10.0 million, respectively, at December 31, 2019. There were no FHLB borrowings or notes payable outstanding as of December 31, 2018. Subordinated debt increased $7.1 million to $18.6 million at December 31, 2019 from $11.5 million at December 31, 2018. The increase in subordinated debt is entirely due to a borrowing that was acquired as part of the Partnership transaction. Stockholders’ Equity. Total stockholders’ equity increased $55.9 million, or 32.1%, to $230.2 million at December 31, 2019 from $174.3 million at December 31, 2018. LOANS Our lending activities are conducted principally in Wisconsin. The Bank makes commercial and industrial loans, commercial real estate loans, construction and development loans, residential real estate loans, and a variety of consumer loans and other loans. Much of the loans made by the Bank are secured by real estate collateral. The Bank’s commercial business loans are primarily made based on the cash flow of the borrower and secondarily on the underlying collateral provided by the borrower, with liquidation of the underlying real estate collateral typically being viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are also often collateralized by equipment, inventory, accounts receivable, or other business assets, the liquidation of collateral in the event of default is often an insufficient source of repayment. Repayment of the Bank’s residential loans are generally dependent on the health of the employment market in the borrowers’ geographic areas and that of the general economy with liquidation of the underlying real estate collateral being typically viewed as the primary source of repayment in the event of borrower default. Our loan portfolio is our most significant earning asset, comprising 78.6%, 79.7% and 79.7% of our total assets as of December 31, 2019, 2018 and 2017, respectively. Our strategy is to grow our loan portfolio by originating quality commercial and consumer loans that comply with our credit policies and that produce revenues consistent with our financial objectives. We believe our loan portfolio is well-balanced, which provides us with the opportunity to grow while monitoring our loan concentrations. Total loans increased $307.8 million, or 21.6%, to $1.74 billion as of December 31, 2019 as compared to $1.43 billion as of December 31, 2018. Our loan growth during the year ended December 31, 2019 has been comprised of an increase of  $5.1 million or 1.7% in commercial and industrial loans, an increase of  $144.8 million or 21.7% in commercial real estate loans, an increase of  $71.4 million or 117.4% in construction and development loans, an increase of  $79.9 million or 21.7% in residential 1-4 family loans and an increase of  $6.7 million or 20.1% in consumer and other loans. The increase in loans during the year ended December 31, 2019 is attributable to loans purchased as part of the Partnership transaction along with modest organic loan growth. This was offset by a reduction in loans which were acquired as part of the Waupaca transaction, which were primarily poor quality, out-of-market loan relationships which were never intended to be a long-term part of the Bank’s portfolio. Total loans increased $30.9 million, or 2.2%, to $1.43 billion as of December 31, 2018 as compared to $1.40 billion as of December 31, 2017. Our loan growth during the year ended December 31, 2018 has been comprised of an increase of  $33.8 million or 12.8% in commercial and industrial loans, an increase of  $24.5 million or 3.8% in commercial real estate loans, a decrease of $15.0 million or 19.8% in construction and development loans, a decrease of  $8.6 million or 2.3% in residential 1-4 family loans and a decrease of  $3.7 million or 10.1% in consumer and other loans. The increase in loans during the year ended December 31, 2018 is attributable to modest organic loan growth, which was offset by a planned reduction of a portion of the loan portfolio acquired from Waupaca. The following table presents the balance and associated percentage of each major category in our loan portfolio at December 31, 2019, 2018, 2017, 2016 and 2015: Our directors and officers and their associates are customers of, and have other transactions with, the Bank in the normal course of business. All loans and commitments included in such transactions were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons and do not involve more than normal risk of collection or present other unfavorable features. At December 31, 2019 and December 31, 2018, total loans outstanding to such directors and officers and their associates were $68.6 million and $84.1 million, respectively. During the year ended December 31, 2019, $27.9 million of additions and $43.4 million of repayments were made to these loans, compared to $59.7 million of additions and $41.3 million of repayments during the year ended December 31, 2018. At December 31, 2019 and December 31, 2018, all of the loans to directors and officers were performing according to their original terms. Loan categories The principal categories of our loan portfolio are discussed below: Commercial and Industrial (C&I). Our C&I portfolio totaled $302.4 million, $297.3 million and $263.5 million at December 31, 2019, 2018 and 2017, respectively, and represented 17%, 21% and 19% of our total loans, respectively. C&I loans increased 1.7% during 2019. C&I loans increased 12.8% during 2018 due to the increased business needs of customers in our markets in response to strong economic conditions in those markets. C&I loans increased 30.3% during 2017 due primarily to the Waupaca acquisition Our C&I loan customers represent various small and middle-market established businesses involved in professional services, accommodation and food services, health care, financial services, wholesale trade, manufacturing, distribution, retailing and non-profits. Most clients are privately owned with markets that range from local to national in scope. Many of the loans to this segment are secured by liens on corporate assets and the personal guarantees of the principals. The regional economic strength or weakness impacts the relative risks in this loan category. There is little concentration in any one business sector, and loan risks are generally diversified among many borrowers. Commercial Real Estate (CRE). Our CRE loan portfolio totaled $813.1 million, $668.3 million and $643.8 million at December 31, 2019, 2018 and 2017, respectively, and represented 47%, 47% and 46% of our total loans, respectively. Our CRE loans increased 21.7% during 2019 due primarily to the Partnership acquisition. Our CRE loans increased 3.8% during 2018 due to modest organic loan growth spurred by the business needs of customers in our markets, offset by a planned reduction in out-of-market CRE loans acquired in the Waupaca acquisition that was planned at the time of acquisition Our CRE loans are secured by a variety of property types including multifamily dwellings, retail facilities, office buildings, commercial mixed use, lodging and industrial and warehouse properties. We do not have any specific industry or customer concentrations in our CRE portfolio. Our commercial real estate loans are generally for terms up to twenty years, with loan-to-values that generally do not exceed 85%. Amortization schedules are long term and thus a balloon payment is generally due at maturity. Under most circumstances, the Bank will offer to rewrite or otherwise extend the loan at prevailing interest rates. Construction and Development (C&D). Our C&D loan portfolio totaled $132.2 million, $60.8 million and $75.8 million at December 31, 2019, 2018 and 2017, respectively, and represented 8%, 4% and 5% of our total loans, respectively. C&D loans increased 117.4% during 2019 due to a combination of loans acquired in the Partnership acquisition and strong development in both owner-occupied and multifamily developments in our markets due to a continued strong economy. C&D loans decreased 19.8% during 2018 as a result of targeted efforts to reduce this type of lending as it had approached an internally set maximum allowable percentage to regulatory capital during 2017 Our C&D loans are generally for the purpose of creating value out of real estate through construction and development work, and also include loans used to purchase recreational use land. Borrowers typically provide a copy of a construction or development contract which is subject to bank acceptance prior to loan approval. Disbursements are handled by a title company. Borrowers are required to inject their own equity into the project prior to any note proceeds being disbursed. These loans are, by their nature, intended to be short term and are refinanced into other loan types at the end of the construction and development period. Residential 1-4 Family. Our residential 1-4 family loan portfolio totaled $448.6 million, $368.7 million and $377.3 million at December 31, 2019, 2018 and 2017, respectively, and represented 26%, 26% and 27% of our total loans, respectively. Residential 1-4 family loans increased 21.7% during 2019 primarily as a result of the Partnership transaction.. Residential 1-4 family loans decreased 2.3% during 2018 as a result of an overall slowdown in the residential mortgage lending environment. We offer fixed and adjustable rate residential mortgage loans with maturities up to 30 years. One-to-four family residential mortgage loans are generally underwritten according to Fannie Mae guidelines, and we refer to loans that conform to such guidelines as “conforming loans.” We generally originate both fixed and adjustable rate mortgage loans in amounts up to the maximum conforming loan limits as established by the Federal Housing Finance Agency. In addition, we also offer loans above conforming lending limits typically referred to as “jumbo” loans. These loans are typically underwritten to the same guidelines as conforming loans; however, we may choose to hold a jumbo loan within its portfolio with underwriting criteria that does not exactly match conforming guidelines. We do not offer reverse mortgages nor do we offer loans that provide for negative amortization of principal, such as “Option ARM” loans, where the borrower can pay less than the interest owed on his loan, resulting in an increased principal balance during the life of the loan. We also do not offer “subprime loans” (loans that are made with low down payments to borrowers with weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, bankruptcies, or borrowers with questionable repayment capacity as evidenced by low credit scores or high debt-burden ratios) or Alt-A loans (defined as loans having less than full documentation). Residential real estate loans are originated both for sale to the secondary market as well as for retention in the Bank’s loan portfolio. The decision to sell a loan to the secondary market or retain within the portfolio is determined based on a variety of factors including but not limited to our asset/liability position, the current interest rate environment, and customer preference. Servicing rights are retained on all loans sold to the secondary market. We were servicing mortgage loans sold to others without recourse of approximately $554.4 million, $316.5 million and $316.3 million at December 31, 2019, 2018 and 2017, respectively. Loans sold with the retention of servicing assets result in the capitalization of servicing rights. Loan servicing rights are included in other assets and are subsequently amortized as an offset to other income over the estimated period of servicing. The net balance of capitalized servicing rights amounted to $4.3 million, $3.1 million and $2.6 million at December 31, 2019, 2018 and 2017, respectively. Consumer Loans. Our consumer loan portfolio totaled $29.6 million, $27.0 million and $33.6 million at December 31, 2019, 2018 and 2017, respectively, and represented and represented 2% of our total loans at the end of each period.. Consumer loans include secured and unsecured loans, lines of credit and personal installment loans. Our consumer loans increased by 9.8% during 2019. Our consumer loans decreased by 19.7% during 2018 due to one loan totaling $7.6 million, secured by a trust, which was paid in full when the trust grantor passed away. Consumer loans generally have greater risk compared to longer-term loans secured by improved, owner-occupied real estate, particularly consumer loans that are secured by rapidly depreciable assets. In these cases, any repossessed collateral for a defaulted loan may not provide an adequate source of repayment of the outstanding loan balance. As a result, consumer loan repayments are dependent on the borrower’s continuing financial stability and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Other Loans. Our other loans totaled $10.4 million, $6.4 million and $3.5 million at December 31, 2019, 2018 and 2017, respectively, and are immaterial to the overall loan portfolio. The other loans category consists primarily of overdrawn depository accounts, loans utilized to purchase or carry securities and loans to nonprofit organizations. Loan Portfolio Maturities. The following tables summarize the dollar amount of loans maturing in our portfolio based on their loan type and contractual terms to maturity at December 31, 2019 and 2018, respectively. The tables do not include any estimate of prepayments, which can significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. The following tables summarize the dollar amount of loans maturing in our portfolio based on whether the loan has a fixed or variable rate of interest and their contractual terms to maturity at December 31, 2019 and 2018, respectively. The tables do not include any estimate of prepayments, which can significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less. NONPERFORMING LOANS AND TROUBLED DEBT RESTRUCTURINGS In order to operate with a sound risk profile, we focus on originating loans that we believe to be of high quality. We have established loan approval policies and procedures to assist us in maintaining the overall quality of our loan portfolio. When delinquencies in our loans exist, we rigorously monitor the levels of such delinquencies for any negative or adverse trends. From time to time, we may modify loans to extend the term or make other concessions to help a borrower with a deteriorating financial condition stay current on their loan and to avoid foreclosure. We generally do not forgive principal or interest on loans or modify the interest rates on loans to rates that are below market rates. Furthermore, we are committed to collecting on all of our loans and, as a result, at times have lower net charge-offs compared to many of our peer banks. We believe that our commitment to collecting on all of our loans results in higher loan recoveries. Our nonperforming assets consist of nonperforming loans and foreclosed real estate. Nonperforming loans are those on which the accrual of interest has stopped, as well as loans that are contractually 90 days past due on which interest continues to accrue. The composition of our nonperforming assets is as follows: At December 31, 2019, 2018, 2017, 2016 and 2015, impaired loans had specific reserves of $840,000, $1,079,000, $281,000, $225,000 and $360,000, respectively. Levels of specific reserves are dependent on the specific underlying impaired loans at any given time, and the decrease in specific reserves as of December 31, 2019 is due to management’s determination of the collectability of loans considered impaired at that time. Management has evaluated the aforementioned loans and other loans classified as nonperforming and believes that all nonperforming loans have been adequately reserved for in the allowance for loan losses at December 31, 2019. Until 2017, the steady decline in our nonperforming assets was the result of the consistent improvement in our overall credit quality as economic conditions in our markets have continued to improve. Our nonperforming assets have increased during the years ended December 31, 2018 and 2017, primarily due to the Waupaca acquisition, which included $19.4 million of loans which were considered nonperforming. This increase in nonperforming assets was anticipated in conjunction with the Waupaca acquisition, and management has and will continue to actively manage these relationships out of the Bank through pay downs, refinances with or sales of loans to other institutions, or foreclosure actions. As a result of these actions nonperforming assets declined sharply during 2019. Nonaccrual Loans Loans are typically placed on nonaccrual status when any payment of principal and/or interest is 90 days or more past due, unless the collateral is sufficient to cover both principal and interest and the loan is in the process of collection. Loans are also placed on nonaccrual status when management believes, after considering economic and business conditions, that the principal or interest will not be collectible in the normal course of business. We monitor closely the performance of our loan portfolio. In addition to the monitoring and review of loan performance internally, we have also contracted with an independent organization to review our commercial and retail loan portfolios. The status of delinquent loans, as well as situations identified as potential problems, is reviewed on a regular basis by senior management. Troubled Debt Restructurings A troubled debt restructuring includes a loan modification where a borrower is experiencing financial difficulty and we grant a concession to that borrower that we would not otherwise consider except for the borrower’s financial difficulties. These concessions may include modifications of the terms of the debt such as deferral of payments, extension of maturity, reduction of principal balance, reduction of the stated interest rate other than normal market rate adjustments, or a combination of these concessions. Debt may be bifurcated with separate terms for each tranche of the restructured debt. Restructuring a loan in lieu of aggressively enforcing the collection of the loan may benefit the Company by increasing the ultimate probability of collection. A TDR may be either on accrual or nonaccrual status based upon the performance of the borrower and management’s assessment of collectability. If a TDR is placed on nonaccrual status, which would occur based on the same criteria as non-TDR loans, it remains there until a sufficient period of performance under the restructured terms has occurred at which it returned to accrual status, generally 6 months. As of December 31, 2019 and 2018, the Company had specific reserves of  $80,000 and $353,000 for TDRs, respectively, and none of them have subsequently defaulted. Classified loans Accounting standards require the Company to identify loans, where full repayment of principal and interest is doubtful, as impaired loans. These standards require that impaired loans be valued at the present value of expected future cash flows, discounted at the loan’s effective interest rate, or using one of the following methods: the observable market price of the loan or the fair value of the underlying collateral if the loan is collateral dependent. We have implemented these standards in our quarterly review of the adequacy of the ALLL, and identify and value impaired loans in accordance with guidance on these standards. As part of the review process, we also identify loans classified as watch, which have a potential weakness that deserves management’s close attention. Loans totaling $60.3 million and $67.6 million were classified substandard under the Bank’s policy as of December 31, 2019 and 2018, respectively. The following table sets forth information related to the credit quality of our loan portfolio at December 31, 2019 and 2018. ALLOWANCE FOR LOAN AND LEASE LOSSES ALLL represents management’s estimate of probable and inherent credit losses in the loan portfolio. Estimating the amount of the ALLL require the exercise of significant judgment and the use of estimates related to the amount and timing of expected future cash flows or impaired loans, estimated losses on pools of homogenous loans based on historical loss experience, and consideration of other qualitative factors such as current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset on the consolidated balance sheets. Loan losses are charged off against the ALLL, while recoveries of amounts previously charged off are credited to the ALLL. A provision for loan losses is charged to operations based on management’s periodic evaluation of the factors previously mentioned, as well as other pertinent factors. The ALLL consists of specific reserves for certain individually evaluated impaired loans and general reserves for collectively evaluated non-impaired loans. Specific reserves reflect estimated losses on impaired loans from management’s analyses developed through specific credit allocations. The specific reserves are based on regular analyses of impaired, non-homogenous loans greater than $250,000. These analyses involve a high degree of judgment in estimating the amount of loss associated with specific loans, including estimating the amount and timing of future cash flows and collateral values. The general reserve is based in part on the Bank’s historical loss experience which is updated quarterly. The general reserve portion of the ALLL also includes consideration of certain qualitative factors such as (1) changes in lending policies and/or underwriting practices, (2) national and local economic conditions, (3) changes in portfolio volume and nature, (4) experience, ability and depth of lending management and other relevant staff, (5) levels of and trends in past-due and nonaccrual loans and quality, (6) changes in loan review and oversight, (7) impact and effects of concentrations and (8) other issues deemed relevant. There are many factors affecting the ALLL; some are quantitative while others require qualitative judgment. The process for determining the ALLL (which management believes adequately considers potential factors which might possibly result in credit losses) includes subjective elements and, therefore, may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provision for loan losses could be required that could adversely affect our earnings or financial position in future periods. Allocations of the ALLL may be made for specific loans but the entire ALLL is available for any loan that, in management’s judgment, should be charged off or for which an actual loss is realized. As an integral part of their examination process, various regulatory agencies review the ALLL as well. Such agencies may require that changes in the ALLL be recognized when such regulators’ credit evaluations differ from those of management based on information available to the regulators at the time of their examinations. The following table summarizes the changes in our ALLL for the years indicated: The level of charge-offs depends on many factors, including the national and regional economy. Cyclical lagging factors may result in charge-offs being higher than historical levels. The dollar amount of the ALLL increased primarily as a result of loan growth and changes in the portfolio composition. Although the allowance is allocated between categories, the entire allowance is available to absorb losses attributable to all loan categories. Management believes that the ALLL is adequate. The following table summarizes an allocation of the ALLL and the related percentage of loans outstanding in each category for the periods below. SOURCES OF FUNDS General. Deposits traditionally have been our primary source of funds for our investment and lending activities. We continue to focus on growing core deposits through our relationship driven banking philosophy and community-focused marketing programs. We also borrow from the FHLB of Chicago to supplement cash needs, to lengthen the maturities of liabilities for interest rate risk management purposes and to manage our cost of funds. Our additional sources of funds are scheduled payments and prepayments of principal and interest on loans and investment securities and fee income and proceeds from the sales of loans and securities. Deposits. Our current deposit products include non-interest bearing and interest-bearing checking accounts, savings accounts, money market accounts, and certificate of deposits. As of December 31, 2019, deposit liabilities accounted for approximately 83.4% of our total liabilities and equity. We accept deposits primarily from customers in the communities in which our branches and offices are located, as well as from small businesses and other customers throughout our lending area. We rely on our competitive pricing and products, quality customer service, and convenient locations and hours to attract and retain deposits. Deposit rates and terms are based primarily on current business strategies, market interest rates, liquidity requirements and our deposit growth goals. Total deposits were $1.84 billion, $1.56 billion and $1.51 billion as of December 31, 2019, 2018 and 2017, respectively. Noninterest-bearing deposits at December 31, 2019, 2018 and 2017 were $476.5 million, $448.8 million and $436.6 million, respectively, while interest-bearing deposits were $1.37 billion, $1.11 billion and $1.07 billion at December 31, 2019, 2018 and 2017, respectively. At December 31, 2019, we had a total of  $389.0 million in certificates of deposit, including $15.6 million of brokered deposits, of which $3.0 million had remaining maturities of one year or less. Based on historical experience and our current pricing strategy, we believe we will retain a large portion of these accounts upon maturity. The following tables set forth the average balances of our deposits for the periods indicated: Certificates of deposit of  $100,000 or greater by maturity are as follows: Retail certificates of deposit of  $100,000 or greater totaled $176.6 million, $198.4 million and $176.7 million at December 31, 2019, 2018 and 2017, respectively. Interest expense on retail certificates of deposit of  $100,000 or greater was $3.5 million, $2.5 million and $1.4 million for the years ended December 31, 2019, 2018 and 2017, respectively. The following table sets forth certificates of deposit (including brokered deposits) classified by interest rate as of the dates indicated: Borrowings Deposits and investment securities for sale are the primary source of funds for our lending activities and general business purposes. However, we may also obtain advances from the FHLB, purchase federal funds and engage in overnight borrowing from the Federal Reserve, correspondent banks, or enter into repurchase agreements. Securities sold under repurchase agreements The Company has securities sold under repurchase agreements which have contractual maturities up to one year from the transaction date with variable and fixed rate terms. The agreements to repurchase require that the Company (seller) repurchase identical securities as those that are sold. The securities underlying the agreements are under the Company’s control. The following table summarizes securities sold under repurchase agreements, and the weighted average interest rates paid: Lines of credit and other borrowings The Company’s other borrowings have historically consisted primarily of FHLB of Chicago advances collateralized by a blanket pledge agreement on the Company’s FHLB capital stock and retail and commercial loans held in the Company’s portfolio. There were $39.8 million of advances outstanding from the FHLB at December 31, 2019. There were no advances outstanding from the FHLB as of December 31, 2018. From time to time the Company utilized short-term FHLB advances to fund liquidity during 2018 The total loans pledged as collateral were $815.2 million, $697.3 million and $564.4 million at December 31, 2019, 2018 and 2017, respectively. Outstanding letters of credit from the FHLB totaled $14.4 million, $55.0 million and $20.7 million at December 31, 2019, 2018 and 2017, respectively. The following table summarizes borrowings, which consist of borrowings from the FHLB, and the weighted average interest rates paid: We maintain a $5.0 million line of credit with a commercial bank. At December 31, 2019, 2018 and 2017, we had outstanding balances on this note of  $5.0 million, $-0- and $5.0 million respectively. Borrowings under this note carry interest at a variable rate with a floor of 3.50% , due in full on May 25, 2020. We also maintain another $5.0 million line of credit with another commercial bank. There were outstanding balances on this note of  $5.0 million as of December 31, 2019. There were no advances on this note at December 31, 2018 or 2017. Borrowings under this note carry interest at a variable rate with a floor of 3.25% , due in full on May 19, 2020. During September 2017, the Company entered into subordinated note agreements with three separate commercial banks. The Company had up to twelve months from entering these agreements to borrow funds up to a maximum availability of  $22.5 million. As of December 31, 2019 and 2018, the Company had borrowed $11.5 million under these agreements. These notes were all issued with 10-year maturities, carry interest at a variable rate payable quarterly, are callable on or after the sixth anniversary of their issuance dates, and qualify for Tier 2 capital for regulatory purposes. As part of the Partnership acquisition, the Company assumed a subordinated note agreement with an outstanding balance of  $7.0 million, and a fair market value adjustment of  $0.2 million. The note matures on October 1, 2025, requires quarterly interest-only payments at a rate of 7.1% prior to maturity, and can be prepaid without penalty after October 1, 2020. This note qualifies for Tier 2 capital for regulatory purposes. INVESTMENT SECURITIES Our securities portfolio consists of securities available for sale and securities held to maturity. Securities are classified as held to maturity or available for sale at the time of purchase. Obligations of states and political subdivisions and mortgage-backed securities, all of which are issued by U.S. government agencies or U.S. government-sponsored enterprises, make up the largest components of the securities portfolio. We manage our investment portfolio to provide an adequate level of liquidity as well as to maintain neutral interest rate-sensitive positions, while earning an adequate level of investment income without taking undue or excessive risk. Securities available for sale consist of U.S. Treasury securities, obligations of states and political subdivision, mortgage-backed securities, and corporate notes. Securities classified as available for sale, which management has the intent and ability to hold for an indefinite period of time, but not necessarily to maturity, are carried at fair value, with unrealized gains and losses, net of related deferred income taxes, included in stockholders’ equity as a separate component of other comprehensive income. The fair value of securities available for sale totaled $181.5 million and included gross unrealized gains of  $3.4 million and gross unrealized losses of  $0.2 million at December 31, 2019. At December, 31 2018, the fair value of securities available for sale totaled $118.9 million and included gross unrealized gains of  $0.8 million and gross unrealized losses of $1.4 million. Securities classified as held to maturity consist of U.S. Treasury securities and obligations of states and political subdivisions. These securities, which management has the intent and ability to hold to maturity, are reported at amortized cost. Securities held to maturity as of December 31, 2019 are carried at their amortized cost of  $43.7 million. At December 31, 2018, securities held to maturity totaled $40.8 million. The Company recognized a net gain of  $0.2 million on the sale of an investment previously classified as an “other investment” and also a net gain on sale of investment securities of $0.6 million during the year ended December 31, 2019. The Company recognized a net loss on sale of investment securities of  $31,000 and $32,000 for the years ended December 31, 2018 and 2017, respectively. As of December 31, 2019, the Company had an investment in commercial paper, issued by Toronto-Dominion Bank, with a book and fair value of  $24,880,000. This commercial paper totaled more than 10% of the Company’s stockholder’s equity and has a maturity date of April 9, 2020. The following table sets forth the fair value of available for sale investment securities, the amortized costs of held to maturity and the percentage distribution at the dates indicated: The following tables set forth the composition and maturities of investment securities as of December 31, 2019 and December 31, 2018. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. (1) Weighted Average Yield is shown on a fully taxable equivalent basis using a federal tax rate of 21% at December 31, 2019 and December 31, 2018, respectively. The Company evaluates securities for other-than-temporary impairment on at least a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. Consideration is given to (1) credit quality of individual securities and their issuers are assessed; (2) the length of time and the extent to which the fair value has been less than cost; (3) the financial condition and near-term prospects of the issuer; and (4) that the Company does not have the intent to sell the security and it is more likely than not that it will not have to sell the security before recovery of its cost basis. As of December 31, 2019, 20 debt securities had gross unrealized losses, with an aggregate depreciation of 0.11% from our amortized cost basis. The largest unrealized loss percentage of any single security was 1.87% (or $6,000) of its amortized cost. The largest unrealized dollar loss of any single security was $67,000 (or 1.46%) of its amortized cost. As of December 31, 2018, 64 debt securities had gross unrealized losses, with an aggregate depreciation of 1.11% from our amortized cost basis. The largest unrealized loss percentage of any single security was 4.98% (or $148,000) of its amortized cost. This was also the largest unrealized dollar loss of any single security. RETURN ON AVERAGE EQUITY AND ASSETS Over the past five years, we have consistently improved our profitability as a result of the success of our growth strategies to grow quality loans and low-cost deposits as well as the improving economic conditions in our markets during the periods indicated in the table below. The following table sets forth our ROAA, ROAE, dividend payout ratio and average shareholders’ equity to average assets ratio for the periods indicated: LIQUIDITY AND CAPITAL RESOURCES Impact of Inflation and Changing Prices. Our consolidated financial statements and related notes have been prepared in accordance with GAAP. GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration of changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on our performance than they would on industrial companies. Liquidity. Liquidity is defined as the Company’s ability to generate adequate cash to meet its needs for day-to-day operations and material long and short-term commitments. Liquidity is the risk of potential loss if we were unable to meet our funding requirements at a reasonable cost. We are expected to maintain adequate liquidity at the Bank to meet the cash flow requirements of customers who may be either depositors wishing to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs. Our asset and liability management policy is intended to cause the Bank to maintain adequate liquidity and, therefore, enhance our ability to raise funds to support asset growth, meet deposit withdrawals and lending needs, maintain reserve requirements and otherwise sustain our operations. We continuously monitor our liquidity position to ensure that assets and liabilities are managed in a manner that will meet all of our short-term and long-term cash requirements. We manage our liquidity based on demand and specific events and uncertainties to meet current and future financial obligations of a short-term nature. We also monitor our liquidity requirements in light of interest rate trends, changes in the economy and the scheduled maturity and interest rate sensitivity of the investment and loan portfolios and deposits. Our objective in managing liquidity is to respond to the needs of depositors and borrowers as well as to increase earnings enhancement opportunities in a changing marketplace. Our liquidity is maintained through investment portfolio, deposits, borrowings from the FHLB, and lines available from correspondent banks. Our highest priority is placed on growing noninterest bearing deposits through strong community involvement in the markets that we serve. Borrowings and brokered deposits are considered short-term supplements to our overall liquidity but are not intended to be relied upon for long-term needs. We believe that our present position is adequate to meet our current and future liquidity needs, and management knows of no trend or event that will have a material impact on the Company’s ability to maintain liquidity at satisfactory levels. Capital Adequacy. Total shareholders’ equity was $230.2 million at December 31, 2019, compared to $174.3 million at December 31, 2018, and $161.7 million at December 31, 2017. Our total shareholders’ equity increased during 2018 as a result of our profitability, reduced by dividends paid and common share repurchases. Our total shareholders’ equity increased during 2017 primarily as a result of the Waupaca acquisition, and to a lesser extent due to our profitability, reduced by dividends paid and common share repurchases. Our capital management consists of providing adequate equity to support our current and future operations. We are subject to various regulatory capital requirements administered by state and federal banking agencies, including the Federal Reserve and the OCC. Failure to meet minimum capital requirements may prompt certain actions by regulators that, if undertaken, could have a direct material adverse effect on our financial condition and results of operations. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measure of their assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and the classifications are also subject to qualitative judgment by the regulator in regards to risk weighting and other factors. See “Business-Supervision and Regulation-Capital Requirements.” The following table reflects capital ratios computed pursuant to the regulatory capital rules as applicable to the Company and the Bank. As a result of the Economic Growth Act, the Company is no longer required to comply with its risk-based capital rules. For more information, see “Business-Supervision and Regulation-Capital Requirements.” As previously mentioned, the Company carried $18.6 and $11.5 million of subordinated debt as of December 31, 2019 and 2018, respectively, which is included in total capital for the Company in the tables above. CONTRACTUAL OBLIGATIONS, COMMITMENTS, AND CONTINGENCIES The Company has entered into contractual obligations and commitments. The following tables summarize the Company’s contractual cash obligations and other commitments by maturity at December 31, 2019: We believe that we will be able to meet our contractual obligations as they come due through the maintenance of adequate cash levels. We expect to maintain adequate cash levels through profitability, loan and securities repayment and maturity activity and continued deposit gathering activities. We have in place various borrowing mechanisms for both short-term and long-term liquidity needs. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK We are party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments primarily include commitments to originate and sell loans, standby and direct pay letters of credit, unused lines of credit and unadvanced portions of construction and development loans. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in these particular classes of financial instruments. Our exposure to credit loss in the event of nonperformance by the other party to the financial instrument for loan commitments, standby and direct pay letters of credit and unadvanced portions of construction and development loans is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Off-Balance Sheet Arrangements. Our significant off-balance-sheet arrangements consist of the following: • Unused lines of credit • Standby and direct pay letters of credit • Credit card arrangements Off-balance sheet arrangement means any transaction, agreement or other contractual arrangement to which an entity unconsolidated with the registrant is a party, under which the registrant has (1) any obligation under a guarantee contract, (2) retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement, (3) any obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument, or (4) any obligation, including a contingent obligation, arising out of a variable interest. Loan commitments are made to accommodate the financial needs of our customers. Standby and direct pay letters of credit commit us to make payments on behalf of customers when certain specified future events occur. Both arrangements have credit risk essentially the same as that involved in extending loans to clients and are subject to our normal credit policies. Collateral (e.g., securities, receivables, inventory, equipment, etc.) is obtained based on management’s credit assessment of the customer. Loan commitments and standby and direct pay letters of credit do not necessarily represent our future cash requirements because while the borrower has the ability to draw upon these commitments at anytime, these commitments occasionally expire without being drawn upon. Our off-balance sheet arrangements as of December 31, 2019 were as follows: We closely monitor the amount of our remaining future commitments to borrowers in light of prevailing economic conditions and adjust these commitments as necessary. We will continue this process as new commitments are entered into or existing commitments are renewed. Effects of Inflation The effect of inflation on a financial institution differs significantly from the effect on an industrial company. While a financial institution’s operating expenses, particularly salary and employee benefits, are affected by general inflation, the asset and liability structure of a financial institution consists largely of monetary items. Monetary items, such as cash, investments, loans, deposits and other borrowings, are those assets and liabilities which are or will be converted into a fixed number of dollars regardless of changes in prices. As a result, changes in interest rates have a more significant impact on a financial institution’s performance than does general inflation. For additional information regarding interest rates and changes in net interest income see “Quantitative and Qualitative Disclosures About Market Risk - Interest Rate Sensitivity.” Inflation may have impacts on the Bank’s customers, on businesses and consumers and their ability or willingness to invest, save or spend, and perhaps on their ability to repay loans. As such, there would likely be impacts on the general appetite of banking products and the credit health of the Bank’s customer base. Selected Quarterly Financial Data The following is selected financial data summarizing the results of operations for each quarter in the years ended December 31, 2019 and 2018. *Cumulative quarterly per share performance may not equal annual per share totals due to the effects of the amount and timing of capital increases. When computing earnings per share for an interim period, the denominator is based on the weighted average shares outstanding during the interim period, and not on an annualized weighted average basis. Accordingly, the sum of the quarters’ earnings per share data will not necessarily equal the year to date earnings per share data.

<s>[INST] The following discussion and analysis of our consolidated financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes. Historical results of operations and the percentage relationships among any amounts included, and any trends that may appear, may not indicate trends in operations or results of operations for any future periods. We are a bank holding company and we conduct all of our material business operations through the Bank. As a result, the discussion and analysis above relates to activities primarily conducted at the Bank level. We have made, and will continue to make, various forwardlooking statements with respect to financial and business matters. Comments regarding our business that are not historical facts are considered forwardlooking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in these forwardlooking statements. For additional information regarding our cautionary disclosures, see the “Cautionary Note Regarding ForwardLooking Statements” at the beginning of this Annual Report. OVERVIEW Bank First Corporation is a Wisconsin corporation that was organized primarily to serve as the holding company for Bank First, N.A. Bank First, N.A., which was incorporated in 1894, is a nationallychartered bank headquartered in Manitowoc, Wisconsin. It is a member of the Federal Reserve, and is regulated by the OCC. Including its headquarters in Manitowoc, Wisconsin, the Bank has 23 banking locations in Manitowoc, Outagamie, Brown, Winnebago, Sheboygan, Waupaca, Ozaukee, Monroe, Jefferson and Barron counties in Wisconsin. The Bank offers loan, deposit and treasury management products at each of its banking locations. As with most community banks, the Bank derives a significant portion of its income from interest received on loans and investments. The Bank’s primary source of funding is deposits, both interestbearing and noninterestbearing. In order to maximize the Bank’s net interest income, or the difference between the income on interestearning assets and the expense of interestbearing liabilities, the Bank must not only manage the volume of these balance sheet items, but also the yields earned on interestearning assets and the rates paid on interestbearing liabilities. To account for credit risk inherent in all loans, the Bank maintains an Allowance for Loan and Lease Losses (“ALLL”) to absorb possible losses on existing loans that may become uncollectible. The Bank establishes and maintains this allowance by charging a provision for loan losses against operating earnings. Beyond its net interest income, the Bank further receives income through the net gain on sale of loans held for sale as well as servicing income which is retained on those sold loans. In order to maintain its operations and bank locations, the Bank incurs various operating expenses which are further described within the “Results of Operations” later in this section. The Bank is a 49.8% member of a data processing subsidiary, UFS, LLC, which provides core data processing, endpoint management cloud services, cyber security and digital banking solutions for over 60 Midwest banks. The Bank, through its 100% owned subsidiary TVG Holdings, Inc., also holds a 40% (up from 30% due to a purchase of member interest on October 1, 2019) ownership interest in Ansay & Associates, LLC, an insurance agency providing clients primarily located in Wisconsin with insurance and risk management solutions. These unconsolidated subsidiary interests contribute noninterest income to the Bank through their underlying annual earnings. As of December 31, 2019, the Company had total consolidated assets of  $2.21 billion, total loans of  $1.74 billion, total deposits of  $1.84 billion and total stockholders’ equity of  $230.2 million. The Company employs approximately 284 fulltime equivalent employees and has an assetstoFTE ratio of approximately $7.8 million. For more information, see the Company’s website at www.bankfirstwi.bank. Recent acquisitions On October 27, 2017, the Company completed a merger with Waupaca Bancorporation, Inc. (“Waupaca”), a bank holding company headquartered in Waupaca, Wisconsin, pursuant to the [/INST] Positive. </s>

Capital Bancorp Inc

2019-04-01

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is intended as a review of significant factors affecting the Company’s financial condition and results of operations for the periods indicated. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements and the related notes. The discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this Form 10-K, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements Results of Operations for the Years Ended December 31, 2018 and 2017 Net Income The following table sets forth the principal components of net income for the periods indicated. Net income for the year ended December 31, 2018 was $12.8 million, an increase of $5.7 million, or 79.6%, from net income for the year ended December 31, 2017 of $7.1 million. The increase was primarily due to nonrecurring items in 2017 including $2.3 million of nonrecurring data processing expenses due to a system conversion, $2.4 million of interest and fees waived on our credit card portfolio due to that system conversion, net the nonrecurring tax impact of $1.8 million on those items, and a nonrecurring tax expense of $1.4 million due to the revaluation of deferred tax assets as a result of the Tax Act. Net Interest Income and Net Margin Analysis We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest income is the difference between the interest and fees earned on interest earning assets, such as loans and securities, and the interest expense incurred in connection with interest bearing liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Net interest spread is the difference between average interest rates earned on interest earning assets and average interest rates paid on interest bearing liabilities. Changes in market interest rates and the interest rates we earn on interest earning assets or pay on interest bearing liabilities, as well as in the volume and types of interest earning assets, interest bearing and noninterest bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in the Washington, D.C. and Baltimore metropolitan areas, as well as developments affecting the real estate, technology, government services, hospitality and tourism and financial services sectors within our target markets and throughout the Washington, D.C. and Baltimore metropolitan areas. Our ability to respond to changes in these factors by using effective asset-liability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings. The following table shows the average outstanding balance of each principal category of our assets, liabilities and stockholders’ equity, together with the average yields on our assets and the average costs of our liabilities for the periods indicated. Such yields and cost are calculated by dividing income or expense by the average daily balances of the corresponding assets or liabilities for the same period. AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS _______________ (1) Includes loans held for sale. (2) Includes nonaccrual loans. (3) Interest income includes amortization of deferred loan fees, net of deferred loan costs. (4) Net interest spread is the difference between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities. (5) Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and interest bearing liabilities and distinguishes between the changes attributable to changes in volume and changes attributable to changes in interest rates. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been proportionately allocated to both volume and rate. ANALYSIS OF CHANGES IN NET INTEREST INCOME Net interest income increased by $9.0 million to $57.9 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The Company’s total interest income included an increase in interest earning assets and seven market rate increases between March 15, 2017 and December 19, 2018. The year over year increase of total interest income was impacted by $2.4 million of interest and fees waived on our credit card portfolio in 2017 due to a system conversion. Average total interest earning assets were $1.0 billion for the year ended December 31, 2018 compared with $955.5 million for the year ended December 31, 2017. The yield on those interest earning assets increased 74 basis points from 5.93% for 2017 to 6.67% for 2018. The increase in the average balance of interest earning assets was driven almost entirely by growth in the average balance of the loan portfolio of $85.8 million, or 10%, to $939.5 million for the year ended December 31, 2018 compared to $853.7 million for the year ended December 31, 2017. Average interest bearing liabilities increased by $19.3 million from $704.5 million for the year ended December 31, 2017 to $723.9 million for the year ended December 31, 2018. The increase was due to an increase in the average balance of interest bearing deposits of $17.7 million, or 3%, and an increase in the average balance of borrowed funds of $1.7 million, or 5%. Deposits are our primary funding source. The increase in the average balance of interest bearing deposits was primarily due to increases in certificates of deposit and money market accounts for the year ended December 31, 2018 compared to the year ended December 31, 2017, and, to a lesser extent, NOW accounts. The average interest rate paid on interest bearing liabilities increased to 1.55% for 2018 compared to 1.10% for 2017, while the average interest rate paid on interest bearing deposits increased 46 basis points and the average interest rate paid on borrowed funds decreased by 17 basis points. The increases in average interest rates reflect an increase in market interest rates between March 2017 and December 2018. For the year ended December 31, 2018, the Company’s net interest margin was 5.59% and net interest spread was 5.12%. For the year ended December 31, 2017, net interest margin was 5.12% and net interest spread was 4.83%. With the impact of the Company’s 2017 non-recurring foregone interest and fees of $2.4 million for the credit card portfolio, the net interest margin as adjusted was 5.37% for the year ended December 31, 2017, compared to 5.59% for the year ended December 31, 2018, an increase of 22 basis points year over year. Provision for Loan Losses The provision for loan losses is a charge to income in order to bring our allowance for loan losses to a level deemed appropriate by management. For a description of the factors taken into account by our management in determining the allowance for loan losses see “Financial Condition-Allowance for Loan Losses.” Our provision for loan losses amounted to $2.1 million for the year ended December 31, 2018 and $2.7 million for the year ended December 31, 2017. Our allowance for loan losses as a percent of total loans remained steady at 1.13% at December 31, 2018 and 2017. Charge-offs amounted to $1.1 million for the year ended December 31, 2018 compared to $1.7 million for the year ended December 31, 2017. The credit card portfolio represented 74% and 68%, respectively, of total charge-offs. Noninterest Income Our primary sources of recurring noninterest income are service charges on deposit accounts, certain credit card fees, such as interchange fees and statement fees, and mortgage banking revenue. Noninterest income does not include (i) loan origination fees to the extent they exceed the direct loan origination costs, which are generally recognized over the life of the related loan as an adjustment to yield using the interest method or (ii) annual, renewal and late fees related to our credit card portfolio, which are generally recognized over the twelve month life of the related loan as an adjustment to yield using the interest method. The following table presents, for the periods indicated, the major categories of noninterest income: NONINTEREST INCOME Noninterest income for the the year ended December 31, 2018 was $16.1 million, a $975 thousand or 6% increase compared to noninterest income of $15.1 million for the year ended December 31, 2017. Credit card fees increased $2.0 million, or 51%, for the year ended December 31, 2018 to $6.0 million compared to $4.0 million for the year ended December 31, 2017, primarily as a result of an increase in outstanding cards from 149,226 at December 31, 2017 to 169,981 at December 31, 2018. Mortgage banking revenue decreased $900 thousand, or 9%, during 2018 to $9.5 million compared to $10.4 million for 2017. In response to changing market conditions during 2017, we shifted our mortgage origination focus within Church Street Mortgage, which had been heavily dependent on refinance transactions, to purchase transactions, which have slightly higher rates and prices. Proceeds from the sale of loans held for sale amounted to $354.4 million for the year ended December 31, 2018 compared to $452.3 million for the year ended December 31, 2017. Noninterest Expense Generally, noninterest expense is composed of all employee expenses and costs associated with operating our facilities, obtaining and retaining customer relationships and providing bank services. The largest component of noninterest expense is salaries and employee benefits. Noninterest expense also includes operational expenses, such as occupancy and equipment expenses, professional fees, advertising expenses, loan processing expenses and other general and administrative expenses, including FDIC assessments, communications, travel, meals, training, supplies and postage. The following table presents, for the periods indicated, the major categories of noninterest expense: NONINTEREST EXPENSE Noninterest expense amounted to $54.1 million for the year ended December 31, 2018, an increase of $6.8 million, or 14%, compared to $47.3 million for the year ended December 31, 2017. The increase was primarily due to an increase in data processing expenses and, to a lesser extent, increases in salaries and employee benefits, occupancy and equipment expenses, professional services and other expenses. During 2017, to further scale the business and enhance our capabilities, we converted our credit card processing system to a new vendor. Data processing costs will continue to be a significant expense due to the growth of our credit card, mortgage and commercial banking businesses. Salaries and employee benefits increased mainly due to additional personnel. Occupancy and equipment expenses increased due to additional software licensing fees related to our credit card platform, and rental expense associated with our new branch locations in Columbia, Maryland and Reston, Virginia. The increase in professional services was primarily due to audit and other outside services related to being a public company, and other expenses increased due to other credit card expenses. Income Tax Expense The amount of income tax expense we incur is influenced by our pre-tax income and our other nondeductible expenses. Deferred tax assets and liabilities are reflected at current income tax rates in effect for the period in which the deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, such as the Tax Act deferred tax assets and liabilities are adjusted through the provision for income taxes. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense was $5.0 million for 2018 compared to $7.0 million for 2017. Our effective tax rates for those periods were 28% and 50%, respectively. Our effective tax rate decreased in 2018 primarily as a result of the Tax Act, which includes a number of changes to existing U.S. tax laws that impact the Company, most notably a reduction of the U.S. corporate income tax rate to 21% for tax years beginning after December 31, 2017, as well as the significant charge of $1.4 million taken in 2017 to revalue deferred tax assets due to the Tax Act. Financial Condition As of December 31, 2018, our total assets increased $79.0 million from December 31, 2017 to approximately $1.1 billion. Loans receivable and cash increased, while interest bearing deposits at other financial institutions, loans held for sale and securities decreased over that period. Deposits increased $50.3 million, and securities sold under agreements to repurchase decreased $7.9 million due mainly to transfers of customer deposits to interest bearing checking accounts. Stockholders’ equity increased $34.4 million, or 43%, to $114.6 million at December 31, 2018, primarily due to our IPO which closed on September 28, 2018, including the exercise in full by the underwriters of their option to purchase an additional 334,310 shares of our common stock on October 4, 2018, and our 2018 net income. Interest Bearing Deposits at Other Financial Institutions As of December 31, 2018, interest bearing deposits at other financial institutions decreased $18.4 million, or 45%, to $22.0 million from $40.4 million at December 31, 2017. The decrease was primarily due to increased loan funding during the year ended December 31, 2018. Securities We use our securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk, meet collateral requirements and meet regulatory capital requirements. Management classifies investment securities as either held to maturity or available for sale based on our intentions and the Company’s ability to hold such securities until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held to maturity and carried at amortized cost. All other securities are designated as available for sale and carried at estimated fair value with unrealized gains and losses included in shareholders’ equity on an after-tax basis. For the years presented, all securities were classified as available for sale. Our investment portfolio decreased 13%, or approximately $7.1 million, from $54.0 million at December 31, 2017, to $46.9 million at December 31, 2018 primarily due to paydowns received on mortgage-backed securities. To supplement interest income earned on our loan portfolio, we invest in high quality mortgage-backed securities, government agency bonds, high quality municipal and corporate bonds. The following tables summarize the contractual maturities and weighted-average yields of investment securities at December 31, 2018 and the amortized cost and carrying value of those securities as of the indicated dates. INVESTMENT PORTFOLIO Loan Portfolio Our primary source of income is derived from interest earned on loans. Our loan portfolio consists of loans secured by real estate as well as commercial business loans, credit card loans, substantially all of which are secured by corresponding deposits at the Bank and, to a very limited extent, other consumer loans. Our loan customers primarily consist of small- to medium-sized businesses, professionals, real estate investors, small residential builders and individuals. Our owner-occupied and investment commercial real estate loans, residential construction loans and commercial business loans provide us with higher risk-adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations, and are complemented by our relatively lower risk residential real estate loans to individuals. To a lesser but growing extent, our credit card portfolio supplements our traditional lending products with enhanced yields. Our lending activities are principally directed to our market area consisting of the Washington, D.C. and Baltimore metropolitan areas. The following table summarizes our loan portfolio by type of loan as of the dates indicated: COMPOSITION OF LOAN PORTFOLIO Residential Real Estate Loans. We offer one-to-four family mortgage loans primarily on owner-occupied primary residences and, to a lesser extent, investor owned residences. Residential loans are originated through our commercial sales teams and our Church Street Mortgage division. Our residential loans also include home equity lines of credit. Our one-to-four family residential loans have a relatively small balance spread between many individual borrowers compared to our other loan categories. Our owner-occupied residential real estate loans usually have fixed rates for five or seven years and adjust on an annual basis after the initial term based on a typical maturity of 30 years. Our investor residential real estate loans are based on 25-year terms with a balloon payment due after five years. The required minimum debt service coverage ratio is 1.15. Residential real estate loans have represented a stable and growing portion of our loan portfolio. We intend to continue to emphasize residential real estate lending. Commercial Real Estate Loans. We originate both owner-occupied and non-owner-occupied commercial real estate loans. These loans may be more adversely affected by conditions in the real estate markets or in the general economy. Commercial loans that are secured by owner-occupied commercial real estate and primarily collateralized by operating cash flows are also included in this category of loans. As of December 31, 2018, we had approximately $129.1 million of owner-occupied commercial real estate loans, representing approximately 46% of our commercial real estate portfolio. Commercial real estate loan terms are generally extended for 10 years or less and amortize generally over 25 years or less. The interest rates on our commercial real estate loans have initial fixed rate terms that adjust typically at 5 years and we routinely charge an origination fee for our services. We generally require personal guarantees from the principal owners of the business, supported by a review of the principal owners’ personal financial statements and global debt service obligations. The properties securing the portfolio are located primarily throughout our markets and are generally diverse in terms of type. This diversity helps reduce the exposure to adverse economic events that affect any single industry. Construction Loans. Our construction loans are offered within our Washington, D.C. and Baltimore, Maryland metropolitan operating areas to builders primarily for the construction of single-family homes and condominium and townhouse conversions or renovations and, to a lesser extent, to individuals. Our construction loans typically have terms of 12 to 18 months with the goal of transitioning the borrowers to permanent financing or re-underwriting and selling into the secondary market through Church Street Mortgage. According to our underwriting standards, the ratio of loan principal to collateral value, as established by an independent appraisal, cannot exceed 75% for investor-owned and 80% for owner-occupied properties. We conduct semi-annual stress testing of our construction loan portfolio and closely monitor underlying real estate conditions as well as our borrower’s trends of sales valuations as compared to underwriting valuations as part of our ongoing risk management efforts. We also closely monitor our borrowers’ progress in construction buildout and strictly enforce our original underwriting guidelines for construction milestones and completion timelines. Commercial Business Loans. In addition to our other loan products, we provide general commercial loans, including commercial lines of credit, working capital loans, term loans, equipment financing, letters of credit and other loan products, primarily in our target markets, and underwritten based on each borrower’s ability to service debt from income. These loans are primarily made based on the identified cash flows of the borrower and secondarily, on the underlying collateral provided by the borrower. Most commercial business loans are secured by a lien on general business assets including, among other things, available real estate, accounts receivable, promissory notes, inventory and equipment, and we generally obtain a personal guaranty from the borrower or other principal. Credit Cards. Through our OpenSky® credit card division, we provide credit cards on a nationwide basis to under-banked populations and those looking to rebuild their credit scores through a fully digital and mobile platform. Substantially all of the lines of credit are secured by a noninterest bearing demand account at the Bank in an amount equal to the full credit limit of the credit card. In addition, using our proprietary scoring model, which considers credit score and repayment history (typically a minimum of six months of on-time repayments, but ultimately determined on a case-by-case basis) the Bank has recently begun to offer certain customers an unsecured line in excess of their secured line of credit. Other Consumer Loans. To a very limited extent and typically as an accommodation to existing customers, we offer personal consumer loans such as term loans, car loans or boat loans. The repayment of loans is a source of additional liquidity for us. The following table details maturities and sensitivity to interest rate changes for our loan portfolio at December 31, 2018: LOAN MATURITY AND SENSITIVITY TO CHANGES IN INTEREST RATES Nonperforming Assets Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. When interest accrual is discontinued, all unpaid accrued interest is reversed from income. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, reasonably assured. Any loan which the Bank deems to be uncollectible, in whole or in part, is charged off to the extent of the anticipated loss. Consumer credit card balances are moved into the charge off queue after they become more than 90 days past due and are charged off not later than 120 days after they become past due. Loans that are past due for 180 days or more are charged off unless the loan is well secured and in the process of collection. We believe our disciplined lending approach and focused management of nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. We have several procedures in place to assist us in maintaining the overall quality of our loan portfolio. We have established underwriting guidelines to be followed by our bankers, and we also monitor our delinquency levels for any negative or adverse trends. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions. Nonperforming loans decreased to $4.7 million, or 0.47% of total loans, at December 31, 2018 compared to $5.4 million, or 0.61% of total loans, at December 31, 2017. Foreclosed real estate increased to $142 thousand as of December 31, 2018 compared to $93 thousand as of December 31, 2017 due to the foreclosure of a construction loan for $188 thousand and two non-owner occupied residential loans totaling $179 thousand in the aggregate. OREO of approximately $357 thousand was sold during 2018. Accruing restructured loans decreased $3.2 million between December 31, 2017 and December 31, 2018 primarily due to two restructured performing loans which were repaid in full in April 2018. Total nonperforming assets were $4.8 million at December 31, 2018 compared to $5.5 million at December 31, 2017, or 0.44% and 0.54%, respectively, of corresponding total assets. The following table presents information regarding nonperforming assets at the dates indicated: NONPERFORMING ASSETS Potential Problem Loans From a credit risk standpoint, we grade watchlist and problem loans into one of five categories: pass/watch, special mention, substandard, doubtful or loss. The classifications of loans reflect a judgment about the risks of default and loss associated with the loan. We review the ratings on credits regularly. Ratings are adjusted regularly to reflect the degree of risk and loss that our management believes to be appropriate for each credit. Our methodology is structured so that specific reserve allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss). Our lending policy requires the routine monitoring of weekly past due reports, daily overdraft reports, monthly maturing loans, monthly risk rating reports and internal loan review reports. The lending and credit management of the Bank remain actively engaged in weekly meetings to review loans rated pass/watch. The focus of each meeting is to identify and promptly determine any necessary required action with this loan population, which consists of loans that, although considered satisfactory and performing to terms, may exhibit special risk features that warrant management’s attention. Loans that are deemed special mention, substandard, doubtful or loss are listed in the Bank’s Problem Loan Status Report. The Problem Loan Status Report provides a detailed summary of the borrower and guarantor status, loan accrual status, collateral evaluation and includes a description of the planned collection and administration program designed to mitigate the Bank’s risk of loss and remove the loan from problem status. The Special Asset Committee reviews the Problem Loan Status Report on a quarterly basis for borrowers with an overall loan exposure in excess of $250,000. The Bank uses the following definitions for watch list risk ratings: •Pass/Watch. Borrowers who are considered satisfactory and performing to terms, however exhibit special risk features such as declining earnings, strained cash flow, increasing leverage, and/or weakening fundamentals that indicate above average risk. •Special Mention. A special mention loan has potential weaknesses deserving of management’s attention. If uncorrected, such weaknesses may result in deterioration of the repayment prospects for the asset or in our credit position at some future date. •Substandard. A substandard loan is inadequately protected by the current financial condition and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that we will sustain some loss if deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets that are classified as substandard. •Doubtful. A doubtful loan has all weaknesses inherent in one classified as substandard, with the added characteristic that weaknesses make collection or liquidation in full, on the basis of existing facts, conditions, and values, highly questionable and improbable. The probability of loss is extremely high, but certain important and reasonably specific factors that may work to the advantage and strengthening of the asset exist. Therefore, its classification as an estimated loss is deferred until a more precise status may be determined by management. Pending factors include proposed merger, acquisition or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans. •Loss. Credits rated as loss are charged-off. We have no expectation of the recovery of any payments in respect of credits rated as loss. Loans not meeting the criteria above are considered to be pass-rated loans. The following tables present the loan balances by category as well as risk rating. No assets were classified as loss during the periods presented. LOAN CLASSIFICATION _______________ (1) Category includes loans graded exceptional, very good, good, satisfactory and pass / watch. At December 31, 2018, the recorded investment in impaired loans was $4.4 million, $386 thousand of which required a specific reserve of $262 thousand compared to a recorded investment in impaired loans of $8.2 million including $366 thousand requiring a specific reserve of $60 thousand at December 31, 2017. Of the $8.2 million of impaired loans at December 31, 2017, approximately $3.1 million was related to one loan relationship. The Bank received payment in full on the $3.1 million indebtedness in April 2018. Impaired loans also include certain loans that have been modified as troubled debt restructurings (“TDRs”). At December 31, 2018, the Company had four loans amounting to $284 thousand that were considered to be TDRs, compared to nine loans amounting to $3.8 million at December 31, 2017. The decline from December 31, 2017 to December 31, 2018 was largely due to one accruing TDR relationship amounting to $3.1 million that was paid in full during the period. Allowance for Loan Losses We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts, or at all. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of our loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. The following table presents a summary of changes in the allowance for loan losses for the periods and dates indicated: ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES Our allowance for loan losses at December 31, 2018 and December 31, 2017 was $11.3 million and $10.0 million, respectively, or 1.13% of loans for each respective period end. The allowance for loan losses at December 31, 2018 included specific reserves of $262 thousand set aside for impaired loans. Our charge-offs for the year ended December 31, 2018 were $1.1 million and were partially offset by recoveries of $231 thousand. The allowance for loan losses at December 31, 2017 included specific reserves of $60 thousand set aside for impaired loans. Our charge-offs for the year ended December 31, 2017 were $1.7 million and were partially offset by recoveries of $432 thousand. The charge-offs for the years ended December 31, 2018 and 2017 were primarily due to credit card charge-offs as a result of growth in our credit card portfolio and certain charges in excess of credit limits. Although we believe that we have established our allowance for loan losses in accordance with GAAP and that the allowance for loan losses was adequate to provide for known and inherent losses in the portfolio at all times shown above, future provisions for loan losses will be subject to ongoing evaluations of the risks in our loan portfolio. The following table shows the allocation of the allowance for loan losses among loan categories and certain other information as of the dates indicated. The total allowance is available to absorb losses from any loan category. ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES _______________ (1) Loan category as a percentage of total loans. Deposits Deposits are the major source of funding for the Company. We offer a variety of deposit products including NOW, savings, money market and time accounts all of which we actively market at competitive pricing. We generate deposits from our customers on a relationship basis and through the efforts of our commercial lending officers and our business banking officers. Our credit card customers are also a significant source of low cost deposits. As of December 31, 2018, our credit card customers accounted for $60.0 million, or 25%, of our total noninterest bearing deposit balances. We supplement our deposits with wholesale funding sources such as the Certificate of Deposit Account Registry Service (“CDARS”) and brokered deposits. Interest bearing deposits increased $4.7 million, or 0.67%, from December 31, 2017 to December 31, 2018 primarily due to a limited number of large withdrawals in commercial money market accounts. During the same period, certificates of deposit increased $18.1 million or 31% due mainly to two large public fund accounts. In order to fund the loan growth of the Bank, we built upon our prior success of focusing our strategic efforts to grow core deposits through an expanded deposits sales force, incentives to our commercial loan team and increased marketing efforts. The average rate paid on interest bearing deposits increased 46 basis points from 0.96% for the year ended December 31, 2017 to 1.42% for the year ended December 31, 2018. Rates paid on certificates of deposit increased 57 basis points over the same period. The increase in the average rates was primarily due to increases in market interest rates. The following table presents the average balances and average rates paid on deposits for the periods indicated: COMPOSITION OF DEPOSITS The following table presents the maturities of our certificates of deposit as of December 31, 2018. MATURITIES OF CERTIFICATES OF DEPOSIT Borrowings We primarily utilize short-term and long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below. FHLB Advances. The FHLB allows us to borrow up to 25% of our assets on a blanket floating lien status collateralized by certain securities and loans. As of December 31, 2018, approximately $235.2 million in real estate loans and $6.7 million in investment securities were pledged as collateral for our FHLB borrowings. We utilize these borrowings to meet liquidity needs and to fund certain fixed rate loans in our portfolio. As of December 31, 2018, we had $2.0 million in outstanding advances and $185.6 million in available borrowing capacity from the FHLB. The following table sets forth certain information on our FHLB borrowings during the periods presented: FHLB ADVANCES Other borrowed funds. The Company has also issued a senior promissory note, junior subordinated debentures and other subordinated notes. At December 31, 2018, these other borrowings amounted to $15.4 million. On July 30, 2014, we issued a senior promissory note in an aggregate principal amount of $5.0 million, which was scheduled to mature on July 31, 2019. The senior promissory note was repaid during the first quarter of 2018. At December 31, 2018, our junior subordinated debentures amounted to $2.1 million. The junior subordinated debentures were issued in June of 2006, mature on June 15, 2036, and may be redeemed prior to that date under certain circumstances. The principal amount of the debentures has not changed since issuance, and they accrue interest at a floating rate equal to the three-month LIBOR plus 1.87%. On November 24, 2015, the Company issued $13.5 million in aggregate principal amount of subordinated notes with a maturity date of December 1, 2025. The notes may be redeemed prior to the maturity date under certain circumstances. The notes bear interest at 6.95% for the first five years, then adjust to the three-month LIBOR plus 5.33%. Federal Reserve Bank of Richmond. The Federal Reserve Bank of Richmond has an available borrower in custody arrangement which allows us to borrow on a collateralized basis. The Company’s borrowing capacity under the Federal Reserve’s discount window program was $13.1 million as of December 31, 2018. Certain commercial loans are pledged under this arrangement. We maintain this borrowing arrangement to meet liquidity needs pursuant to our contingency funding plan. No advances were outstanding under this facility as of December 31, 2018. The Company also has available lines of credit of $28.0 million with other correspondent banks at December 31, 2018, as well as access to certificate of deposit funding through a financial network which is limited to 15% of the Bank’s assets. The total outstanding lines of credit, or federal funds purchased from correspondent banks was $2.0 million at December 31, 2018. The Company also sells securities under repurchase agreements to provide cash management services to commercial account customers. These borrowings totaled $3.3 million as of December 31, 2018. Liquidity Liquidity is defined as the Bank’s capacity to meet its cash and collateral obligations at a reasonable cost. Maintaining an adequate level of liquidity depends on the Bank’s ability to meet both expected and unexpected cash flows and collateral needs efficiently without adversely affecting either daily operations or the financial condition of the Bank. Liquidity risk is the risk that we will be unable to meet our obligations as they become due because of an inability to liquidate assets or obtain adequate funding. The Bank’s obligations, and the funding sources used to meet them, depend significantly on our business mix, balance sheet structure and the cash flow profiles of our on- and off-balance sheet obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints on the ability to convert assets into cash or in accessing sources of funds (i.e., market liquidity) and contingent liquidity events. Changes in economic conditions or exposure to credit, market, operation, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity and asset/liability management. Management has established a comprehensive management process for identifying, measuring, monitoring and controlling liquidity risk. Because of its critical importance to the viability of the Bank, liquidity risk management is fully integrated into our risk management processes. Critical elements of our liquidity risk management include: effective corporate governance consisting of oversight by the board of directors and active involvement by management; appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; comprehensive liquidity risk measurement and monitoring systems (including assessments of the current and prospective cash flows or sources and uses of funds) that are commensurate with the complexity and business activities of the Bank; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of highly liquid marketable securities free of legal, regulatory or operational impediments, that can be used to meet liquidity needs in stressful situations; comprehensive contingency funding plans that sufficiently address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes sufficient to determine the adequacy of the institution’s liquidity risk management process. We expect funds to be available from a number of basic banking activity sources, including the core deposit base, the repayment and maturity of loans and investment security cash flows. Other potential funding sources include brokered certificates of deposit, deposit listing services, CDARS, borrowings from the FHLB and other lines of credit. We did not have any borrowings outstanding with the Federal Reserve Bank of Richmond at December 31, 2018 or December 31, 2017, and our borrowing capacity is limited only by eligible collateral. As of December 31, 2018, we had $185.6 million of available borrowing capacity from the FHLB, $13.1 million of available borrowing capacity from the Federal Reserve Bank of Richmond and available lines of credit of $26.0 million with other correspondent banks. Cash and cash equivalents were $34.7 million at December 31, 2018 and $52.3 million at December 31, 2017. Accordingly, our liquidity resources were at sufficient levels to fund loans and meet other cash needs as necessary. Capital Resources Stockholders’ equity increased $34.4 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The Company’s IPO added approximately $19.8 million of capital. Net income resulted in an increase to retained earnings of $12.5 million as of December 31, 2018. Stock options exercised, shares issued as compensation, shares sold and stock-based compensation increased common stock and additional paid-in capital aggregately by $2.3 million. This increase was offset by $45 thousand, or 5,500 shares, repurchased and retired during 2018, and net unrealized losses on available for sale securities and cash flow hedging derivative of $595 thousand. The Company uses several indicators of capital strength. The most commonly used measure is average common equity to average assets (computed as average equity divided by average total assets), which was 8.76% at December 31, 2018 and 7.93% at December 31, 2017. The following table shows the return on average assets (computed as net income divided by average total assets), return on average equity (computed as net income divided by average equity) and average equity to average assets ratios for the years ended December 31, 2018 and 2017. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum ratios of common equity Tier 1, Tier 1, and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1250%. The Bank is also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. In July 2013, federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule applies to all depository institutions and bank holding companies and savings and loan holding companies with total consolidated assets of more than $1 billion. The Bank was required to implement the new Basel III capital standards (subject to the phase-in for certain parts of the new rules) as of January 1, 2015. In August of 2018 the Regulatory Relief Act directed the Federal Reserve Board to revise the Small BHC Policy Statement to raise the total consolidated asset limit in the Small BHC Policy Statement from $1 billion to $3 billion. The Company was previously required to comply with the minimum capital requirements on a consolidated basis; however, the Company continues to meet the conditions of the revised Small BHC Policy Statement and was, therefore, exempt from the consolidated capital requirements at December 31, 2018. As of December 31, 2018, the Company and the Bank were in compliance with all applicable regulatory capital requirements to which they were subject, and the Bank was classified as “well capitalized” for purposes of the prompt corrective action regulations. As we deploy our capital and continue to grow our operations, our regulatory capital levels may decrease depending on our level of earnings. However, we intend to monitor and control our growth in order to remain in compliance with all regulatory capital standards applicable to us. The following table presents the regulatory capital ratios for the Company and the Bank as of the dates indicated. Contractual Obligations We have contractual obligations to make future payments on debt and lease agreements. While our liquidity monitoring and management consider both present and future demands for and sources of liquidity, the following table of contractual commitments focuses only on future obligations and summarizes our contractual obligations as of December 31, 2018. CONTRACTUAL OBLIGATIONS Off-Balance Sheet Items In the normal course of business, we enter into various transactions that, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and issue letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets. Our exposure to credit loss is represented by the contractual amounts of these commitments. The same credit policies and procedures are used in making these commitments as for on-balance sheet instruments. We are not aware of any accounting loss to be incurred by funding these commitments, however we maintain an allowance for off-balance sheet credit risk which is recorded in other liabilities on the consolidated balance sheet. Our commitments associated with outstanding letters of credit and commitments to extend credit expiring by period as of the date indicated are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. CREDIT EXTENSION COMMITMENTS Unfunded lines of credit represent unused credit facilities to our current borrowers that represent no change in credit risk that exist in our portfolio. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. Lines of credit generally have variable interest rates. In the event of nonperformance by the customer in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek recovery from the client from the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our policies generally require that letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements and our credit risk associated with issuing letters of credit is essentially the same as the risk involved in extending loan facilities to our customers. We minimize our exposure to loss under letters of credit and credit commitments by subjecting them to the same credit approval and monitoring procedures as we do for on-balance sheet instruments. The effect on our revenue, expenses, cash flows and liquidity of the unused portions of these letters of credit commitments cannot be precisely predicted because there is no guarantee that the lines of credit will be used. Commitments to extend credit are agreements to lend funds to a customer, as long as there is no violation of any condition established in the contract, for a specific purpose. Commitments generally have variable interest rates, fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn, the total commitment amounts disclosed above do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by us, upon extension of credit is based on management’s credit evaluation of the customer. We enter into forward commitments for the delivery of mortgage loans in our current pipeline. Interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from our commitments to fund the loans. These commitments to fund mortgage loans, to be sold into the secondary market, (interest rate lock commitments) and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. Impact of Inflation Our consolidated financial statements and related notes included elsewhere in this report have been prepared in accordance with GAAP. GAAP requires the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession. Unlike many industrial companies, substantially all of our assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, other operating expenses do reflect general levels of inflation.

<s>[INST] The discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under “Cautionary Note Regarding ForwardLooking Statements,” “Risk Factors” and elsewhere in this Form 10K, may cause actual results to differ materially from those projected in the forwardlooking statements. We assume no obligation to update any of these forwardlooking statements Results of Operations for the Years Ended December 31, 2018 and 2017 Net Income The following table sets forth the principal components of net income for the periods indicated. Net income for the year ended December 31, 2018 was $12.8 million, an increase of $5.7 million, or 79.6%, from net income for the year ended December 31, 2017 of $7.1 million. The increase was primarily due to nonrecurring items in 2017 including $2.3 million of nonrecurring data processing expenses due to a system conversion, $2.4 million of interest and fees waived on our credit card portfolio due to that system conversion, net the nonrecurring tax impact of $1.8 million on those items, and a nonrecurring tax expense of $1.4 million due to the revaluation of deferred tax assets as a result of the Tax Act. Net Interest Income and Net Margin Analysis We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest income is the difference between the interest and fees earned on interest earning assets, such as loans and securities, and the interest expense incurred in connection with interest bearing liabilities, such as deposits and borrowings, which are used to fund those assets. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Net interest spread is the difference between average interest rates earned on interest earning assets and average interest rates paid on interest bearing liabilities. Changes in market interest rates and the interest rates we earn on interest earning assets or pay on interest bearing liabilities, as well as in the volume and types of interest earning assets, interest bearing and noninterest bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in the Washington, D.C. and Baltimore metropolitan areas, as well as developments affecting the real estate, technology, government services, hospitality and tourism and financial services sectors within our target markets and throughout the Washington, D.C. and Baltimore metropolitan areas. Our ability to respond to changes in these factors by using effective assetliability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings. The following table shows the average outstanding balance of each principal category of our assets, liabilities and stockholders’ equity, together with the average yields on our assets and the average costs of our liabilities for the periods indicated. Such yields and cost are calculated by dividing income or expense by the average daily balances of the corresponding assets or liabilities for the same period. AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS _______________ (1) Includes loans held for sale. (2) Includes nonaccrual loans. (3) Interest income includes amortization of deferred loan fees, net of deferred loan costs. (4) Net interest spread is the difference between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities. (5) Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. The following table presents information regarding the dollar amount of changes in interest income and interest expense for the periods indicated for each major component of interest earning assets and [/INST] Positive. </s>

Capital Bancorp Inc

2020-03-16

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis is intended as a review of significant factors affecting the Company’s financial condition and results of operations for the periods indicated. This discussion and analysis should be read in conjunction with the accompanying consolidated financial statements and the related notes. The discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under “Cautionary Note Regarding Forward-Looking Statements,” “Risk Factors” and elsewhere in this Form 10-K, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements Results of Operations for the Years Ended December 31, 2019 and 2018 Net Income The following table sets forth the principal components of net income for the periods indicated. Net income for the year ended December 31, 2019 was $16.9 million, an increase of $4.1 million, or 32%, from net income for the year ended December 31, 2018 of $12.8 million. The increase was primarily the result of the $142.6 million increase in average loans outstanding year over year. The increase in loan volume resulted in an increase of $10.4 million of loan interest income. Net Interest Income and Net Margin Analysis Net interest income is the difference between interest income on earning assets and the cost of funds supporting those assets. Earning assets are composed primarily of loans, loans held for sale, investment securities, and interest bearing deposits with banks. The cost of funds represents interest expense on deposits, and borrowings, which consist of federal funds purchased, advances from the FHLB and subordinated notes. Noninterest bearing deposits and capital are other components representing funding sources. We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Net interest spread is the difference between average interest rates earned on interest earning assets and average interest rates paid on interest bearing liabilities. Changes in market interest rates and the interest rates we earn on interest earning assets or pay on interest bearing liabilities, as well as in the volume and mix of interest earning assets, interest bearing and noninterest bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in the Washington, D.C. and Baltimore metropolitan areas, as well as developments affecting the real estate, technology, government services, hospitality and tourism and financial services sectors within our target markets and throughout the Washington, D.C. and Baltimore metropolitan areas. Our ability to respond to changes in these factors by using effective asset-liability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings. The table below presents the average balances and rates of the major categories of the Company’s assets and liabilities for the years ended December 31, 2019, 2018 and 2017. Included in the table is a measurement of interest rate spread and margin. Interest rate spread is the difference (expressed as a percentage) between the interest rate earned on earning assets less the interest expense on interest bearing liabilities. While the interest rate spread provides a quick comparison of earnings rates versus cost of funds, management believes that the net interest margin provides a better measurement of performance. The net interest margin (as compared to the net interest spread) includes the effect of noninterest bearing sources in its calculation and is net interest income expressed as a percentage of average earning assets. As the table shows, the increase in net interest income in 2019 as compared to 2018 was primarily a function of an increase in the volume of earning assets and particularly loans. AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS _______________ (1) Includes nonaccrual loans. (2) Interest income includes amortization of deferred loan fees, net of deferred loan costs. (3) Net interest spread is the difference between interest rates earned on interest earning assets and interest rates paid on interest bearing liabilities. (4) Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Rate/Volume Analysis of Net Interest Income The rate/volume table below presents the composition of the change in net interest income for the periods indicated, as allocated between the change in net interest income due to changes in the volume of average earning assets and interest bearing liabilities, and the changes in net interest income due to changes in interest rates. The increase in net interest income in 2018 relative to 2017 was primarily due to an increase in both the yield on and volume of interest earning assets, and particularly loans. For purposes of this table, changes attributable to both rate and volume that cannot be segregated have been proportionately allocated to both volume and rate. ANALYSIS OF CHANGES IN NET INTEREST INCOME Net interest income increased by $9.6 million to $67.5 million for the year ended December 31, 2019 compared to 2018, primarily as a result of the growth in average earning assets of 16.3%. For the twelve months ended December 31, 2019, our average interest-earning assets increased by $169.1 million, compared to the prior year. In addition to the average earning asset growth in 2019, year over year net interest income was bolstered by an increase in the average yield on our interest-earning assets of 25 basis points. Net interest margin increased 1 basis point to 5.60% for the twelve months ended December 31, 2019 from 5.59% for the twelve months ended 2018. The Company was able to improve its average loan yield in 2019 to 7.4% as compared to 7.1% in 2018. These levels are the result of disciplined loan pricing practices. The Company believes its net interest margin remains favorable as compared to its peer banking companies Average total interest earning assets were $1.2 billion for the year ended December 31, 2019 compared with $1.0 billion for the year ended December 31, 2018. The yield on those interest earning assets increased 25 basis points to 6.92% for 2019 compared to 6.67% for 2018. The increase in the average balance of interest earning assets was driven almost entirely by growth in the average balance of the loan portfolio of $142.6 million, or 15.5%, to $1.1 billion for the year ended December 31, 2019 compared to $921.8 million for year ended December 31, 2018. Average interest bearing liabilities increased by $95.5 million to $819.4 million for the year ended December 31, 2019 from $723.9 million for the year ended December 31, 2018. The increase was due to an increase in the average balance of interest bearing demand accounts of $37.5 million, or 51.6%, an increase in money market accounts of $58.0 million, or 20.3% and an increase in the average balance of borrowed funds of $24.8 million, or 71.8%. compared to the year ended December 31, 2018 balances. Deposits are the primary funding source for the Company. The average interest rate paid on interest bearing liabilities increased to 1.93% for 2019 compared to 1.56% for 2018. While the average interest rate paid on interest bearing deposits increased 32 basis points, the average interest rate paid on borrowed funds decreased by 36 basis points. For the year ended December 31, 2019, the Company’s net interest margin was 5.60% and net interest spread was 4.99% compared to 5.59% and 5.11% for 2018. Provision for Loan Losses The provision for loan losses represents the amount of expense charged to current earnings to fund the allowance for loan losses. The amount of the allowance for credit losses is based on many factors which reflect management’s assessment of the risk in the loan portfolio. Those factors include historical losses, economic conditions and trends, the value and adequacy of collateral, volume and mix of the portfolio, performance of the portfolio, and internal loan processes of the Company and Bank. For a detailed description of the factors taken into account by our management in determining the allowance for loan losses see “Financial Condition-Allowance for Loan Losses.” For the year ended December 31, 2019, the Company recorded a provision for loan losses of $2.8 million, compared to $2.1 million for the previous year. The increase in the provision for 2019 compared to 2018 was primarily due to growth in the loan portfolio and an increase in classified loans. Year over year our allowance for loan losses as a percent of total loans remained relatively steady at 1.14% at December 31, 2019 and 1.13% at December 31, 2018. Net charge-offs for 2019 amounted to $799 thousand, representing 0.08% of average loans, compared to $865 thousand for 2018. Included in the net charge-offs for 2019 were $331 thousand and $442 thousand for commercial loans and credit cards, respectively. The credit card portfolio charge-offs represented 55.4% and 73.6% of total charge-offs, respectively, for the periods presented. The maintenance of a high quality loan portfolio, with an adequate allowance for possible credit losses, will continue to be a primary management objective for the Company. Noninterest Income Our primary sources of recurring noninterest income are service charges on deposit accounts, credit card fees, such as interchange fees and statement fees, and gain on sale of residential mortgage loans and other mortgage banking revenue. Noninterest income does not include (i) loan origination fees to the extent they exceed the direct loan origination costs, which are generally recognized over the life of the related loan as an adjustment to yield using the interest method or (ii) annual, renewal and late fees related to our credit card portfolio, which are generally recognized over the twelve month life of the related loan as an adjustment to yield using the interest method. The following table presents, for the periods indicated, the major categories of noninterest income: NONINTEREST INCOME Noninterest income for the the year ended December 31, 2019 was $24.5 million, a $8.4 million or 52.1% increase compared to noninterest income of $16.1 million for the year ended December 31, 2018. This increase is largely due to increases in credit card fees and mortgage banking revenue. Credit card fees increased $1.6 million, or 25.7%, for the year ended December 31, 2019 to $7.6 million compared to $6.0 million for 2018 . This increase was primarily due to an increase in outstanding cards accounts to 223 thousand at December 31, 2019, compared to 170 thousand at December 31, 2018, an increase of 53 thousand accounts, or 31.4%. Mortgage banking revenue increased $6.5 million, or 68.4%, during 2019 to $16.0 million compared to 2018 revenue of $9.5 million, primarily as a result of an increase in mortgage origination volume driven by the favorable mortgage refinancing market in 2019. Year over year mortgage originations increased to $593.2 million from prior year originations of $337.1 million, a 76.0% increase. Mortgage loans sold are subject to repurchase in circumstances where documentation is deficient or the underlying loan becomes delinquent or pays off within a specified period following loan funding and sale. The Bank considers these potential recourse provisions to be a risk and has established a reserve under generally accepted accounting principles for possible repurchases. The reserve amounted to $184 thousand at December 31, 2019, compared to $106 thousand for the same period in 2018. The Bank does not originate “sub-prime” loans and has no exposure to this market segment Noninterest Expense Generally, noninterest expense is composed of all employee expenses and costs associated with operating our facilities, obtaining and retaining customer relationships and providing bank services. The largest component of noninterest expense is salaries and employee benefits. Noninterest expense also includes operational expenses, such as occupancy and equipment expenses, professional fees, advertising expenses, loan processing expenses and other general and administrative expenses, including FDIC assessments, communications, travel, meals, training, supplies and postage. The following table presents, for the periods indicated, the major categories of noninterest expense: NONINTEREST EXPENSE Noninterest expense was $66.5 million for the year ended December 31, 2019, an increase of $12.4 million, or 22.9%, compared to $54.1 million for 2018. The increase was driven primarily by increases in salaries and benefits, which includes commissions paid on mortgage originations. In 2019, as a result of robust mortgage originations, commissions were $5.4 million, compared to $2.8 million in 2018, an increase of 88.5%. The increase in professional fees resulted primarily from increased audit and other outside services related to being a public company. Other operating expenses increased as a result of increases in marketing, losses from credit card fraud and director fees. Income Tax Expense The amount of income tax expense we incur is influenced by our pre-tax income and our other nondeductible expenses. Deferred tax assets and liabilities are reflected at current income tax rates in effect for the period in which the deferred tax assets and liabilities are expected to be realized or settled. A valuation allowance is established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense was $5.8 million for 2019 compared to $5.0 million for 2018. Our effective tax rates for those periods were 25.6% and 28.1%, respectively. Financial Condition Total assets at December 31, 2019 were $1.43 billion, a 29.3% increase as compared to $1.1 billion at December 31, 2018. Total loans (excluding mortgage loans held for sale) were $1.2 billion at December 31, 2019, a 17.1% increase as compared to $970.4 million at December 31, 2018. Loans held for sale amounted to $71.0 million at December 31, 2019 as compared to $18.5 million for the same period in 2018, a 283.4% increase year over year. Total borrowed funds at December 31, 2019, were $47.6 million compared to $17.4 million at December 31, 2018. In 2019, in an effort to reduce funding costs, manage liquidity and mitigate interest rate risk, the Company acquired a long term $40 million FHLB Principal Reducing Fixed Rate Advance to reduce our reliance on Daily Rate Credit advances. As of December 31, 2019, $32.2 million of the advance remains outstanding. Deposits were $1.23 billion at December 31, 2019, an increase of $270.2 million, a 28.3% as compared to $955.2 million at December 31, 2018. The growth in the portfolio was primarily due to an increase in the interest bearing demand account category. The Company continues to execute on its strategic initiative to improve the deposit portfolio mix by reducing reliance on wholesale time deposits. Accordingly, wholesale time deposits decreased by $26.3 million or 13.6% to $167.0 million at December 31, 2019, from $193.3 million at December 31, 2018. Stockholders’ equity increased $18.8 million, or 16%, to $133.3 million at December 31, 2019, compared to $114.6 million at December 31, 2018. The increase was primarily attributable to 2019 earnings of $16.9 million and proceeds from exercise of stock options of $1.5 million. Shares repurchased and retired in 2019 as part of the Company’s stock repurchase program totaled 28,480 shares at a weighted average price of $13.53 for a total cost of $371 thousand including commissions. As of December 31, 2019, the Bank’s capital ratios continued to exceed the regulatory requirements for a “well capitalized” institution. Interest Bearing Deposits at Other Financial Institutions As of December 31, 2019, interest bearing deposits at the Federal Reserve Bank of Richmond increased by $80.4 million million, or 365.5%, to $102.4 million from a balance of $22.0 million at December 31, 2018. The Bank increased liquidity in the fourth quarter of 2019 to continue re-balancing the deposit portfolio, to fund loan growth and to bolster its investment portfolio. Excess liquidity will be deployed in early 2020 for the same purposes. Securities The Company uses its securities portfolio to provide a source of liquidity, provide an appropriate return on funds invested, manage interest rate risk, meet collateral requirements and meet regulatory capital requirements. Management classifies investment securities as either held to maturity or available for sale based on our intentions and the Company’s ability to hold such securities until maturity. In determining such classifications, securities that management has the positive intent and the Company has the ability to hold until maturity are classified as held to maturity and carried at amortized cost. All other securities are designated as available for sale and carried at estimated fair value with unrealized gains and losses included in stockholders’ equity on an after-tax basis. For the years presented, all securities were classified as available for sale. Our investment portfolio totaled $60.8 million at December 31, 2019, a 29.6% increase from $46.9 million at December 31, 2018. To supplement interest income earned on our loan portfolio, The Company invests in high quality mortgage-backed securities, government agency bonds, high quality municipal and corporate bonds. The following tables summarize the contractual maturities and weighted-average yields of investment securities at December 31, 2019 and the amortized cost and carrying value of those securities as of the indicated dates. INVESTMENT PORTFOLIO Loan Portfolio Our primary source of income is derived from interest earned on loans. Our loan portfolio consists of loans secured by real estate, commercial business loans and credit card loans, substantially all of which are secured by corresponding deposits at the Bank and, to a very limited extent, other consumer loans. Our loan customers primarily consist of small- to medium-sized businesses, professionals, real estate investors, small residential builders and individuals. Our owner-occupied and investment commercial real estate loans, residential construction loans and commercial business loans provide us with higher risk-adjusted returns, shorter maturities and more sensitivity to interest rate fluctuations, and are complemented by our relatively lower risk residential real estate loans to individuals. To a lesser but growing extent, our credit card portfolio supplements our traditional lending products with enhanced yields. Our lending activities are principally directed to our market area consisting of the Washington, D.C. and Baltimore metropolitan areas. The following table summarizes our loan portfolio by type of loan as of the dates indicated: COMPOSITION OF LOAN PORTFOLIO Residential Real Estate Loans. We offer one-to-four family mortgage loans primarily on owner-occupied primary residences and, to a lesser extent, investor owned residences. Residential loans are originated through our commercial sales teams and our Capital Bank Home Loan division. Our residential loans also include home equity lines of credit. Our owner-occupied residential real estate loans usually have fixed rates for five or seven years and adjust on an annual basis after the initial term based on a typical maturity of 30 years. Our investor residential real estate loans are generally based on 25-year terms with a balloon payment due after five years. In general, the required minimum debt service coverage ratio is 1.15. Residential real estate loans have represented a stable and growing portion of our loan portfolio. The Company intends to continue to emphasize residential real estate lending. Commercial Real Estate Loans. The Company originates both owner-occupied and non-owner-occupied commercial real estate loans. These loans may be adversely affected by conditions in the real estate markets or in the general economy. Commercial loans that are secured by owner-occupied commercial real estate and primarily collateralized by operating cash flows are also included in this category of loans. As of December 31, 2019, The Company had approximately $165.4 million of owner-occupied commercial real estate loans, representing approximately 47.5% of our commercial real estate portfolio. Commercial real estate loan terms are generally extended for 10 years or less and amortize generally over 25 years or less. The interest rates on our commercial real estate loans have an initial fixed rate terms that adjust typically at 5 years. Origination fees are routinely charged for our services. The Company generally requires personal guarantees from the principal owners of the business, supported by a review of the principal owners’ personal financial statements and global debt service obligations. The properties securing the portfolio are diverse in terms of type. This diversity helps reduce the exposure to adverse economic events that affect any single industry. Construction Loans. Our construction loans are offered within our Washington, D.C. and Baltimore, Maryland metropolitan operating areas to builders primarily for the construction of single-family homes, condominium and townhouse conversions or renovations and, to a lesser extent, to individuals. Our construction loans typically have terms of 12 to 18 months with the goal of transitioning the borrowers to permanent financing or re-underwriting and selling into the secondary market through Capital Bank Home Loan. According to our underwriting standards, the ratio of loan principal to collateral value, as established by an independent appraisal, cannot exceed 75% for investor-owned and 80% for owner-occupied properties. We conduct semi-annual stress testing of our construction loan portfolio and closely monitor underlying real estate conditions as well as our borrower’s trends of sales valuations as compared to underwriting valuations as part of our ongoing risk management efforts. Borrowers’ progress is closely monitored in construction buildout and strictly enforce our original underwriting guidelines for construction milestones and completion timelines. Commercial Business Loans. In addition to our other loan products, the Company provides general commercial loans, including commercial lines of credit, working capital loans, term loans, equipment financing, letters of credit and other loan products, primarily in our target markets, and underwritten based on each borrower’s ability to service debt from income. These loans are primarily made based on the identified cash flows of the borrower and secondarily, on the underlying collateral provided by the borrower. Most commercial business loans are secured by a lien on general business assets including, among other things, available real estate, accounts receivable, promissory notes, inventory and equipment, and we generally obtain a personal guaranty from the borrower or other principal. Credit Cards. Through our OpenSky® credit card division, the Company provides credit cards on a nationwide basis to under-banked populations and those looking to rebuild their credit scores through a fully digital and mobile platform. Substantially all of the lines of credit are secured by a noninterest bearing demand account at the Bank in an amount equal to the full credit limit of the credit card. In addition, using our proprietary scoring model, which considers credit score and repayment history (typically a minimum of six months of on-time repayments, but ultimately determined on a case-by-case basis) the Bank offers certain customers an unsecured line in excess of their secured line of credit. Other Consumer Loans. To a very limited extent and typically as an accommodation to existing customers, we offer personal consumer loans such as term loans, car loans or boat loans. The repayment of loans is a source of additional liquidity for us. The following table details maturities and sensitivity to interest rate changes for our loan portfolio at December 31, 2019: LOAN MATURITY AND SENSITIVITY TO CHANGES IN INTEREST RATES Nonperforming Assets Loans are considered past due if the required principal and interest payments have not been received as of the date such payments were due. Loans are placed on nonaccrual status when, in management’s opinion, the borrower may be unable to meet payment obligations as they become due, as well as when required by regulatory provisions. Loans may be placed on nonaccrual status regardless of whether or not such loans are considered past due. In general, we place loans on nonaccrual status when they become 90 days past due. We also place loans on nonaccrual status if they are less than 90 days past due if the collection of principal or interest is in doubt. When interest accrual is discontinued, all unpaid accrued interest is reversed from income. Interest income is subsequently recognized only to the extent cash payments are received in excess of principal due. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, reasonably assured. Any loan which the Bank deems to be uncollectible, in whole or in part, is charged off to the extent of the anticipated loss. Consumer credit card balances are moved into the charge off queue after they become more than 90 days past due and are charged off not later than 120 days after they become past due. Loans that are past due for 180 days or more are charged off unless the loan is well secured and in the process of collection. The Company believes its disciplined lending approach and focused management of nonperforming assets has resulted in sound asset quality and timely resolution of problem assets. There are several procedures in place to assist the Company in maintaining the overall quality of our loan portfolio. The Company has established underwriting guidelines to be followed by our bankers, and monitor our delinquency levels for any negative or adverse trends. There can be no assurance, however, that our loan portfolio will not become subject to increasing pressures from deteriorating borrower credit due to general economic conditions. Nonperforming loans were $4.7 million at December 31, 2019 and December 31, 2018 . Nonperforming loans were 0.40% and 0.47% of total loans at the respective year ends. Foreclosed real estate increased to $2.4 million as of December 31, 2019 compared to $142 thousand, for the same period of 2018. The foreclosure of a construction loan with an outstanding balance of $2.1 million was the primary reason for the increase. The property is currently being marketed. As of December 31, 2019, we had $620 thousand of accruing loans past due 90 days. These loans were past due as a result of maturity date, not payment issues. Total nonperforming assets were $7.1 million at December 31, 2019 compared to $4.8 million at December 31, 2018, or 0.50% and 0.44%, respectively, of corresponding total assets. Of the $7.1 million in total nonperforming assets, nonperforming loans represented $4.7 million and other real estate owned totaled $2.4 million. Nonperforming loans included five restructured loans totaling $459 thousand. The following table presents information regarding nonperforming assets at the dates indicated: NONPERFORMING ASSETS Potential Problem Loans From a credit risk standpoint, we grade watchlist and problem loans into one of five categories: pass/watch, special mention, substandard, doubtful or loss. The classifications of loans reflect a judgment about the risks of default and loss associated with the loan. Credits ratings are reviewed regularly. Ratings are adjusted regularly to reflect the degree of risk and loss that our management believes to be appropriate for each credit. Our methodology is structured so that specific reserve allocations are increased in accordance with deterioration in credit quality (and a corresponding increase in risk and loss) or decreased in accordance with improvement in credit quality (and a corresponding decrease in risk and loss). Our lending policy requires the routine monitoring of weekly past due reports, daily overdraft reports, monthly maturing loans, monthly risk rating reports and internal loan review reports. The lending and credit management of the Bank meet several times a week to review loans rated pass/watch. The focus of each meeting is to identify and promptly determine any necessary required action with this loan population, which consists of loans that, although considered satisfactory and performing to terms, may exhibit special risk features that warrant management’s attention. Loans that are deemed special mention, substandard, doubtful or loss are listed in the Bank’s Problem Loan Status Report. The Problem Loan Status Report provides a detailed summary of the borrower and guarantor status, loan accrual status, collateral evaluation and includes a description of the planned collection and administration program designed to mitigate the Bank’s risk of loss and remove the loan from problem status. The Special Asset Committee reviews the Problem Loan Status Report on a quarterly basis for borrowers with an overall loan exposure in excess of $250,000. The Bank uses the following definitions for watch list risk ratings: •Pass/Watch. Borrowers who are considered satisfactory and performing to terms, however exhibiting special risk features such as declining earnings, strained cash flow, increasing leverage, and/or weakening fundamentals that indicate above average risk. •Special Mention. A special mention loan has potential weaknesses deserving of management’s attention. If uncorrected, such weaknesses may result in deterioration of the repayment prospects for the asset or in our credit position at some future date. •Substandard. A substandard loan is inadequately protected by the current financial condition and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that we will sustain some loss if deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets that are classified as substandard. •Doubtful. A doubtful loan has all weaknesses inherent in one classified as substandard, with the added characteristic that weaknesses make collection or liquidation in full, on the basis of existing facts, conditions, and values, highly questionable and improbable. The probability of loss is extremely high, but certain important and reasonably specific factors that may work to the advantage and strengthening of the asset exist. Therefore, its classification as an estimated loss is deferred until a more precise status may be determined by management. Pending factors include proposed merger, acquisition or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans. •Loss. Credits rated as loss are charged-off. We have no expectation of the recovery of any payments in respect of credits rated as loss. Loans not meeting the criteria above are considered to be pass-rated loans. The following tables present the loan balances by category as well as risk rating. No assets were classified as loss during the periods presented. LOAN CLASSIFICATION _______________ (1) Category includes loans graded exceptional, very good, good, satisfactory and pass / watch. At December 31, 2019, the recorded investment in impaired loans was $4.1 million, $273 thousand of which required a specific reserve of $119 thousand compared to a recorded investment in impaired loans of $4.4 million including $386 thousand requiring a specific reserve of $262 thousand at December 31, 2018. Of the $4.1 million of impaired loans, $2.2 million was related to one loan relationship. Impaired loans also include certain loans that have been modified as troubled debt restructurings (“TDRs”). At December 31, 2019, the Company had five loans amounting to $459 thousand that were considered to be TDRs, compared to four loans amounting to $284 thousand at December 31, 2018. Allowance for Loan Losses We maintain an allowance for loan losses that represents management’s best estimate of the loan losses and risks inherent in our loan portfolio. The amount of the allowance for loan losses should not be interpreted as an indication that charge-offs in future periods will necessarily occur in those amounts, or at all. In determining the allowance for loan losses, we estimate losses on specific loans, or groups of loans, where the probable loss can be identified and reasonably determined. The balance of the allowance for loan losses is based on internally assigned risk classifications of loans, historical loan loss rates, changes in the nature of our loan portfolio, overall portfolio quality, industry concentrations, delinquency trends, current economic factors and the estimated impact of current economic conditions on certain historical loan loss rates. The following table presents a summary of changes in the allowance for loan losses for the periods and dates indicated: ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES Our allowance for loan losses at December 31, 2019 and December 31, 2018 was $13.3 million and $11.3 million, respectively, or 1.14% and 1.13% of loans for each respective period end. The allowance for loan losses at December 31, 2019 included specific reserves of $119 thousand set aside for impaired loans. Our charge-offs for the year ended December 31, 2019 were $832 thousand and were partially offset by recoveries of $34 thousand. The allowance for loan losses at December 31, 2018 included specific reserves of $262 thousand set aside for impaired loans. Our charge-offs for the year ended December 31, 2018 were $1.1 million and were partially offset by recoveries of $231 thousand. Total charge-offs for the years ended December 31, 2019 and 2018 were primarily due to credit card charge-offs resulting from growth in our credit card portfolio and certain charges in excess of credit limits. Additionally in 2019, there was a charge-off of a commercial and industrial loan in the amount of $331 thousand. As the loan portfolio and allowance for loan losses review processes continue to evolve, there may be changes to elements of the allowance and this may have an effect on the overall level of the allowance maintained. Historically, the Bank has enjoyed a high quality loan portfolio with relatively low levels of net charge-offs and low delinquency rates. The maintenance of a high quality portfolio will continue to be a high priority for both management and the Board of Directors. Management, being aware of the significant loan growth experienced by the Company, is intent on maintaining a strong credit review function and risk rating process. The Company has an experienced Credit Administration function, which provides independent analysis of credit requests and the management of problem credits. The Credit Department has developed and implemented analytical procedures for evaluating credit requests, has refined the Company’s risk rating system, and continues to adopt and enhance the monitoring of the loan portfolio. The loan portfolio analysis process is ongoing and proactive in order to maintain a portfolio of quality credits and to identify any weaknesses before they become more severe. Although we believe that we have established our allowance for loan losses in accordance with GAAP and that the allowance for loan losses was adequate to provide for known and inherent losses in the portfolio at all times shown above, future provisions for loan losses will be subject to ongoing evaluations of the risks in our loan portfolio. The following table sets forth activity in the allowance for loan losses for the past five years for the categories and certain other information as of the dates indicated. The total allowance is available to absorb losses from any loan category. ANALYSIS OF THE ALLOWANCE FOR LOAN LOSSES _______________ (1) Loan category as a percentage of total loans. Deposits Deposits are the major source of funding for the Company. We offer a variety of deposit products including interest bearing demand, savings, money market and time accounts all of which we actively market at competitive pricing. We generate deposits from our customers on a relationship basis and through the efforts of our commercial lending officers and our business banking officers. Year over year, deposits increased 28.3% with the largest increase occurring in interest bearing demand accounts and money market accounts. The Company continues to execute on its strategic initiative to improve the deposit portfolio mix by reducing reliance on wholesale time deposits. This is evident in the reduction in our wholesale time deposit portfolio of $26.3 million or 13.6%, to $167.0 million at December 31, 2019, from $193.3 million, or 20.2% at December 31, 2018. Our credit card customers are also a significant source of low cost deposits. As of December 31, 2019, our credit card customers accounted for $78.2 million, or 26.8%, of our total noninterest bearing deposit balances. We supplement our deposits with wholesale funding sources such as brokered deposits as needed. At December 31, 2019, interest bearing deposits were $933.6 million, an increase of $220.7 million, or 30.9%, compared to $713.0 million at December 31, 2018. This increase was primarily due to the Company’s continued effort to improve the deposit mix by reducing reliance on wholesale time deposits. During the same period, money market balances increased to $429.1 million, a $140.2 million or 48.5% change from the prior year’s balance of $288.9 million. In order to fund the loan growth of the Bank, we built upon our prior success of focusing our strategic efforts on growing core deposits through an expanded deposits sales force, incentives to our commercial loan team and increased marketing efforts. The average rate paid on interest bearing deposits increased nine basis points to 1.74% at December 31, 2019 from 1.64% for the same period in 2018. Rates paid on certificates of deposit and money market increased 61 and 36 basis points, respectively, for the period presented. The increase in the average rates was primarily due to increases in market interest rates resulting from the December 2018 increase in the federal funds rate. The following table presents the average balances and average rates paid on deposits for the periods indicated: COMPOSITION OF DEPOSITS The following table presents the maturities of our certificates of deposit as of December 31, 2019. MATURITIES OF CERTIFICATES OF DEPOSIT Borrowings We utilize short-term and long-term borrowings to supplement deposits to fund our lending and investment activities, each of which is discussed below. FHLB Advances. The FHLB allows us to borrow up to 25% of our assets on a blanket floating lien status collateralized by certain securities and loans. As of December 31, 2019, approximately $193.7 million in real estate loans and $1.5 million in investment securities were pledged as collateral for our FHLB borrowings. We utilize these borrowings to meet liquidity needs and to fund certain fixed rate loans in our portfolio. As of December 31, 2019, we had $32.2 million in outstanding advances and $140.5 million in available borrowing capacity from the FHLB. The following table sets forth certain information on our FHLB borrowings during the periods presented: FHLB ADVANCES Other borrowed funds. The Company has also issued junior subordinated debentures and other subordinated notes. At December 31, 2019, these other borrowings amounted to $15.4 million. At December 31, 2019, our junior subordinated debentures amounted to $2.1 million. The junior subordinated debentures were issued in June of 2006, mature on June 15, 2036, and may be redeemed prior to that date under certain circumstances. The principal amount of the debentures has not changed since issuance, and they accrue interest at a floating rate equal to the three-month LIBOR plus 1.87%. On November 24, 2015, the Company issued $13.5 million in aggregate principal amount of subordinated notes with a maturity date of December 1, 2025. The notes may be redeemed prior to the maturity date under certain circumstances. The notes bear interest at 6.95% for the first five years, then adjust to the three-month LIBOR plus 5.33%. Federal Reserve Bank of Richmond. The Federal Reserve Bank of Richmond has an available borrower in custody arrangement which allows us to borrow on a collateralized basis. The Company’s borrowing capacity under the Federal Reserve’s discount window program was $12.5 million as of December 31, 2019. Certain commercial loans are pledged under this arrangement. We maintain this borrowing arrangement to meet liquidity needs pursuant to our contingency funding plan. No advances were outstanding under this facility as of December 31, 2019. The Company also has lines of credit of $28.0 million available with other correspondent banks at December 31, 2019, as well as access to certificate of deposit funding through a financial network which the Bank limits to 15% of the Bank’s assets. There were no outstanding balances on the lines of credit from correspondent banks at December 31, 2019. Liquidity Liquidity is defined as the Bank’s capacity to meet its cash and collateral obligations at a reasonable cost. Maintaining an adequate level of liquidity depends on the Bank’s ability to meet both expected and unexpected cash flows and collateral needs efficiently without adversely affecting either daily operations or the financial condition of the Bank. Liquidity risk is the risk that we will be unable to meet our obligations as they become due because of an inability to liquidate assets or obtain adequate funding. The Bank’s obligations, and the funding sources used to meet them, depend significantly on our business mix, balance sheet structure and the cash flow profiles of our on- and off-balance sheet obligations. In managing our cash flows, management regularly confronts situations that can give rise to increased liquidity risk. These include funding mismatches, market constraints on the ability to convert assets into cash or in accessing sources of funds (i.e., market liquidity) and contingent liquidity events. Changes in economic conditions or exposure to credit, market, operation, legal and reputational risks also could affect the Bank’s liquidity risk profile and are considered in the assessment of liquidity and asset/liability management. Management has established a comprehensive management process for identifying, measuring, monitoring and controlling liquidity risk. Because of its critical importance to the viability of the Bank, liquidity risk management is fully integrated into our risk management processes. Critical elements of our liquidity risk management include: effective corporate governance consisting of oversight by the board of directors and active involvement by management; appropriate strategies, policies, procedures, and limits used to manage and mitigate liquidity risk; comprehensive liquidity risk measurement and monitoring systems (including assessments of the current and prospective cash flows or sources and uses of funds) that are commensurate with the complexity and business activities of the Bank; active management of intraday liquidity and collateral; an appropriately diverse mix of existing and potential future funding sources; adequate levels of highly liquid marketable securities free of legal, regulatory or operational impediments, that can be used to meet liquidity needs in stressful situations; comprehensive contingency funding plans that sufficiently address potential adverse liquidity events and emergency cash flow requirements; and internal controls and internal audit processes sufficient to determine the adequacy of the institution’s liquidity risk management process. We expect funds to be available from a number of basic banking activity sources, including the core deposit base, the repayment and maturity of loans and investment security cash flows. Other potential funding sources include brokered certificates of deposit, deposit listing services, CDARS, borrowings from the FHLB and other lines of credit. We did not have any borrowings outstanding with the Federal Reserve Bank of Richmond at December 31, 2019 or December 31, 2018, and our borrowing capacity is limited only by eligible collateral. As of December 31, 2019, we had $140.5 million of available borrowing capacity from the FHLB, $12.5 million of available borrowing capacity from the Federal Reserve Bank of Richmond and available lines of credit of $28.0 million with other correspondent banks. Cash and cash equivalents were $114.8 million million at December 31, 2019 and $34.7 million at December 31, 2018. Accordingly, our liquidity resources were at sufficient levels to fund loans and meet other cash needs as necessary. Capital Resources Stockholders’ equity increased $18.8 million for the year ended December 31, 2019 largely due to net income of $16.9 million for the year. Stock options exercised, shares issued as compensation, shares sold and stock-based compensation increased common stock and additional paid-in capital aggregately by $1.32 million . These increases were offset by the repurchase of 28,480 shares aggregating $371 thousand during 2019, and net unrealized losses on available for sale securities and cash flow hedging derivative of $13 thousand. The Company uses several indicators of capital strength. The most commonly used measure is average common equity to average assets (computed as average equity divided by average total assets), which was 10.14% at December 31, 2019 and 8.76% at December 31, 2018. The following table shows the return on average assets (computed as net income divided by average total assets), return on average equity (computed as net income divided by average equity) and average equity to average assets ratios for the years ended December 31, 2019 and 2018. The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can precipitate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of its assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum ratios of common equity Tier 1, Tier 1, and total capital as a percentage of assets and off-balance sheet exposures, adjusted for risk weights ranging from 0% to 1250%. The Bank is also required to maintain capital at a minimum level based on quarterly average assets, which is known as the leverage ratio. In July 2013, federal bank regulatory agencies issued a final rule that revised their risk-based capital requirements and the method for calculating risk-weighted assets to make them consistent with certain standards that were developed by Basel III and certain provisions of the Dodd-Frank Act. The final rule applies to all depository institutions and bank holding companies and savings and loan holding companies with total consolidated assets of more than $1 billion. The Bank was required to implement the new Basel III capital standards (subject to the phase-in for certain parts of the new rules) as of January 1, 2015. In August of 2018 the Regulatory Relief Act directed the Federal Reserve Board to revise the Small BHC Policy Statement to raise the total consolidated asset limit in the Small BHC Policy Statement from $1 billion to $3 billion. The Company is currently exempt from the consolidated capital requirements. The ability of the Company to continue to grow is dependent on its earnings and those of the Bank, the ability to obtain additional funds for contribution to the Bank’s capital, through additional borrowings, through the sale of additional common stock or preferred stock, or through the issuance of additional qualifying capital instruments, such as subordinated debt. The capital levels required to be maintained by the Company and Bank may be impacted as a result of the Bank’s concentrations in commercial real estate loans. See “Regulation” at page 18 and “Risk Factors” at page 33. As of December 31, 2019, the Bank was in compliance with all applicable regulatory capital requirements to which it was subject and was classified as “well capitalized” for purposes of the prompt corrective action regulations. As we deploy our capital and continue to grow our operations, our regulatory capital levels may decrease depending on our level of earnings. However, we intend to monitor and control our growth in order to remain in compliance with all regulatory capital standards applicable to us. The following table presents the regulatory capital ratios for the Company (as if such requirements applied to the Company) and the Bank as of the dates indicated. Contractual Obligations We have contractual obligations to make future payments on debt and lease agreements. While our liquidity monitoring and management consider both present and future demands for and sources of liquidity, the following table of contractual commitments focuses only on future obligations and summarizes our contractual obligations as of December 31, 2019. CONTRACTUAL OBLIGATIONS Off-Balance Sheet Items In the normal course of business, we enter into various transactions that, in accordance with GAAP, are not included in our consolidated balance sheets. We enter into these transactions to meet the financing needs of our customers. These transactions include commitments to extend credit and issue letters of credit, which involve, to varying degrees, elements of credit risk and interest rate risk in excess of the amounts recognized in our consolidated balance sheets. Our exposure to credit loss is represented by the contractual amounts of these commitments. The same credit policies and procedures are used in making these commitments as for on-balance sheet instruments. We are not aware of any accounting loss to be incurred by funding these commitments; however we maintain an allowance for off-balance sheet credit risk which is recorded in other liabilities on the consolidated balance sheet. Our commitments associated with outstanding letters of credit and commitments to extend credit expiring by period as of the date indicated are summarized below. Since commitments associated with letters of credit and commitments to extend credit may expire unused, the amounts shown do not necessarily reflect the actual future cash funding requirements. CREDIT EXTENSION COMMITMENTS Unfunded lines of credit represent unused credit facilities to our current borrowers. Lines of credit generally have variable interest rates. Letters of credit are conditional commitments issued by us to guarantee the performance of a customer to a third party. In the event of nonperformance by the customer in accordance with the terms of the agreement with the third party, we would be required to fund the commitment. The maximum potential amount of future payments we could be required to make is represented by the contractual amount of the commitment. If the commitment is funded, we would be entitled to seek recovery from the customer from the underlying collateral, which can include commercial real estate, physical plant and property, inventory, receivables, cash and/or marketable securities. Our policies generally require that letter of credit arrangements contain security and debt covenants similar to those contained in loan agreements and our credit risk associated with issuing letters of credit is substantially the same as the risk involved in extending loan facilities to our customers. We minimize our exposure to loss under letters of credit and credit commitments by subjecting them to the same credit approval and monitoring procedures as we do for on-balance sheet instruments. The effect on our revenue, expenses, cash flows and liquidity of the unused portions of these lines of credit commitments cannot be precisely predicted because there is no guarantee that the lines of credit will be used. Commitments to extend credit are agreements to lend funds to a customer, as long as there is no violation of any condition established in the contract, for a specific purpose. Commitments generally have variable interest rates, fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being fully drawn, the total commitment amounts disclosed above do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if considered necessary by us, upon extension of credit is based on management’s credit evaluation of the customer. We enter into forward commitments for the delivery of mortgage loans in our current pipeline. Interest rate lock commitments are entered into in order to economically hedge the effect of changes in interest rates resulting from our commitments to fund the loans. These commitments to fund mortgage loans, to be sold into the secondary market, (interest rate lock commitments) and forward commitments for the future delivery of mortgage loans to third party investors are considered derivatives. Impact of Inflation Our consolidated financial statements and related notes included elsewhere in this report have been prepared in accordance with GAAP. GAAP requires the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative value of money over time due to inflation or recession. Unlike many industrial companies, substantially all of our assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on our performance than the effects of general levels of inflation. Interest rates may not necessarily move in the same direction or in the same magnitude as the prices of goods and services. However, other operating expenses do reflect general levels of inflation.

<s>[INST] The discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under “Cautionary Note Regarding ForwardLooking Statements,” “Risk Factors” and elsewhere in this Form 10K, may cause actual results to differ materially from those projected in the forwardlooking statements. We assume no obligation to update any of these forwardlooking statements Results of Operations for the Years Ended December 31, 2019 and 2018 Net Income The following table sets forth the principal components of net income for the periods indicated. Net income for the year ended December 31, 2019 was $16.9 million, an increase of $4.1 million, or 32%, from net income for the year ended December 31, 2018 of $12.8 million. The increase was primarily the result of the $142.6 million increase in average loans outstanding year over year. The increase in loan volume resulted in an increase of $10.4 million of loan interest income. Net Interest Income and Net Margin Analysis Net interest income is the difference between interest income on earning assets and the cost of funds supporting those assets. Earning assets are composed primarily of loans, loans held for sale, investment securities, and interest bearing deposits with banks. The cost of funds represents interest expense on deposits, and borrowings, which consist of federal funds purchased, advances from the FHLB and subordinated notes. Noninterest bearing deposits and capital are other components representing funding sources. We analyze our ability to maximize income generated from interest earning assets and control the interest expenses of our liabilities, measured as net interest income, through our net interest margin and net interest spread. Net interest margin is a ratio calculated as net interest income divided by average interest earning assets for the same period. Net interest spread is the difference between average interest rates earned on interest earning assets and average interest rates paid on interest bearing liabilities. Changes in market interest rates and the interest rates we earn on interest earning assets or pay on interest bearing liabilities, as well as in the volume and mix of interest earning assets, interest bearing and noninterest bearing liabilities and stockholders’ equity, are usually the largest drivers of periodic changes in net interest income, net interest margin and net interest spread. Fluctuations in market interest rates are driven by many factors, including governmental monetary policies, inflation, deflation, macroeconomic developments, changes in unemployment, the money supply, political and international conditions and conditions in domestic and foreign financial markets. Periodic changes in the volume and types of loans in our loan portfolio are affected by, among other factors, economic and competitive conditions in the Washington, D.C. and Baltimore metropolitan areas, as well as developments affecting the real estate, technology, government services, hospitality and tourism and financial services sectors within our target markets and throughout the Washington, D.C. and Baltimore metropolitan areas. Our ability to respond to changes in these factors by using effective assetliability management techniques is critical to maintaining the stability of our net interest income and net interest margin as our primary sources of earnings. The table below presents the average balances and rates of the major categories of the Company’s assets and liabilities for the years ended December 31, 2019, 2018 and 2017. Included in the table is a measurement of interest rate spread and margin. Interest rate spread is the difference (expressed as a percentage) between the interest rate earned on earning assets less the interest expense on interest bearing liabilities. While the interest rate spread provides a quick comparison of earnings rates versus cost of funds, management believes that the net interest margin provides a better measurement of performance. The net interest margin (as compared to the net interest spread) includes the effect of noninterest bearing sources in its calculation and is net interest income expressed as a percentage of average earning assets. As the table shows, the increase in net interest income in 2019 as compared to 2018 was primarily a function of an increase in the volume of earning assets and particularly loans. AVERAGE BALANCE SHEET AND NET INTEREST ANALYSIS _______________ (1) Includes nonaccrual loans. (2) Interest income includes amortization of deferred loan fe [/INST] Positive. </s>

WestRock Co

2018-11-16

2018-09-30

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview We are a multinational provider of paper and packaging solutions for consumer and corrugated packaging markets. We partner with our customers to provide differentiated paper and packaging solutions that help them win in the marketplace. Our team members support customers around the world from our operating and business locations in North America, South America, Europe, Asia and Australia. We also sell real estate primarily in the Charleston, SC region. Organization WestRock was formed on March 6, 2015 for the purpose of effecting the Combination and, prior to the Combination, did not conduct any activities other than those incidental to its formation and the matters contemplated by the Business Combination Agreement. On July 1, 2015, pursuant to the Business Combination Agreement, RockTenn and MWV completed a strategic combination of their respective businesses and RockTenn and MWV each became wholly-owned subsidiaries of WestRock. RockTenn was the accounting acquirer in the Combination. On May 15, 2016, WestRock completed the Separation, pursuant to which we disposed of our former Specialty Chemicals segment in its entirety and ceased to consolidate its assets, liabilities and results of operations in our consolidated financial statements. Accordingly, we have presented the financial position and results of operations of our former Specialty Chemicals segment as discontinued operations in the accompanying consolidated financial statements for all periods presented. See “Note 7. Discontinued Operations” of the Notes to Consolidated Financial Statements for additional information. On April 6, 2017, we completed the HH&B Sale. We used the proceeds from the HH&B Sale in connection with the of MPS Acquisition. We recorded a pre-tax gain on sale of HH&B of $192.8 million in fiscal 2017. See “Note 1. Description of Business and Summary of Significant Accounting Policies - Description of Business” of the Notes to Consolidated Financial Statements for additional information. On June 6, 2017, we completed the MPS Acquisition. MPS is reported in our Consumer Packaging segment. See “Note 2. Mergers, Acquisitions and Investment” of the Notes to Consolidated Financial Statements for additional information. On November 2, 2018, pursuant to the Merger Agreement, the Company acquired all of the outstanding shares of KapStone through the Mergers. As a result of the Mergers, among other things, the Company became the ultimate parent of WRKCo, KapStone and their respective subsidiaries. Effective as of the the Effective Time, the Company changed its name to “WestRock Company” and WRKCo changed its name to “WRKCo Inc.”. See “Note 23. Subsequent Events (Unaudited)” of the Notes to Consolidated Financial Statements for additional information. Presentation We report our financial results of operations in the following three reportable segments: Corrugated Packaging, which consists of our containerboard mill and corrugated packaging operations, as well as our recycling operations; Consumer Packaging, which consists of consumer mills, folding carton, beverage, merchandising displays and partition operations; and Land and Development, which sells real estate, primarily in the Charleston, SC region. Following the Combination and until the completion of the Separation, our financial results of operations had a fourth reportable segment, Specialty Chemicals. Prior to the HH&B Sale, our Consumer Packaging segment included HH&B. In fiscal 2019, we plan to operate our recycling operations primarily as a procurement function, shifting its focus to the procurement of low cost, high quality fiber for our mill system. As a result, we will no longer record recycling sales. Acquisitions and Investments We completed a number of acquisitions in the last three years that expanded our product and geographic scope or allowed us to increase our integration levels, and we expect to continue to evaluate similar potential acquisitions in the future. Below we summarize certain of these acquisitions and investments. On September 4, 2018, we completed the Schlüter Acquisition. Schlüter is a leading provider of differentiated paper and packaging solutions and a German-based supplier of a full range of leaflets and booklets. The Schlüter Acquisition allows us to further enhance our pharmaceutical and automotive platform and expand our geographical footprint in Europe to better serve our customers. We have included the financial results of the acquired operations in our Consumer Packaging segment since the date of the acquisition. On January 5, 2018, we completed the Plymouth Packaging Acquisition. The assets we acquired included Plymouth’s “Box on Demand” systems, which are manufactured by Panotec, an Italian manufacturer of packaging machines. The Box on Demand systems enhance our platform and drive differentiation and innovation. These systems, which are located on customers’ sites under multi-year exclusive agreements, use fanfold corrugated to produce custom, on-demand corrugated packaging that is accurately sized for any product type according to the customer’s specifications. Fanfold corrugated is continuous corrugated board, folded periodically to form an accordion-like stack of corrugated material. As part of the transaction, WestRock acquired Plymouth’s equity interest in Panotec and Plymouth’s exclusive right from Panotec to distribute Panotec’s equipment in the U.S. and Canada. We have fully integrated the approximately 60,000 tons of containerboard used by Plymouth annually. We have included the financial results of Plymouth in our Corrugated Packaging segment since the date of the acquisition. On August 1, 2017, we completed the Hannapak Acquisition. Hanna Group is one of Australia’s leading providers of folding cartons to a variety of markets, including beverage, food, confectionery and healthcare. We expect this acquisition will build on our established and growing packaging business in the region. We have included the financial results of the acquired operations in our Consumer Packaging segment since the date of the acquisition. On July 17, 2017, we completed the Island Container Acquisition. The assets we acquired included a corrugator and corrugated converting operations. We have substantially completed the integration of the 80,000 tons of containerboard used by Island annually into our Corrugated Packaging segment. We have included the financial results of the acquired operations in our Corrugated Packaging segment since the date of the acquisition. On June 9, 2017, we completed the U.S. Corrugated Acquisition. The acquired business provides a comprehensive suite of products and services to customers in a variety of end markets, including food & beverage, pharmaceuticals and consumer electronics. At the time of the transaction, we expected the acquisition to provide us the opportunity to increase the vertical integration of our Corrugated Packaging segment by approximately 105,000 tons of containerboard annually through the acquired facilities and another 50,000 tons under a long-term supply contract with another company owned by the seller, and we have since completed the integration of these tons. We have included the financial results of U.S. Corrugated in our Corrugated Packaging segment since the date of the acquisition. On June 6, 2017, we completed the MPS Acquisition. MPS is a global provider of print-based specialty packaging solutions and its differentiated product offering includes premium folding cartons, inserts, labels and rigid packaging. At the time of the transaction, we expected the acquisition to increase our annual paperboard consumption by approximately 225,000 tons. We are well underway, and we currently expect approximately 100,000 tons to be supplied by us by the first half of fiscal 2019. We have included the financial results of MPS in our Consumer Packaging segment since the date of the acquisition. On March 13, 2017, we completed the Star Pizza Acquisition. The transaction provided us with a leadership position in the fast growing small-run pizza box market and increased our vertical integration. We have fully integrated the approximately 22,000 tons of containerboard used by Star Pizza annually. We have included the financial results of the acquired operations in our Corrugated Packaging segment since the date of the acquisition. On April 1, 2016, we completed the formation of a joint venture with Grupo Gondi to combine our respective operations in Mexico. We contributed cash and the stock of an entity that owns three corrugated packaging facilities in Mexico in return for a 25.0% ownership interest in the joint venture together with future put and call rights. In April 2017, the joint venture entity had a stock redemption from a minority partner which increased our ownership interest to approximately 27.0%. On October 20, 2017, we increased our ownership interest to approximately 32.3% through a $108 million capital contribution. The joint venture operates paper machines, corrugated packaging and high graphic folding carton facilities across various production sites. The majority equity holders of Grupo Gondi manage the joint venture and we provide technical and commercial resources. We believe the joint venture is helping us to grow our presence in the attractive Mexican market. We have included the financial results of the joint venture in our Corrugated Packaging segment since the date of formation. We are accounting for the investment on the equity method. On January 19, 2016, we completed the Packaging Acquisition. The entities acquired provide value-added folding carton and litho-laminated display packaging solutions. We believe the transaction has provided us with attractive and complementary customers, markets and facilities. We have included the financial results of the acquired entities in our Consumer Packaging segment since the date of the acquisition. On October 1, 2015, we completed the SP Fiber Acquisition. The transaction included the acquisition of mills located in Dublin, GA and Newberg, OR, which produce lightweight recycled containerboard and kraft and bag paper. The Newberg mill also produced newsprint. As part of the transaction, we also acquired SP Fiber's 48% interest in Green Power Solutions of Georgia, LLC (“GPS”), which we consolidate. GPS is a joint venture providing steam to the Dublin mill and electricity to Georgia Power. Subsequent to the transaction, we announced the permanent closure of the Newberg mill due to the decline in market conditions of the newsprint business and our need to balance supply and demand in our containerboard system. We have included the financial results of the acquired entities in our Corrugated Packaging segment since the date of the acquisition. See “Note 2. Mergers, Acquisitions and Investment” of the Notes to Consolidated Financial Statements for additional information. See also Item 1A. “Risk Factors - We May Be Unsuccessful in Making and Integrating Mergers, Acquisitions and Investments and Completing Divestitures”. Business In fiscal 2018, we continued to pursue our strategy of offering differentiated paper and packaging solutions that help our customers win. We successfully executed this strategy in fiscal 2018 in a rapidly changing cost and price environment. Net sales of $16,285.1 million for fiscal 2018 increased $1,425.4 million, or 9.6%, compared to fiscal 2017. The increase was primarily a result of an increase in Corrugated Packaging segment sales, driven by higher selling price/mix and the contributions from acquisitions, and increased Consumer Packaging segment sales, primarily due to the contribution from acquisitions (primarily the MPS Acquisition). These increases were partially offset by the absence of net sales from HH&B in fiscal 2018 due to the sale of HH&B in April 2017 and lower Land and Development segment sales compared to the prior year period due to the timing of real estate sales as we monetize the portfolio and lower merchandising display sales in the Consumer Packaging segment. Segment income increased $491.5 million in fiscal 2018 compared to fiscal 2017, primarily due to increased Corrugated Packaging segment income. With respect to segment income, we experienced higher levels of cost inflation during fiscal 2018 as compared to fiscal 2017, which was partially offset by recycled fiber deflation. The primary inflationary items were freight costs, chemical costs, virgin fiber costs and wage and other costs. Productivity improvements in fiscal 2018 more than offset the net impact of cost inflation. While it is difficult to predict specific inflationary items, we expect higher cost inflation to continue through fiscal 2019. Our Corrugated Packaging segment increased its net sales by $695.1 million in fiscal 2018 to $9,103.4 million from $8,408.3 million in fiscal 2017. The increase in net sales was primarily due to higher corrugated selling price/mix and higher corrugated volumes (including acquisitions), which were partially offset by lower net sales from recycling operations due to lower recycled fiber costs, lower sales related to the deconsolidation of a foreign joint venture in fiscal 2017 and the impact of foreign currency. North American box shipments increased 4.1% on a per day basis in fiscal 2018 compared to fiscal 2017. Segment income attributable to the Corrugated Packaging segment in fiscal 2018 increased $454.0 million to $1,207.9 million compared to $753.9 million in fiscal 2017. The increase was primarily due to higher selling price/mix, lower recycled fiber costs and productivity improvements which were partially offset by higher levels of cost inflation and other items, including increased depreciation and amortization. Our Consumer Packaging segment increased its net sales by $838.9 million in fiscal 2018 to $7,291.4 million from $6,452.5 million in fiscal 2017. The increase in net sales was primarily due to an increase in net sales from acquisitions (primarily the MPS Acquisition) and higher selling price/mix partially offset by the absence of net sales from HH&B in fiscal 2018 due to the HH&B Sale in April 2017 and lower volumes. Segment income attributable to the Consumer Packaging segment in fiscal 2018 increased $28.8 million to $454.6 million compared to $425.8 million in fiscal 2017, primarily as a result of productivity improvements, lower depreciation and amortization (excluding the MPS Acquisition), higher selling price/mix and income from acquisitions, which were partially offset by cost inflation and other items, the absence of income from HH&B in fiscal 2018 due to the HH&B Sale in April 2017 and lower volumes. Consumer Packaging’s segment income in fiscal 2017 included a $25.1 million acquisition inventory step-up charge related primarily to the MPS Acquisition. Our Land and Development segment sales were $142.4 million in fiscal 2018 compared to $243.8 million in fiscal 2017, primarily due to the timing of land sales associated with our accelerated monetization. We expect to complete the monetization of our portfolio during fiscal 2019. After we complete the monetization, the segment will cease to exist. Segment income attributable to the Land and Development segment was $22.5 million in fiscal 2018 compared to $13.8 million in fiscal 2017. We generated $2,420.9 million of net cash provided by operating activities in fiscal 2018, compared to $1,900.5 million in fiscal 2017. We remained committed to our disciplined capital allocation strategy during fiscal 2018 by investing $999.9 million in capital expenditures, deployed $347.9 million to strategic acquisitions and investments while returning $440.9 million in dividends and $195.1 million to our stockholders in share repurchases. We believe our strong balance sheet and cash flow provide us the flexibility to continue to invest to sustain and improve our operating performance. In fiscal 2019, we expect capital expenditures to be approximately $1.5 billion, including KapStone. See “Liquidity and Capital Resources” for more information. A detailed review of our fiscal 2018 performance appears below under “Results of Operations (Consolidated)” and “Results of Operations - Segment Data”. Results of Operations (Consolidated) The following table summarizes our consolidated results for the three years ended September 30, 2018: Non-GAAP Measures We report our financial results in accordance with generally accepted accounting principles in the U.S. (“GAAP”). However, we have included financial measures that were not prepared in accordance with GAAP. Non-GAAP financial measures should be viewed in addition to, and not as an alternative for, our GAAP results. The non-GAAP financial measures we present may differ from similarly captioned measures of other companies. We use the non-GAAP financial measures “Adjusted Income from Continuing Operations” and “Adjusted Earnings from Continuing Operations Per Diluted Share”. Management believes these non-GAAP financial measures provide our board of directors, investors, potential investors, securities analysts and others with useful information to evaluate our performance because the measures exclude restructuring and other costs, and other specific items that management believes are not indicative of ongoing operating results. We and our board of directors use this information to evaluate our performance relative to other periods. We believe that the most directly comparable GAAP measures to Adjusted Income from Continuing Operations and Adjusted Earnings from Continuing Operations Per Diluted Share are Income from continuing operations and Earnings from continuing operations per diluted share, respectively. The GAAP results in the tables that follow for Pre-Tax, Tax and Net of Tax are equivalent to the line items “Income from continuing operations before income taxes”, “Income tax benefit (expense)” and “Income from continuing operations”, respectively, as reported on the Consolidated Statements of Operations. Diluted earnings per share from continuing operations were $7.34 in fiscal 2018 compared to $2.77 in fiscal 2017 and $0.59 in fiscal 2016. Adjusted Earnings from Continuing Operations Per Diluted Share were $4.09, $2.62 and $2.52 in fiscal 2018, 2017 and 2016, respectively. Set forth below is a reconciliation of the non-GAAP financial measure Adjusted Earnings from Continuing Operations Per Diluted Share to Earnings from continuing operations per diluted share, the most directly comparable GAAP measure (in dollars per share) for the periods indicated. The GAAP results in the tables below for Pre-Tax, Tax and Net of Tax are equivalent to the line items “Income from continuing operations before income taxes”, “Income tax benefit (expense)” and “Income from continuing operations”, respectively, as reported on the Consolidated Statements of Operations. Set forth below are reconciliations of Adjusted Income from Continuing Operations to the most directly comparable GAAP measure, Income from continuing operations, for the periods indicated (in millions): (1) Essentially no tax was incurred due to a high tax basis and fees associated with the transaction (1) Impacted by non-deductible goodwill We discuss certain of these charges in more detail in “Note 3. Restructuring and Other Costs” and “Note 4. Retirement Plans”, “Note 5. Income Taxes” and See “Note 1. Description of Business and Summary of Significant Accounting Policies - Description of Business”. Net Sales (Unaffiliated Customers) Net sales in fiscal 2018 increased $1,425.4 million, or 9.6%, compared to fiscal 2017. The increase was primarily attributable to increased Corrugated Packaging segment sales, driven by higher selling price/mix and contributions from acquisitions and increased Consumer Packaging segment sales, primarily due to the contribution from acquisitions (primarily the MPS Acquisition). These increases in segment sales were partially offset by the absence of net sales from HH&B in fiscal 2018 due to the sale of HH&B in April 2017. In addition, Land and Development segment sales were lower compared to the prior year period due to the timing of real estate sales as we monetize the portfolio and lower merchandising display sales in the Consumer Packaging segment. Net sales for fiscal 2017 increased $687.9 million to $14,859.7 million compared to $14,171.8 million in fiscal 2016. The increase was primarily a result of an increase in Corrugated Packaging segment sales, including the partial period impact of the U.S. Corrugated Acquisition and the Island Container Acquisition, an increase in Land and Development segment sales due to the accelerated monetization and a net increase in Consumer Packaging segment sales associated with the MPS Acquisition and the Hannapak Acquisition, partially offset by factors that included the absence of full year net sales from HH&B in fiscal 2017 due to the sale of HH&B. The change in net sales by segment is outlined in the “Results of Operations - Segment Data” section below. Cost of Goods Sold Cost of goods sold increased to $12,891.2 million in fiscal 2018 compared to $12,119.5 million in fiscal 2017. Cost of goods sold as a percentage of net sales was 79.2% in fiscal 2018 compared to 81.6% in fiscal 2017. The increase in cost of goods sold in fiscal 2018 compared to fiscal 2017 was primarily due to increased net sales associated with the impact of acquisitions (primarily the MPS Acquisition) and higher levels of cost inflation. The primary inflationary items were freight costs, chemical costs, virgin fiber costs and wage and other costs. These factors were partially offset by the absence of costs associated with HH&B in fiscal 2018 due to the HH&B Sale, productivity improvements, lower recycled fiber costs and decreased land sales. Cost of goods sold as a percentage of net sales also decreased as a result of higher selling prices, primarily in our Corrugated Packaging segment. Fiscal 2018 and 2017 included $1.0 million and $26.5 million, respectively, for the expensing of inventory stepped-up in purchase accounting, net of related LIFO impact. Cost of goods sold increased to $12,119.5 million in fiscal 2017 compared to $11,413.2 million in fiscal 2016. Cost of goods sold as a percentage of net sales was 81.6% in fiscal 2017 compared to 80.5% in fiscal 2016 primarily due to cost inflation, primarily recycled fiber, as well as increased land sales due to the accelerated monetization and the net impact of acquisitions offset by the impact of the HH&B Sale and other items. In addition, fiscal 2017 compared to fiscal 2016 was negatively impacted by the several hurricanes. These factors were partially offset by synergy and productivity improvements. Fiscal 2017 and 2016 included $26.5 million and $8.1 million for the expensing of inventory stepped-up in purchase accounting, net of related LIFO impact, respectively. We discuss these items in greater detail below in “Results of Operations - Segment Data”. Selling, General and Administrative Excluding Intangible Amortization Selling, general, and administrative expenses (“SG&A”) excluding intangible amortization increased $93.7 million to $1,493.3 million in fiscal 2018 compared to fiscal 2017. This increase was primarily due to acquisitions completed in fiscal 2017 and 2018 that were partially offset by the impact of the HH&B Sale. SG&A as a percentage of sales declined in fiscal 2018 to 9.2% from 9.4% in fiscal 2017, in part, due to higher selling prices. SG&A excluding intangible amortization increased $20.2 million to $1,399.6 million in fiscal 2017 compared to $1,379.4 million in fiscal 2016, due primarily to acquisitions. SG&A excluding intangible amortization as a percentage of sales decreased to 9.4% in fiscal 2017 compared to 9.7% in fiscal 2016. Selling, General and Administrative Intangible Amortization SG&A intangible amortization was $296.6 million, $229.6 million and $211.8 million in fiscal 2018, 2017 and 2016, respectively. The increase in fiscal 2018 compared to fiscal 2017 was due to acquisitions completed in fiscal 2018 and 2017, notably the MPS Acquisition. The increase in fiscal 2017 compared to fiscal 2016 was due to acquisitions completed in fiscal 2017, as well as the full year impact of the Packaging Acquisition compared to nine months of impact in fiscal 2016, which were partially offset by the impact of the HH&B Sale. Multiemployer Pension Withdrawals In fiscal 2018, we submitted formal notification to withdraw from PIUMPF and Central States and recorded aggregate estimated withdrawal liabilities of $184.2 million, which includes an estimate of our portion of PIUMPF’s accumulated funding deficiency. Since these withdrawal liabilities assume payment over 20 years, the liabilities were discounted at a credit adjusted risk-free rate and therefore we will accrete the liability over time with a charge to interest expense. See “Note 4. Retirement Plans - Multiemployer Plans” of the Notes to Consolidated Financial Statements for additional information. See also Item 1A. “Risk Factors - We May Incur Withdrawal Liability and/or Increased Funding Requirements in Connection with the MEPPs in Which We Participate”. Pension Risk Transfer Expense In fiscal 2016, we used plan assets to settle $2.5 billion of pension obligations of the Plan by purchasing group annuity contracts from Prudential. This transaction transferred payment responsibility to Prudential for retirement benefits owed to approximately 35,000 U.S. retirees and their beneficiaries. As a result, we recorded a non-cash charge of $370.7 million pre-tax. The settlement reduced our overall U.S. pension obligations and assets by approximately 40%. The monthly retirement benefit payment amounts currently received by retirees and their beneficiaries did not change as a result of this transaction. Those plan participants not included in the transaction remain in the Plan, and responsibility for payment of their retirement benefits remains with us. See “Note 4. Retirement Plans” of the Notes to Consolidated Financial Statements for additional information. Pension Lump Sum Settlement Expense In fiscal 2017, lump sum payments to certain beneficiaries of the Plan, together with several one-time severance benefit payments out of the Plan, triggered pension settlement accounting and resulted in a $32.6 million non-cash charge to our earnings. The lump sum payments were to certain eligible former employees who were not currently receiving a monthly benefit. Eligible former employees whose present value of future pension benefits exceeded a certain minimum threshold had the option to either voluntarily accept lump sum payments or to not accept the offer and continue to be entitled to their monthly benefit upon retirement. See “Note 4. Retirement Plans” of the Notes to Consolidated Financial Statements for additional information. Land and Development Impairments In fiscal 2018, we recorded $31.9 million of pre-tax non-cash impairments of certain mineral rights and real estate. The $23.6 million impairment of mineral rights was driven by the non-renewal of a lease, and the other $8.3 million was recorded to write-down the carrying value on real estate projects. Similarly, in fiscal 2017, we recorded a pre-tax non-cash real estate impairment of $46.7 million, or $39.7 million net of $7.0 million of noncontrolling interest. Due to the accelerated monetization in our Land and Development segment, the real estate impairments in both years were recorded to write-down the carrying value on projects where the projected sales proceeds were less than the carrying value. The charge is not reflected in segment income. Restructuring and Other Costs We recorded aggregate pre-tax restructuring and other costs of $105.4 million, $196.7 million and $366.4 million for fiscal 2018, 2017 and 2016, respectively. We generally expect the integration of a closed facility’s assets and production with other facilities to enable the receiving facilities to better leverage their fixed costs while eliminating fixed costs from the closed facility. Costs recorded in each period are not comparable since the timing and scope of the individual actions associated with each restructuring, acquisition, divestiture or integration vary. The restructuring and other costs exclude the Specialty Chemicals costs, which are included in discontinued operations in fiscal 2016. See “Note 3. Restructuring and Other Costs” and “Note 7. Discontinued Operations” of the Notes to Consolidated Financial Statements for additional information, including a description of the type of costs incurred. We have restructured portions of our operations from time to time and it is possible that we may engage in additional restructuring opportunities in the future. See also Item 1A. “Risk Factors - We May Incur Additional Restructuring Costs and May Not Realize Expected Benefits from Restructuring”. Interest Expense, net Interest expense, net was $293.8 million, $222.5 million and $212.5 million for fiscal 2018, 2017 and 2016, respectively. Interest expense, net in fiscal 2018 increased primarily due to debt incurred as a result of acquisitions in fiscal 2017 and 2018, as well as an increase in market interest rates. The increase in fiscal 2017 as compared to fiscal 2016 was primarily due to debt incurred as a result of acquisitions. Interest expense, net in fiscal 2018, 2017 and 2016 was reduced by $31.0 million, $34.5 million and $44.5 million, respectively, related to the amortization of the fair value of debt stepped-up in purchase accounting. During fiscal 2018, 2017 and 2016 amortization of debt issuance costs charged to interest expense, net were $6.3 million, $4.5 million and $4.6 million, respectively. See Item 1A. “Risk Factors - The Level of Our Indebtedness Could Adversely Affect Our Financial Condition and Impair Our Ability to Operate Our Business”. Other Income, net Other income, net was $12.7 million, $11.5 million and $14.4 million in fiscal 2018, 2017 and 2016, respectively. Other income, net in fiscal 2018 included a $12.3 million gain on the sale of our solid waste management brokerage services business. Other income, net in fiscal 2017 primarily included income from the sale of certain investments. Other income, net in fiscal 2016 included a $12.1 million gain on investment in Grupo Gondi related to the three corrugated box plants we contributed to the joint venture. Gain on Sale of HH&B On April 6, 2017, we announced that we had completed the HH&B Sale. In fiscal 2017, we recorded a pre-tax gain on sale of $192.8 million. We used the proceeds from the HH&B Sale in connection with the MPS Acquisition. Provision for Income Taxes On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (H.R. 1) (the “Tax Act”). The Tax Act contains significant changes to corporate taxation, including (i) the reduction of the corporate income tax rate to 21%, (ii) the acceleration of expensing for certain business assets, (iii) the one-time transition tax related to the transition of U.S. international tax from a worldwide tax system to a territorial tax system, (iv) the repeal of the domestic production deduction, (v) additional limitations on the deductibility of interest expense and (vi) expanded limitations on executive compensation. The key impacts of the Tax Act on our financial statements in fiscal 2018 were the remeasurement of deferred tax balances to the new corporate tax rate and an accrual for the one-time transition tax liability. See “Note 5. Income Taxes - Impacts of the Tax Act” of the Notes to Consolidated Financial Statements for additional information. We recorded income tax benefit from continuing operations of $874.5 million, at an effective tax rate benefit of 84.5% in fiscal 2018, including the $1,128.8 million provisional benefit of the Tax Act, as compared to income tax expense from continuing operations of $159.0 million, at an effective tax rate of 18.5% in fiscal 2017, and compared to an income tax expense from continuing operations of $89.8 million, at an effective tax rate expense of 36.7% in fiscal 2016. The effective tax rate benefit from continuing operations for fiscal 2018 was lower than the statutory federal rate primarily due to (i) the provisional amounts related to the enactment of the Tax Act, (ii) favorable tax items, such as the domestic production deduction, tax benefit of share-based compensation and cash tax planning that resulted in reduced deferred tax liabilities (iii) true up of certain deferred taxes and foreign tax returns, and (iv) a change in valuation allowance, partially offset by (v) the inclusion of state taxes and (vi) the exclusion of tax benefits related to losses recorded by certain foreign operations. The effective tax rate from continuing operations for fiscal 2017 was lower than the statutory rate primarily due to (i) low rates of tax applicable to the HH&B Sale, (ii) a $28.7 million tax benefit related to the reduction of a state deferred tax liability as a result of an internal U.S. legal entity restructuring that simplified future operating activities within the U.S., (iii) favorable tax items, such as the domestic manufacturer’s deduction, (iv) lower tax rates applied to foreign earnings, primarily in Canada, and (v) a change in valuation allowance due to realization of capital loss carryforward, partially offset by (vi) the exclusion of tax benefits related to losses recorded by certain foreign operations and (vii) the inclusion of state taxes. The effective tax rate from continuing operations for fiscal 2016 was different than the statutory rate primarily due to (i) the impact of state taxes, (ii) the ability to claim the domestic manufacturer’s deduction against U.S. taxable earnings, (iii) the deconsolidation of a subsidiary related to the Grupo Gondi joint venture, including non-deductible goodwill disposed of in connection with the transaction, and (iv) an increase in valuation allowances and a tax rate differential with respect to foreign earnings primarily in Canada. See “Note 5. Income Taxes” of the Notes to Consolidated Financial Statements for additional information. Loss from Discontinued Operations On May 15, 2016, we completed the Separation. Subsequent to the Separation, the operating results of our former Specialty Chemicals segment are reported as discontinued operations. Loss from discontinued operations, net of tax, was $544.7 million for fiscal 2016 as a result of goodwill and intangible impairments, and restructuring and other costs being partially offset by income from operations. In the first quarter of fiscal 2016, in light of changing market conditions, expected revenue and earnings of the reporting unit, lower comparative market valuations for companies in Specialty Chemicals’ peer group and the results of our preliminary “Step 2” test, we concluded that an impairment of the Specialty Chemicals reporting unit was probable and could be reasonably estimated. As a result, we recorded a pre-tax and after-tax non-cash goodwill impairment charge of $478.3 million. In the third quarter of fiscal 2016, in conjunction with the Separation, we performed an impairment assessment under the held for sale model and recorded a pre-tax non-cash impairment charge of $101.1 million for a customer relationships intangible. See “Note 7. Discontinued Operations” of the Notes to Consolidated Financial Statements for additional information. Results of Operations - Segment Data We report our financial results of operations in the following three reportable segments: Corrugated Packaging, which consists of our containerboard mill and corrugated packaging operations, as well as our recycling operations; Consumer Packaging, which consists of consumer mills, folding carton, beverage, merchandising displays and partition operations; and Land and Development, which sells real estate, primarily in the Charleston, SC region. Following the Combination and until the completion of the Separation, our financial results of operations had a fourth reportable segment, Specialty Chemicals. Prior to the HH&B Sale, our Consumer Packaging segment included HH&B. Corrugated Packaging Segment North American Corrugated Packaging Shipments Corrugated Packaging Shipments are expressed as a tons equivalent, which includes external and intersegment tons shipped from our Corrugated Packaging mills plus Corrugated Packaging container shipments converted from billion square feet (“BSF”) to tons. We have presented the Corrugated Packaging Shipments in two groups: North American and Brazil / India because we believe investors, potential investors, securities analysts and others find this breakout useful when evaluating our operating performance. The table below reflects shipments in thousands of tons, BSF and millions of square feet (“MMSF”). Brazil / India Corrugated Packaging Shipments Corrugated Packaging Segment (1) Net Sales before intersegment eliminations Net Sales (Aggregate) - Corrugated Packaging Segment Net sales before intersegment elimination for the Corrugated Packaging segment increased $695.1 million in the fiscal 2018 compared to fiscal 2017, primarily due to $683.5 million of higher corrugated selling price/mix, and $156.7 million of higher corrugated volumes (including acquisitions), which were partially offset by $84.5 million of lower net sales from our recycling operations primarily due to lower recycled fiber prices, $36.2 million of unfavorable foreign currency impacts and $24.4 million of other items, primarily due to the deconsolidation of a foreign joint venture in fiscal 2017. Net sales before intersegment eliminations for the Corrugated Packaging segment increased $539.8 million in fiscal 2017 compared to fiscal 2016, primarily due to $321.8 million of higher corrugated selling price/mix, $143.9 million of higher net sales of our recycling operations, primarily due to higher recycled fiber prices, $98.2 million of higher corrugated volumes, including acquisitions, and $55.9 million of favorable foreign currency impacts. These increases were partially offset by an estimated $45.0 million decrease due to the impact of several hurricanes in fiscal 2017 and a net $42.2 million of lower corrugated net sales due to a shift in sales from converted boxes in the prior year period to sales of containerboard in fiscal 2017 as a result of having contributed three box plants to the Grupo Gondi joint venture in April 2016. Segment Income - Corrugated Packaging Segment Segment income attributable to the Corrugated Packaging segment in fiscal 2018 increased $454.0 million compared to fiscal 2017, primarily due to an estimated $529.8 million of higher corrugated selling price/mix, an estimated $110.7 million of productivity improvements and $25.2 million of higher corrugated volumes (including acquisitions). These increases were partially offset by an estimated $78.9 million of increased depreciation and amortization, $52.2 million for the net impact of cost inflation, and an estimated $80.6 million of other items including $20.4 million of lower contributions from our recycling operations driven by lower recycled fiber costs, an estimated $19.0 million impact of start-up issues following major maintenance outages partially offset by a $9.5 million lower asset retirement obligations adjustment than in the prior year. The net impact of cost inflation included lower recycled fiber costs that were more than offset by higher freight costs, chemical costs, virgin fiber costs and wage and other costs compared to the prior year. The increased depreciation and amortization was primarily a function of acquisitions, capital investments and $17.1 million of increased SG&A intangible amortization due to acquisitions, and included $27.0 million of accelerated depreciation associated with assets being replaced due to projects to install a 330” state-of-the-art kraft linerboard machine at our Florence, South Carolina mill and to build a new corrugated box plant in the Brazilian state of Sao Paulo. Segment income attributable to the Corrugated Packaging segment in fiscal 2017 increased $14.0 million to $753.9 million compared to $739.9 million in fiscal 2016. The increase was primarily due to an estimated $285.4 million of favorable selling price/mix, $154.4 million of synergy and productivity improvements and $21.0 million of favorable corrugated volumes, including acquisitions. These factors were largely offset by an estimated $380.0 million of cost inflation, the impact of several hurricanes and legal charges that reduced segment income by an estimated $40.4 million and higher depreciation and amortization of $18.3 million. The primary inflation resulted from materials, energy, freight, and wage and other costs. Consumer Packaging Segment Consumer Packaging Shipments Consumer Packaging Shipments are expressed as a tons equivalent, which includes external and intersegment tons shipped from our Consumer Packaging mills plus Consumer Packaging converting shipments converted from BSF to tons. The shipment data table excludes dispensing sales (prior to the April 6, 2017 HH&B Sale) and merchandising displays since there is not a common unit of measure, as well as gypsum paperboard liner tons produced by Seven Hills since it is not consolidated. Consumer Packaging Segment (1) Net Sales before intersegment eliminations Net Sales (Aggregate) - Consumer Packaging Segment Net sales before intersegment eliminations for the Consumer Packaging segment increased $838.9 million in fiscal 2018 compared to the prior year period primarily due to the $1,143.1 million increase in net sales from acquisitions (primarily the MPS Acquisition) and $66.6 million of higher selling price/mix, partially offset by the absence of net sales from HH&B (which totaled $297.6 million in the prior year period) due to the HH&B Sale and $71.1 million of lower volumes. The volume decline primarily reflects lower sales of merchandising displays and lower pulp shipments. Net sales before intersegment eliminations for the Consumer Packaging segment increased $64.4 million in fiscal 2017 compared to fiscal 2016 primarily as a result of $575.1 million of aggregate net sales from the MPS Acquisition, the Packaging Acquisition and the Hannapak Acquisition, which were largely offset by $188.5 million of lower volumes, a $276.8 million decrease in net sales related to the absence of net sales from HH&B since April 2017, $26.1 million of unfavorable selling price/mix and an estimated $20.0 million decrease due to the impact of several hurricanes in fiscal 2017. Segment Income - Consumer Packaging Segment Segment income attributable to the Consumer Packaging segment in fiscal 2018 increased $28.8 million compared to the prior year period, primarily due to an estimated $140.6 million of productivity improvements, an increase of $60.5 million of segment income related to the MPS Acquisition, $30.5 million of lower depreciation and amortization (excluding the MPS Acquisition), an estimated $31.6 million of higher selling price/mix and a $20.1 million favorable acquisition reserve adjustments, all of which were largely offset by an estimated $178.1 million of cost inflation, $38.8 million related to the absence of income from HH&B, $16.7 million for the impact of lower volumes compared to the prior year period and other items. The net impact of cost inflation included lower recycled fiber that was more than offset by higher freight costs, chemical costs, virgin fiber costs and wage and other costs compared to the prior year period. Consumer Packaging segment income in fiscal 2017 was reduced by $25.1 million of acquisition inventory step-up expense primarily related to the MPS Acquisition. Segment income attributable to the Consumer Packaging segment in fiscal 2017 decreased $55.9 million compared to fiscal 2016, primarily due to an estimated $169.2 million of cost inflation, $50.2 million for the impact of lower volumes, the $25.7 million impact of lower income from HH&B in fiscal 2017 as compared to the full year in fiscal 2016, a $20.4 million increase in fiscal 2017 compared to fiscal 2016 for the expensing of inventory stepped-up in purchase accounting, primarily related to the MPS Acquisition in fiscal 2017 and the Packaging Acquisition in fiscal 2016, an estimated $12.2 million related to the impact of several hurricanes in fiscal 2017 and $8.8 million of lower selling price/mix. These factors were partially offset by synergy and productivity improvements of an estimated $203.8 million, a $29.4 million contribution from the operations acquired in the MPS Acquisition prior to expensing $24.7 million of inventory step-up and $15.3 million of lower depreciation and amortization expense. The lower depreciation and amortization expense was primarily due to a $10.1 million pre-tax benefit from ceasing recording depreciation and amortization expense in the second quarter of fiscal 2017 in HH&B since it was designated as held for sale. The primary inflation resulted from materials, energy, freight, and wage and other costs. Land and Development Segment (1) Net sales before intersegment eliminations Net Sales (Aggregate) - Land and Development Segment Net sales for the Land and Development segment in fiscal 2018, 2017 and 2016 were $142.4 million, $243.8 million and $119.8 million, respectively. The decrease in fiscal 2018 and the increase in fiscal 2017 were due to the timing of land sales as we monetize the portfolio. We include the remainder of the real estate holdings in assets held for sale because we have met the held for sale criteria. We expect to complete the monetization of these holdings during fiscal 2019. After we complete the monetization, the segment will cease to exist. Segment Income (Loss) - Land and Development Segment Segment income attributable to the Land and Development segment was $22.5 million, $13.8 million and $4.6 million in fiscal 2018, 2017 and 2016, respectively. The segment’s assets were stepped-up to fair value in fiscal 2015 as a result of purchase accounting, which resulted in substantially lower margins on the properties sold compared to earlier levels. The pre-tax non-cash impairments of certain mineral rights and real estate discussed above under the caption “Land and Development Impairments” are not included in segment income. Liquidity and Capital Resources On January 29, 2018, we announced that a definitive agreement had been signed for us to acquire all of the outstanding shares of KapStone for $35.00 per share and the assumption of approximately $1.36 billion in net debt, for a total enterprise value of approximately $4.9 billion. In contemplation of the transaction, on March 6, 2018, we issued $600.0 million aggregate principal amount of 3.75% senior notes due 2025 and $600.0 million aggregate principal amount of 4.0% senior notes due 2028 in an unregistered offering pursuant to Rule 144A and Regulation S under the Securities Act of 1933, as amended (the “Securities Act”). In addition, on March 7, 2018, we entered into the Delayed Draw Credit Facilities (as hereinafter defined) that provide for $3.8 billion of senior unsecured term loans. On November 2, 2018, in connection with the closing of the KapStone Acquisition, we drew upon the facility in full. The proceeds of the Delayed Draw Credit Facilities (as hereinafter defined) and other sources of cash were used to pay the consideration for the KapStone Acquisition, to repay certain existing indebtedness of KapStone and to pay fees and expenses incurred in connection with the KapStone Acquisition. We fund our working capital requirements, capital expenditures, mergers, acquisitions and investments, restructuring activities, dividends and stock repurchases from net cash provided by operating activities, borrowings under our credit facilities, proceeds from our New A/R Sales Agreement (as hereinafter defined), proceeds from the sale of property, plant and equipment removed from service and proceeds received in connection with the issuance of debt and equity securities. See “Note 13. Debt” of the Notes to Consolidated Financial Statements for additional information. Funding for our domestic operations in the foreseeable future is expected to come from sources of liquidity within our domestic operations, including cash and cash equivalents, and available borrowings under our credit facilities. As such, our foreign cash and cash equivalents are not expected to be a key source of liquidity to our domestic operations. At September 30, 2018, excluding the Delayed Draw Credit Facilities, we had approximately $3.2 billion of availability under our committed credit facilities, primarily under our revolving credit facility, the majority of which matures on July 1, 2022. This liquidity may be used to provide for ongoing working capital needs and for other general corporate purposes, including acquisitions, dividends and stock repurchases. Certain restrictive covenants govern our maximum availability under the credit facilities. We test and report our compliance with these covenants as required and we were in compliance with all of these covenants at September 30, 2018. At September 30, 2018, we had $104.9 million of outstanding letters of credit not drawn upon. Cash and cash equivalents were $636.8 million at September 30, 2018 and $298.1 million at September 30, 2017. We used a significant portion of the cash and cash equivalents on hand at September 30, 2018 in connection with the closing of the KapStone Acquisition. Approximately 20% of the cash and cash equivalents at September 30, 2018 were held outside of the U.S. At September 30, 2018, total debt was $6,415.2 million, $740.7 million of which was current. At September 30, 2017, total debt was $6,554.8 million, $608.7 million of which was current. Cash Flow Activity Net cash provided by operating activities during fiscal 2018 increased $520.4 million from fiscal 2017 primarily due to higher cash earnings and lower cash taxes due to the impact of the Tax Act. Net cash provided by operating activities during fiscal 2017 increased $212.1 million from fiscal 2016 primarily due to a $111.6 million net increase in cash flow from working capital changes plus higher after-tax cash proceeds from our Land and Development segment’s accelerated monetization. The changes in working capital in fiscal 2018, 2017 and 2016 included a source of cash resulting from the sale of $115.1 million, $64.7 million and $99.4 million, respectively, of accounts receivables in connection with the A/R Sales Agreement. Net cash used for investing activities of $1,298.9 million in fiscal 2018 consisted primarily of $999.9 million for capital expenditures, $239.9 million for cash paid for the purchase of businesses, net of cash acquired primarily related to the Plymouth Acquisition and the Schlüter Acquisition, and $108.0 million for an investment in Grupo Gondi. These investments were partially offset by $24.0 million of proceeds from the sale of certain affiliates as well as our solid waste management brokerage services business and $23.3 million of proceeds from the sale of property, plant and equipment. Net cash used for investing activities in fiscal 2017 consisted primarily of $778.6 million of capital expenditures, $1,588.5 million for the MPS Acquisition, the U.S. Corrugated Acquisition, the Island Container Acquisition, the Hannapak Acquisition and the Star Pizza Acquisition, partially offset by a $3.5 million receipt of an escrow payment from the Packaging Acquisition and proceeds of $1,005.9 million from the HH&B Sale and of $52.6 million of proceeds from the sale of property, plant and equipment. Net cash used for investing activities in fiscal 2016 consisted primarily of $796.7 million of capital expenditures, $376.4 million for the SP Fiber Acquisition and the Packaging Acquisition, $175.0 million for an investment in Grupo Gondi and $36.5 million for the purchase of debt owed by GPS in connection with the SP Fiber Acquisition partially offset by $31.2 million of proceeds from the sale of property, plant and equipment. In fiscal 2018, net cash used for financing activities of $755.1 million consisted primarily of cash dividends paid to stockholders of $440.9 million and purchases of Common Stock of $195.1 million and net repayments of debt of $120.1 million. In fiscal 2017, net cash used for financing activities consisted primarily of cash dividends paid to stockholders of $403.2 million, net repayments of debt of $145.2 million and purchases of Common Stock of $93.0 million. In fiscal 2016, net cash used for financing activities consisted primarily of cash dividends paid to stockholders of $380.7 million, purchases of Common Stock of $335.3 million and $105.0 million of cash and trust funding as a result of the Separation, which was partially offset by net additions to debt of $617.3 million. See “Note 7. Discontinued Operations” of the Notes to Consolidated Financial Statements for additional information. Our capital expenditures aggregated $999.9 million in fiscal 2018. We expect fiscal 2019 capital expenditures to be approximately $1.5 billion, including KapStone and investments to restore operations our Panama City, FL mill following Hurricane Michael. Our base capital expenditures in fiscal 2019 should be approximately $950 million to $1.0 billion, with roughly half invested in maintenance and half invested in high return generating projects. In fiscal 2019, we expect to invest approximately $0.5 billion in strategic projects. The strategic projects include: (i) installation of a 330” state-of-the-art kraft linerboard machine at our Florence, SC mill, (ii) an upgrade of the Tres Barras mill that will add virgin pulping capacity, a biomass power boiler, a turbine generator and other equipment, (iii) construction of a new corrugated box plant in the Brazilian state of Sao Paulo, (iv) installation of a curtain coater at our Mahrt, AL mill, and (v) installation of a headbox and upgrade of other areas of a paper machine at our Covington, VA mill. However, it is possible that our capital expenditure assumptions may change, project completion dates may change, or we may decide to invest a different amount depending upon opportunities we identify, changes in market conditions or to comply with environmental or other regulatory changes. We estimate that we will invest approximately $22 million for capital expenditures during fiscal 2019 in connection with matters relating to environmental compliance, excluding KapStone. We were obligated to purchase approximately $203 million of fixed assets at September 30, 2018 for various capital projects. See Item 1A. “Risk Factors - Our Capital Expenditures May Not Achieve the Desired Outcomes or May Be Achieved at a Higher Cost than Anticipated”. At September 30, 2018, the U.S. federal, state and foreign net operating losses and state tax credits available to us aggregated approximately $117 million in future potential reductions of U.S. federal, state and foreign cash taxes. Based on our current projections, we expect to utilize the remaining U.S. federal net operating losses and other U.S. federal credits primarily over the next two years. Foreign and state net operating losses and credits will be used over a longer period of time. It is possible that our utilization of these net operating losses and credits may change due to changes in taxable income, tax laws or tax rates, capital expenditures or other factors. Fiscal 2018 is the last year in which we will receive a tax benefit from the domestic production deduction. Including the estimated impact of book and tax differences, subject to changes in tax laws, we expect our cash tax rate to move closer to our income tax rate in fiscal 2019, 2020 and 2021. During fiscal 2018 and 2017, we made contributions of $37.7 million and $34.5 million, respectively, to our U.S. and non-U.S. pension plans. Based on current facts and assumptions, we expect to contribute approximately $22 million to our U.S. and non-U.S. pension plans in fiscal 2019. We have made contributions and expect to continue to make contributions in the coming years to our pension plans in order to ensure that our funding levels remain adequate in light of projected liabilities and to meet the requirements of the Pension Act and other regulations. The net over funded status of our U.S. and non-U.S. pension plans at September 30, 2018 was $147.7 million. Based on current assumptions, including future interest rates, we estimate that minimum pension contributions to our U.S. and non-U.S. pension plans will be in the range of approximately $25 million to $27 million annually in fiscal 2020 through 2023. See “Note 4. Retirement Plans” of the Notes to Consolidated Financial Statements. See also Item 1A. “Risk Factors - Certain of Our Pension Plans Will Likely Require Additional Cash Contributions”. In the normal course of business, we evaluate our potential exposure to MEPPs, including with respect to potential withdrawal liabilities. In fiscal 2018, we submitted formal notification to withdraw from two plans and recorded an aggregate estimated withdrawal liability of $184.2 million. See “Note 4. Retirement Plans - Multiemployer Plans” of the Notes to Condensed Consolidated Financial Statements for additional information. See also Item 1A. “Risk Factors - We May Incur Withdrawal Liability and/or Increased Funding Requirements in Connection with the MEPPs in Which We Participate”. In October 2018, our board of directors declared a quarterly dividend of $0.455 per share, representing a 5.8% increase from the prior $0.43 per share quarterly dividend and an annual dividend of $1.82 per share. During fiscal 2018, we paid an annual dividend of $1.72 per share. During fiscal 2017, we paid an annual dividend of $1.60 per share. During fiscal 2016 we paid an annual dividend of $1.50 per share. In July 2015, our board of directors authorized a repurchase program of up to 40.0 million shares of our Common Stock, representing approximately 15% of our outstanding Common Stock as of July 1, 2015. Shares of our Common Stock may be purchased from time to time in open market or privately negotiated transactions. The timing, manner, price and amount of repurchases will be determined by management at its discretion based on factors, including the market price of our Common Stock, general economic and market conditions and applicable legal requirements. The repurchase program may be commenced, suspended or discontinued at any time. In fiscal 2018, we repurchased approximately 3.4 million shares of our Common Stock for an aggregate cost of $195.1 million. In fiscal 2017, we repurchased approximately 1.8 million shares of our Common Stock for an aggregate cost of $93.0 million. In fiscal 2016, we repurchased approximately 8.1 million shares of our Common Stock for an aggregate cost of $335.3 million. As of September 30, 2018, we had remaining authorization under the repurchase program authorized in July 2015 to purchase approximately 21.3 million shares of our Common Stock. We anticipate that we will be able to fund our capital expenditures, interest payments, dividends and stock repurchases, pension payments, working capital needs, note repurchases, restructuring activities, repayments of current portion of long-term debt and other corporate actions for the foreseeable future from cash generated from operations, borrowings under our credit facilities, proceeds from our New A/R Sales Agreement, proceeds from the issuance of debt or equity securities or other additional long-term debt financing, including new or amended facilities. In addition, we continually review our capital structure and conditions in the private and public debt markets in order to optimize our mix of indebtedness. In connection with these reviews, we may seek to refinance existing indebtedness to extend maturities, reduce borrowing costs or otherwise improve the terms and composition of our indebtedness. Contractual Obligations We summarize our enforceable and legally binding contractual obligations at September 30, 2018, and the effect these obligations are expected to have on our liquidity and cash flow in future periods in the following table. Certain amounts in this table are based on management’s estimates and assumptions about these obligations, including their duration, the possibility of renewal, anticipated actions by third parties and other factors, including estimated minimum pension plan contributions and estimated benefit payments related to postretirement obligations, supplemental retirement plans and deferred compensation plans. Because these estimates and assumptions are subjective, the enforceable and legally binding obligations we actually pay in future periods may vary from those presented in the table. (1) Includes only principal payments owed on our debt assuming that all of our long-term debt will be held to maturity, excluding scheduled payments. We have excluded $205.2 million of fair value of debt step-up, deferred financing costs and unamortized bond discounts from the table to arrive at actual debt obligations. See “Note 13. Debt” of the Notes to Consolidated Financial Statements for information on the interest rates that apply to our various debt instruments. (2) See “Note 14. Operating Leases” of the Notes to Consolidated Financial Statements for additional information. (3) The fair value step-up of $18.5 million is excluded. See “Note 13. Debt - Capital Lease and Other Indebtedness” of the Notes to Consolidated Financial Statements for additional information. (4) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provision; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. (5) We have included in the table future estimated minimum pension plan contributions and estimated benefit payments related to postretirement obligations, supplemental retirement plans and deferred compensation plans. Our estimates are based on factors, such as discount rates and expected returns on plan assets. Future contributions are subject to changes in our underfunded status based on factors such as investment performance, discount rates, returns on plan assets and changes in legislation. It is possible that our assumptions may change, actual market performance may vary or we may decide to contribute different amounts. We have excluded $247.8 million of multiemployer pension plan withdrawal liabilities recorded as of September 30, 2018 due to lack of definite payout terms for certain of the obligations. See “Note 4. Retirement Plans - Multiemployer Plans” of the Notes to Consolidated Financial Statements for additional information. (6) We have not included the following items in the table: • An item labeled “other long-term liabilities” reflected on our consolidated balance sheet because these liabilities do not have a definite pay-out scheme. • $158.4 million from the line item “Purchase obligations and other” for certain provisions of the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) 740, “Income Taxes” associated with liabilities for uncertain tax positions due to the uncertainty as to the amount and timing of payment, if any. In addition to the enforceable and legally binding obligations presented in the table above, we have other obligations for goods and services and raw materials entered into in the normal course of business. These contracts, however, are subject to change based on our business decisions. Expenditures for Environmental Compliance See Item 1. “Business - Governmental Regulation - Environmental and Other Matters”, “Business - Governmental Regulation - CERCLA and Other Remediation Costs”, and “Business - Governmental Regulation - Climate Change” for a discussion of our expenditures for environmental compliance. Critical Accounting Policies and Estimates We have prepared our accompanying consolidated financial statements in conformity with GAAP, which requires management to make estimates that affect the amounts of revenues, expenses, assets and liabilities reported. Certain critical accounting matters are described in “Note 1. Description of Business and Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements. See also

<s>[INST] Overview We are a multinational provider of paper and packaging solutions for consumer and corrugated packaging markets. We partner with our customers to provide differentiated paper and packaging solutions that help them win in the marketplace. Our team members support customers around the world from our operating and business locations in North America, South America, Europe, Asia and Australia. We also sell real estate primarily in the Charleston, SC region. Organization WestRock was formed on March 6, 2015 for the purpose of effecting the Combination and, prior to the Combination, did not conduct any activities other than those incidental to its formation and the matters contemplated by the Business Combination Agreement. On July 1, 2015, pursuant to the Business Combination Agreement, RockTenn and MWV completed a strategic combination of their respective businesses and RockTenn and MWV each became whollyowned subsidiaries of WestRock. RockTenn was the accounting acquirer in the Combination. On May 15, 2016, WestRock completed the Separation, pursuant to which we disposed of our former Specialty Chemicals segment in its entirety and ceased to consolidate its assets, liabilities and results of operations in our consolidated financial statements. Accordingly, we have presented the financial position and results of operations of our former Specialty Chemicals segment as discontinued operations in the accompanying consolidated financial statements for all periods presented. See “Note 7. Discontinued Operations” of the Notes to Consolidated Financial Statements for additional information. On April 6, 2017, we completed the HH&B Sale. We used the proceeds from the HH&B Sale in connection with the of MPS Acquisition. We recorded a pretax gain on sale of HH&B of $192.8 million in fiscal 2017. See “Note 1. Description of Business and Summary of Significant Accounting Policies Description of Business” of the Notes to Consolidated Financial Statements for additional information. On June 6, 2017, we completed the MPS Acquisition. MPS is reported in our Consumer Packaging segment. See “Note 2. Mergers, Acquisitions and Investment” of the Notes to Consolidated Financial Statements for additional information. On November 2, 2018, pursuant to the Merger Agreement, the Company acquired all of the outstanding shares of KapStone through the Mergers. As a result of the Mergers, among other things, the Company became the ultimate parent of WRKCo, KapStone and their respective subsidiaries. Effective as of the the Effective Time, the Company changed its name to “WestRock Company” and WRKCo changed its name to “WRKCo Inc.”. See “Note 23. Subsequent Events (Unaudited)” of the Notes to Consolidated Financial Statements for additional information. Presentation We report our financial results of operations in the following three reportable segments: Corrugated Packaging, which consists of our containerboard mill and corrugated packaging operations, as well as our recycling operations; Consumer Packaging, which consists of consumer mills, folding carton, beverage, merchandising displays and partition operations; and Land and Development, which sells real estate, primarily in the Charleston, SC region. Following the Combination and until the completion of the Separation, our financial results of operations had a fourth reportable segment, Specialty Chemicals. Prior to the HH&B Sale, our Consumer Packaging segment included HH&B. In fiscal 2019, we plan to operate our recycling operations primarily as a procurement function, shifting its focus to the procurement of low cost, high quality fiber for our mill system. As a result, we will no longer record recycling sales. Acquisitions and Investments We completed a number of acquisitions in the last three years that expanded our product and geographic scope or allowed us to increase our integration levels, and we expect to continue to evaluate similar potential acquisitions in the future. Below we summarize certain of these acquisitions and investments. On September 4, 2018, we completed the Schlüter [/INST] Positive. </s>

WestRock Co

2019-11-18

2019-09-30

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview We are a multinational provider of paper and packaging solutions for consumer and corrugated packaging markets. We partner with our customers to provide differentiated paper and packaging solutions that help them win in the marketplace. Our team members support customers around the world from our operating and business locations in North America, South America, Europe, Asia and Australia. Organization WestRock was formed on March 6, 2015 for the purpose of effecting the Combination and, prior to the Combination, did not conduct any activities other than those incidental to its formation and the matters contemplated by the Business Combination Agreement. On July 1, 2015, pursuant to the Business Combination Agreement, RockTenn and MWV completed a strategic combination of their respective businesses and RockTenn and MWV each became wholly-owned subsidiaries of WestRock. RockTenn was the accounting acquirer in the Combination. On April 6, 2017, we completed the HH&B Sale. We used the proceeds from the HH&B Sale in connection with the MPS Acquisition. We recorded a pre-tax gain on sale of HH&B of $192.8 million in fiscal 2017. See “Note 1. Description of Business and Summary of Significant Accounting Policies - Description of Business” of the Notes to Consolidated Financial Statements for additional information. On June 6, 2017, we completed the MPS Acquisition. MPS is reported in our Consumer Packaging segment. On November 2, 2018, we completed the KapStone Acquisition. As a result, among other things, the Company became the ultimate parent of WRKCo, KapStone and their respective subsidiaries, and the Company changed its name to “WestRock Company” and WRKCo changed its name to “WRKCo Inc.”. See “Note 3. Acquisitions and Investment” of the Notes to Consolidated Financial Statements for additional information. Presentation Effective in the first quarter of fiscal 2019, we aligned our financial results for all periods presented to move our merchandising displays operations from our Consumer Packaging segment to our Corrugated Packaging segment and to allocate certain previously non-allocated costs and certain pension and other postretirement non-service income (expense) to our reportable segments. Separately, in the first quarter of fiscal 2019, we began conducting our recycling operations primarily as a procurement function. Since then, recycling net sales have not been recorded and the margin from these operations has reduced cost of goods sold. Following the realignment, we report our financial results of operations in the following three reportable segments: Corrugated Packaging, which consists of our containerboard mills, corrugated packaging and distribution operations, as well as our merchandising displays and recycling procurement operations; Consumer Packaging, which consists of our consumer mills, food and beverage and partition operations; and Land and Development, which sells real estate, primarily in the Charleston, SC region. Prior to the HH&B Sale, our Consumer Packaging segment included HH&B. A detailed discussion of the fiscal 2019 year-over-year changes can be found below and a detailed discussion of fiscal 2018 year-over-year changes can be found in “Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Exhibit 99.1 of our Current Report on Form 8-K filed with the Securities and Exchange Commission on May 9, 2019 (the “May 9, 2019 Form 8-K”), which was, as disclosed therein, filed to provide revisions to the Company’s consolidated financial statements, and the notes thereto for the three years ended September 30, 2018 and other related disclosures. Acquisitions and Investments During fiscal 2019 and 2018, we completed acquisitions that expanded our product and geographic scope, allowed us to increase our integration levels and impacted our comparative financials. We expect to continue to evaluate similar potential acquisitions in the future, although the size of individual acquisitions may vary. Below we summarize certain of these acquisitions. On November 2, 2018, we completed the KapStone Acquisition. KapStone is a leading North American producer and distributor of containerboard, corrugated products and specialty papers, including liner and medium containerboard, kraft papers and saturating kraft. KapStone also owns Victory Packaging, a packaging solutions distribution company with facilities in the U.S., Canada and Mexico. We have included the financial results of KapStone in our Corrugated Packaging segment since the date of the acquisition. On September 4, 2018, we completed the acquisition (the “Schlüter Acquisition”) of Schlüter Print Pharma Packaging (“Schlüter”). Schlüter is a leading provider of differentiated paper and packaging solutions and a German-based supplier of a full range of leaflets and booklets. The Schlüter Acquisition allowed us to further enhance our pharmaceutical and automotive platform and expand our geographical footprint in Europe to better serve our customers. We have included the financial results of the acquired operations in our Consumer Packaging segment since the date of the acquisition. On January 5, 2018, we completed the acquisition (the “Plymouth Packaging Acquisition”) of substantially all of the assets of Plymouth Packaging, Inc. (“Plymouth”). The assets we acquired included Plymouth’s “Box on Demand” systems, which are manufactured by Panotec, an Italian manufacturer of packaging machines. The addition of the Box on Demand systems enhanced our platform, differentiation and innovation. These systems, which are located on customers’ sites under multi-year exclusive agreements, use fanfold corrugated to produce custom, on-demand corrugated packaging that is accurately sized for any product type according to the customer’s specifications. Fanfold corrugated is continuous corrugated board, folded periodically to form an accordion-like stack of corrugated material. As part of the transaction, WestRock acquired Plymouth’s equity interest in Panotec and Plymouth’s exclusive right from Panotec to distribute Panotec’s equipment in the U.S. and Canada. We have fully integrated the approximately 60,000 tons of containerboard used by Plymouth annually. We have included the financial results of Plymouth in our Corrugated Packaging segment since the date of the acquisition. See “Note 3. Acquisitions and Investment” of the Notes to Consolidated Financial Statements for additional information. See also Item 1A. “Risk Factors - We May Be Unsuccessful in Making and Integrating Mergers, Acquisitions and Investments, and Completing Divestitures”. Business In fiscal 2019, we continued to pursue our strategy of offering differentiated paper and packaging solutions that help our customers win. We successfully executed this strategy in fiscal 2019 in a rapidly changing cost and price environment. Net sales of $18,289.0 million for fiscal 2019 increased $2,003.9 million, or 12.3%, compared to fiscal 2018. The increase was primarily due to the KapStone Acquisition and higher selling price/mix in our Corrugated Packaging and Consumer Packaging segments. These increases were partially offset by the absence of recycling net sales in fiscal 2019 as a result of conducting the operations primarily as a procurement function beginning in the first quarter of fiscal 2019, lower volumes, unfavorable foreign currency impacts across our segments compared to the prior year and decreased Land and Development net sales. Segment income increased $82.6 million in fiscal 2019 compared to fiscal 2018, primarily due to increased Corrugated Packaging segment income that was partially offset by lower Consumer Packaging and Land and Development segment income. The impact of the contribution from the acquired KapStone operations, higher selling price/mix across our segments and productivity improvements was largely offset by lower volumes across our segments, economic downtime, cost inflation, increased maintenance and scheduled strategic outage expense (including projects at our Mahrt, AL and Covington, VA mills) and lower Land and Development segment income due to the wind-down of sales. With respect to segment income, we experienced higher levels of cost inflation in both our Corrugated Packaging and Consumer Packaging segments during fiscal 2019 as compared to fiscal 2018 that were partially offset by recovered fiber deflation. The primary inflationary items were virgin fiber, freight, energy and wage and other costs. We generated $2,310.2 million of net cash provided by operating activities in fiscal 2019, compared to $1,931.2 million in fiscal 2018. We remained committed to our disciplined capital allocation strategy during fiscal 2019 by investing $1,369.1 million in capital expenditures, deployed $3,374.2 million to strategic acquisitions (excluding the assumption of debt) while returning $467.9 million in dividends and $88.6 million to our stockholders in share repurchases. In the nine months following December 2018, the quarter that included the KapStone Acquisition, we reduced total debt $757.4 million. We believe our strong balance sheet and cash flow provide us the flexibility to continue to invest to sustain and improve our operating performance. In fiscal 2020, we expect capital expenditures to be approximately $1.1 billion. See “Liquidity and Capital Resources” for more information. A detailed review of our fiscal 2019 and 2018 performance appears below under “Results of Operations (Consolidated)” and “Results of Operations - Segment Data”. For fiscal 2020, we expect to generate net sales of between $18.0 billion and $18.5 billion. Our expectations reflect the anticipated impact of the flow through of previously published price declines in North America containerboard and kraft paper index pricing, as well as the full year impact of market pricing declines that we have experienced in export containerboard and kraft paper, and market pulp. We expect that these declines will be partially offset by the impact of an additional month of KapStone sales and growth in our corrugated box volumes in North America and Brazil, as well as increased volumes in our Consumer Packaging segment. We expect our earnings in fiscal 2020 to be impacted by the pricing declines noted above, as well as cost inflation related to wages, benefits and other non-commodity categories. We expect to experience commodity cost deflation, particularly related to recycled fiber. Similar to past years, we expect that slightly more of our earnings will be generated in the second half of the fiscal year than in the first half of the fiscal year due to seasonality, the timing of scheduled mill maintenance outages and our strategic capital projects. In fiscal 2019, we announced plans to reconfigure our North Charleston, SC mill. The project, which we expect to begin in the second quarter of fiscal 2020, is expected to reduce our linerboard capacity by approximately 288,000 tons and our annual costs by approximately $40 million, including a workforce reduction over a five-month period. We expect to invest approximately $1.1 billion in capital expenditures in fiscal 2020, including approximately $275 million for our strategic capital projects at our Florence, SC and Tres Barras, Brazil mills. We expect to start up the project at our Florence, SC mill in the spring of 2020 and to incur maintenance downtime during the first quarter of fiscal 2020 in connection with this project. Results of Operations (Consolidated) The following table summarizes our consolidated results for the two years ended September 30, 2019: Non-GAAP Financial Measures We report our financial results in accordance with generally accepted accounting principles in the U.S. (“GAAP”). However, we have included financial measures that were not prepared in accordance with GAAP. Non-GAAP financial measures should be viewed in addition to, and not as an alternative for, our GAAP results. The non-GAAP financial measures we present may differ from similarly captioned measures of other companies. We use the non-GAAP financial measures “Adjusted Net Income” and “Adjusted Earnings Per Diluted Share”. Management believes these non-GAAP financial measures provide our board of directors, investors, potential investors, securities analysts and others with useful information to evaluate our performance because the measures exclude restructuring and other costs and other specific items that management believes are not indicative of the ongoing operating results of the business. We and our board of directors use this information to evaluate our performance relative to other periods. We believe that the most directly comparable GAAP measures to Adjusted Net Income and Adjusted Earnings Per Diluted Share are Net income attributable to common stockholders and Earnings per diluted share, respectively. Diluted earnings per share were $3.33 in fiscal 2019 compared to $7.34 in fiscal 2018. Adjusted Earnings Per Diluted Share were $3.98 and $4.09 in fiscal 2019 and 2018, respectively. Set forth below is a reconciliation of the non-GAAP financial measure Adjusted Earnings Per Diluted Share to Earnings per diluted share, the most directly comparable GAAP measure (in dollars per share) for the periods indicated. (1) Includes a $13.0 million and $23.6 million impairment of mineral rights in fiscal 2019 and 2018, respectively. The GAAP results in the tables below for Pre-Tax, Tax and Net of Tax are equivalent to the line items “Income before income taxes”, “Income tax (expense) benefit” and “Consolidated net income”, respectively, as reported on the statements of income. Set forth below are reconciliations of Adjusted Net Income to the most directly comparable GAAP measure, Net income attributable to common stockholders (represented in the table below as the GAAP Results for Consolidated net income (i.e. Net of Tax) plus Noncontrolling interests), for the periods indicated (in millions): (1) Includes a $13.0 million impairment of mineral rights in fiscal 2019. (1) Includes a $23.6 million impairment of mineral rights in fiscal 2018. We discuss certain of these charges in more detail in “Note 4. Restructuring and Other Costs”, “Note 5. Retirement Plans”, and “Note 6. Income Taxes”. Net Sales (Unaffiliated Customers) Net sales in fiscal 2019 increased $2,003.9 million, or 12.3%, compared to fiscal 2018. The increase was primarily attributable to the KapStone Acquisition and higher selling price/mix in our Corrugated Packaging and Consumer Packaging segments. These increases were partially offset by the absence of recycling net sales in fiscal 2019 as a result of conducting the operations primarily as a procurement function beginning in the first quarter of fiscal 2019, lower volumes and unfavorable foreign currency impacts across our segments compared to the prior year. The change in net sales by segment is outlined below in “Results of Operations - Segment Data”. Cost of Goods Sold Cost of goods sold increased to $14,540.0 million in fiscal 2019 compared to $12,923.1 million in fiscal 2018. Cost of goods sold as a percentage of net sales was 79.5% in fiscal 2019 compared to 79.4% in fiscal 2018. The increase in cost of goods sold in fiscal 2019 compared to fiscal 2018 was primarily due to increased net sales associated with the impact of acquisitions (primarily the KapStone Acquisition), higher levels of cost inflation and other items. These factors were partially offset by lower recovered fiber costs and productivity improvements. We discuss these items in greater detail below. In fiscal 2019, we received $180.0 million of insurance proceeds related to Hurricane Michael, primarily associated with our Panama City, FL mill that were recorded as a reduction of cost of goods sold. See “Hurricane Michael” below for additional information. We discuss these items in greater detail below in “Results of Operations - Segment Data”. Selling, General and Administrative Excluding Intangible Amortization Selling, general, and administrative expenses (“SG&A”) excluding intangible amortization increased $168.6 million to $1,715.2 million in fiscal 2019 compared to fiscal 2018 primarily due to the KapStone Acquisition. SG&A excluding intangible amortization as a percentage of net sales declined in fiscal 2019 to 9.4% from 9.5% in fiscal 2018. Selling, General and Administrative Intangible Amortization SG&A intangible amortization was $400.2 million and $296.6 million in fiscal 2019 and 2018, respectively. The increase in fiscal 2019 compared to fiscal 2018 was primarily due to the KapStone Acquisition. (Gain) Loss on Disposal of Assets The gain on disposal of assets in fiscal 2019 was $41.2 million and the loss on disposal of assets in fiscal 2018 was $10.1 million. The gain on disposal of assets in fiscal 2019 was primarily due to the $48.5 million gain on sale of our former Atlanta beverage facility recorded in the first quarter of fiscal 2019. Multiemployer Pension Withdrawal (Income) Expense In the fiscal 2019, we recorded a $6.3 million reduction to a previously recorded MEPP withdrawal liabilities. In fiscal 2018, we submitted formal notification to withdraw from PIUMPF and Central States and recorded aggregate estimated withdrawal liabilities of $184.2 million, which includes an estimate of our portion of PIUMPF’s accumulated funding deficiency. Since these withdrawal liabilities assume payment over 20 years, the liabilities were discounted at a credit adjusted risk-free rate and, therefore, we will accrete the liability over time with a charge to interest expense. See “Note 5. Retirement Plans - Multiemployer Plans” of the Notes to Consolidated Financial Statements for additional information, including the receipt of demand letters from PIUMPF. See also Item 1A. “Risk Factors - We May Incur Withdrawal Liability and/or Increased Funding Requirements in Connection with MEPPs”. Land and Development Impairments In fiscal 2019, we recorded $13.0 million of pre-tax non-cash impairments of certain mineral rights following the termination of a third party leasing relationship. In fiscal 2018, we recorded $31.9 million of pre-tax non-cash impairments of certain mineral rights and real estate. The $23.6 million impairment of mineral rights in fiscal 2018 was driven by the non-renewal of a lease and associated with declining oil and gas prices, and the other $8.3 million was recorded to write-down the carrying value of certain real estate projects where the projected sales proceeds were less than the carrying value. These charges are not reflected in segment income. Restructuring and Other Costs We recorded aggregate pre-tax restructuring and other costs of $173.7 million and $105.4 million for fiscal 2019 and 2018, respectively. We generally expect the integration of a closed facility’s assets and production with other facilities to enable the receiving facilities to better leverage their fixed costs while eliminating fixed costs from the closed facility. Costs recorded in each period are not comparable since the timing and scope of the individual actions associated with each restructuring, acquisition, divestiture or integration vary. See “Note 4. Restructuring and Other Costs” of the Notes to Consolidated Financial Statements for additional information, including a description of the type of costs incurred. We have restructured portions of our operations from time to time and it is likely that we will engage in additional restructuring opportunities in the future. See also Item 1A. “Risk Factors - We May Incur Additional Restructuring Costs and May Not Realize Expected Benefits from Restructuring”. Interest Expense, net Interest expense, net was $431.3 million and $293.8 million for fiscal 2019 and 2018, respectively. Interest expense, net in fiscal 2019 increased primarily due to debt incurred as a result of the KapStone Acquisition and higher interest rates. Interest expense, net in fiscal 2019 and 2018 was reduced by $27.8 million and $31.0 million, respectively, related to the amortization of the fair value of debt stepped-up in purchase accounting. See Item 1A. “Risk Factors - The Level of Our Indebtedness Could Adversely Affect Our Financial Condition and Impair Our Ability to Operate Our Business”. Pension and Other Postretirement Non-Service Income Pension and other postretirement non-service income was $74.2 million and $95.3 million in fiscal 2019 and 2018, respectively. Subsequent to the adoption of ASU 2017-07 (as hereinafter defined) we began presenting the non-service components of our pension and other postretirement income (expense) separately from the service cost components and outside the subtotal of operating profit. The decrease in fiscal 2019 was primarily due to the decline in plan asset balances used to determine the expected return on plan assets. Other Income, net Other income, net was $2.4 million and $12.7 million in fiscal 2019 and 2018, respectively. Other income, net in fiscal 2018 included a $12.3 million gain on the sale of our solid waste management brokerage services business. Provision for Income Taxes We recorded income tax expense of $276.8 million for fiscal 2019 at an effective tax rate of 24.2% compared to an income tax benefit of $874.5 million at an effective tax rate benefit of 84.5% in fiscal 2018, including a $1,128.8 million provisional benefit from the Tax Act. The effective tax rate for fiscal 2019 was higher than the statutory federal rate primarily due to (i) the inclusion of state taxes, (ii) income derived from certain foreign jurisdictions subject to higher tax rates, (iii) the exclusion of tax benefits related to losses recorded by certain foreign operations, (iv) the limitation of certain transaction costs and (v) the increase of deferred tax liabilities in certain state jurisdictions, partially offset by (vi) the inclusion of tax benefits related to share-based compensation and state tax law changes, (vii) research and development tax credits and (viii) an adjustment of the valuation allowance against net operating losses of foreign subsidiaries. The effective tax rate benefit for fiscal 2018 was lower than the statutory federal rate primarily due to (i) the provisional amounts related to the enactment of the Tax Act, (ii) favorable tax items, such as the domestic production deduction, tax benefit of share-based compensation and cash tax planning that resulted in reduced deferred tax liabilities (iii) the true up of certain deferred taxes and foreign tax returns, and (iv) a change in valuation allowance, partially offset by (v) the inclusion of state taxes and (vi) the exclusion of tax benefits related to losses recorded by certain foreign operations. See “Note 6. Income Taxes” of the Notes to Consolidated Financial Statements for additional information, including the impact of the Tax Act. Hurricane Michael In October 2018, our containerboard and pulp mill located in Panama City, FL sustained extensive damage from Hurricane Michael. We shut down the mill’s operations in advance of the hurricane’s landfall. Repair work was completed during June 2019 on the two paper machines and related infrastructure and these paper machines are now producing at normal production levels. Other repairs at the mill are continuing and all remaining repair work is expected to be completed during fiscal 2020 and 2021. While we are still identifying the full cost associated with the damage from Hurricane Michael, we anticipate the total of our property damage and business interruption claim will exceed $200 million. In fiscal 2019, we received $180.0 million of insurance proceeds (net of our $15 million deductible) that were recorded as a reduction of cost of goods sold in our Corrugated Packaging segment related primarily to the Panama City mill. The insurance proceeds consisted of $55.3 million for business interruption recoveries and $124.7 million for direct costs and property damage. Our consolidated statements of cash flow in fiscal 2019 included $154.5 million in net cash provided by operating activities and $25.5 million net cash used for investing activities. We expect to recover the majority of the additional amount of direct costs and lost production and sales in future periods through insurance reimbursements. Results of Operations - Segment Data Corrugated Packaging Segment North American Corrugated Packaging Shipments Corrugated Packaging Shipments are expressed as a tons equivalent, which includes external and intersegment tons shipped from our Corrugated Packaging mills plus Corrugated Packaging container shipments converted from billion square feet (“BSF”) to tons. We have presented the Corrugated Packaging Shipments in two groups: North American and Brazil / India because we believe investors, potential investors, securities analysts and others find this breakout useful when evaluating our operating performance. We have included the impact of the KapStone Acquisition beginning in the first quarter of fiscal 2019. The shipment data table excludes merchandising displays since there is not a common unit of measure. The table below reflects shipments in thousands of tons, BSF and millions of square feet (“MMSF”). Brazil / India Corrugated Packaging Shipments Corrugated Packaging Segment (1) Net Sales before intersegment eliminations Net Sales (Aggregate) - Corrugated Packaging Segment Net sales before intersegment elimination for the Corrugated Packaging segment increased $2,123.7 million in the fiscal 2019 compared to fiscal 2018. The increase in net sales was primarily due to $2,851.5 million from acquisitions, notably the KapStone Acquisition, and $203.5 million from higher corrugated selling price/mix as we had higher selling prices for domestic containerboard and corrugated containers that were partially offset by declining export prices. These increases were partially offset by the absence of $461.6 million of recycling net sales in fiscal 2019 as a result of conducting the operations primarily as a procurement function beginning in the first quarter of fiscal 2019, $417.7 million of lower volumes as lower containerboard volumes were partially offset by increased corrugated container shipments and $65.4 million related to the impact of unfavorable foreign currency. Segment Income - Corrugated Packaging Segment Segment income attributable to the Corrugated Packaging segment in fiscal 2019 increased $159.6 million compared to fiscal 2018, primarily due to a $231.0 million of contribution from the acquired KapStone operations before an estimated $23.1 million of economic downtime and net of a $24.7 million acquisition inventory step-up charge, an estimated $122.8 million of productivity improvements and $118.8 million of higher corrugated selling price/mix. These increases were partially offset by $126.5 million of lower volumes, unfavorable cost inflation of $90.9 million, an estimated $66.4 million of economic downtime (including KapStone), $12.4 million of unfavorable foreign currency impacts, and other costs. The net impact of cost inflation was unfavorable compared to the prior year as lower recovered fiber costs were more than offset by higher wage and other costs, virgin fiber costs, freight costs, energy costs and chemical costs. In fiscal 2019, Corrugated Packaging segment income included $11.3 million for a receivable established for the recovery of indirect taxes in Brazil. See “Note 18. Commitments and Contingencies - Indirect Tax Claim” of the Notes to Consolidated Financial Statements for additional information. Fiscal 2018 results were negatively affected by an estimated $20.7 million due to the impact of winter weather and $19.0 million of start-up issues following a major maintenance outage at our Panama City, FL and Tacoma, WA mills. Fiscal 2019 results included an estimated $7.7 million and $5.9 million of expense due to the impact of Hurricane Dorian and start-up issues following a major maintenance outage, respectively. The full year impact of Hurricane Michael, net of recoveries on Corrugated Packaging segment income was not significant. Consumer Packaging Segment Consumer Packaging Shipments Consumer Packaging Shipments are expressed as a tons equivalent, which includes external and intersegment tons shipped from our Consumer Packaging mills plus Consumer Packaging converting shipments converted from BSF to tons. The fiscal 2018 shipment numbers below have been revised by an immaterial amount. The shipment data table excludes gypsum paperboard liner tons produced by Seven Hills since it is not consolidated. Consumer Packaging Segment (1) Net Sales before intersegment eliminations Net Sales (Aggregate) - Consumer Packaging Segment Net sales before intersegment eliminations for the Consumer Packaging segment decreased $11.5 million in fiscal 2019 compared to the prior year primarily due to $128.3 million of higher selling price/mix and $32.0 million from acquisitions, which were more than offset by $88.0 million of unfavorable foreign currency impacts and $83.7 million of lower volumes. Lower volumes were primarily driven by a decline in mill volumes that were partially offset by a 3.7% increase in North American food and beverage tons shipped. Segment Income - Consumer Packaging Segment Segment income attributable to the Consumer Packaging segment in fiscal 2019 decreased $57.0 million compared to the prior year. Segment income in the period was reduced by an estimated $112.5 million due to the net impact of cost inflation compared to the prior year, an estimated $35.1 million of increased maintenance and scheduled strategic outage expense (including the projects at the Mahrt, AL and Covington, VA mills), $44.5 million due to the impact of lower volumes, $14.5 million of unfavorable foreign currency impacts, $5.6 million of higher depreciation and amortization, and other items. These items were partially offset by an estimated $107.9 million of higher selling price/mix and an estimated $84.9 million of productivity improvements. While the net impact of cost inflation was unfavorable compared to the prior year, recovered fiber costs and chemical costs were lower than the prior year but were more than offset by higher virgin fiber costs, freight costs and wage and other costs. Fiscal 2018 results were negatively affected by an estimated $17.2 million due to the impact of winter weather that was more than offset by $20.1 million of favorable acquisition reserve adjustments. Land and Development Segment (1) Net sales before intersegment eliminations Net Sales (Aggregate) - Land and Development Segment Net sales for the Land and Development segment in fiscal 2019 and 2018 were $23.4 million and $142.4 million, respectively. The decrease in fiscal 2019 was due to the wind-down of sales. We include the remainder of the real estate holdings in assets held for sale because we have met the held for sale criteria. Segment Income (Loss) - Land and Development Segment Segment income attributable to the Land and Development segment was $2.5 million and $22.5 million in fiscal 2019 and 2018, respectively. The pre-tax non-cash impairments of certain mineral rights and real estate discussed above under the caption “Land and Development Impairments” are not included in segment income. Liquidity and Capital Resources We fund our working capital requirements, capital expenditures, mergers, acquisitions and investments, restructuring activities, dividends and stock repurchases from net cash provided by operating activities, borrowings under our credit facilities, proceeds from our A/R Sales Agreement (as hereinafter defined), proceeds from the sale of property, plant and equipment removed from service and proceeds received in connection with the issuance of debt and equity securities. See “Note 13. Debt” of the Notes to Consolidated Financial Statements for additional information. Funding for our domestic operations in the foreseeable future is expected to come from sources of liquidity within our domestic operations, including cash and cash equivalents, and available borrowings under our credit facilities. As such, our foreign cash and cash equivalents are not expected to be a key source of liquidity to our domestic operations. At September 30, 2019, we had approximately $2.9 billion of availability under our committed credit facilities, primarily under our revolving credit facility, the majority of which matures on July 1, 2022. This liquidity may be used to provide for ongoing working capital needs and for other general corporate purposes, including acquisitions, dividends and stock repurchases. Certain restrictive covenants govern our maximum availability under the credit facilities. We test and report our compliance with these covenants as required and we were in compliance with all of these covenants at September 30, 2019. At September 30, 2019, we had $129.8 million of outstanding letters of credit not drawn upon. Cash and cash equivalents were $151.6 million at September 30, 2019 and $636.8 million at September 30, 2018. We used a significant portion of the cash and cash equivalents on hand at September 30, 2018 in connection with the closing of the KapStone Acquisition. Primarily all of the cash and cash equivalents at September 30, 2019 were held outside of the U.S. At September 30, 2019, total debt was $10,063.4 million, $561.1 million of which was current. At September 30, 2018, total debt was $6,415.2 million, $740.7 million of which was current. The increase in debt was primarily related to the KapStone Acquisition. Cash Flow Activity Net cash provided by operating activities during fiscal 2019 increased $379.0 million from fiscal 2018 primarily due to higher cash earnings and a $340.3 million net decrease in the use of working capital compared to the prior year. As a result of the retrospective adoption of ASU 2016-15 and ASU 2016-18 (each as hereinafter defined) as discussed in “Note 1. Description of Business and Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements, net cash provided by operating activities for fiscal 2018 was reduced by $489.7 million and cash provided by investing activities increased $483.8 million, primarily for the change in classification of proceeds received for beneficial interests obtained for transferring trade receivables in securitization transactions. Net cash used for investing activities of $4,579.6 million in fiscal 2019 consisted primarily of $3,374.2 million for cash paid for the purchase of businesses, net of cash acquired (excluding the assumption of debt), primarily related to the KapStone Acquisition, and $1,369.1 million for capital expenditures that were partially offset by $119.1 million of proceeds from the sale of property, plant and equipment primarily related to the sale of our Atlanta beverage facility, $33.2 million of proceeds from corporate owned life insurance benefits and $25.5 million of proceeds from property, plant and equipment insurance proceeds related to the Panama City, FL mill. Net cash used for investing activities of $815.1 million in fiscal 2018 consisted primarily of $999.9 million for capital expenditures, $239.9 million for cash paid for the purchase of businesses, net of cash acquired primarily related to the Plymouth Acquisition and the Schlüter Acquisition, and $108.0 million for an investment in Grupo Gondi. These investments were partially offset by $461.6 million of cash receipts on sold trade receivables as a result of the adoption of ASU 2016-15, $24.0 million of proceeds from the sale of certain affiliates as well as our solid waste management brokerage services business and $23.3 million of proceeds from the sale of property, plant and equipment. In fiscal 2019, net cash provided by financing activities of $1,780.2 million consisted primarily of a net increase in debt of $2,314.6 million, primarily related to the KapStone Acquisition and partially offset by cash dividends paid to stockholders of $467.9 million and purchases of Common Stock of $88.6 million. In fiscal 2018, net cash used for financing activities of $755.1 million consisted primarily of cash dividends paid to stockholders of $440.9 million and purchases of Common Stock of $195.1 million and net repayments of debt of $120.1 million. Our capital expenditures aggregated $1,369.1 million in fiscal 2019. We expect fiscal 2020 capital expenditures to be approximately $1.1 billion, including approximately $275 million for our strategic capital projects at our Florence, SC and Tres Barras, Brazil mills. We expect to start up the project at our Florence mill in the spring of 2020 and the Tres Barras project in the first half of calendar 2021. With the completion of certain of our strategic capital projects in fiscal 2019 and 2020, we expect to transition to our long-range capital expenditure run rate of approximately $900 million to $1.0 billion a year in fiscal 2021. We generally expect our base capital expenditures to be roughly half invested in maintenance and half invested in high return generating projects. However, it is possible that our capital expenditure assumptions may change, project completion dates may change, or we may decide to invest a different amount depending upon opportunities we identify, or changes in market conditions, or to comply with environmental or other regulatory changes. We estimate that we will invest approximately $15 million for capital expenditures during fiscal 2020 in connection with matters relating to environmental compliance. We were obligated to purchase approximately $623 million of fixed assets at September 30, 2019 for various capital projects. See Item 1A. “Risk Factors - Our Capital Expenditures May Not Achieve the Desired Outcomes or May Be Achieved at a Higher Cost than Anticipated”. At September 30, 2019, the U.S. federal, state and foreign net operating losses and state tax credits available to us aggregated approximately $83 million in future potential reductions of U.S. federal, state and foreign cash taxes. Based on our current projections, we expect to utilize the remaining U.S. federal net operating losses over the next two years. Foreign and state net operating losses and credits will be used over a longer period of time. It is possible that our utilization of these net operating losses and credits may change due to changes in taxable income, tax laws or tax rates, capital expenditures or other factors. Including the estimated impact of book and tax differences, subject to changes in tax laws, we expect our cash tax rate to move closer to our income tax rate in fiscal 2020, 2021 and 2022. During fiscal 2019 and 2018, we made contributions of $25.0 million and $37.7 million, respectively, to our U.S. and non-U.S. pension plans. Based on current facts and assumptions, we expect to contribute approximately $27 million to our U.S. and non-U.S. pension plans in fiscal 2020. We have made contributions and expect to continue to make contributions in the coming years to our pension plans in order to ensure that our funding levels remain adequate in light of projected liabilities and to meet the requirements of the Pension Act and other regulations. The net underfunded status of our U.S. and non-U.S. pension plans at September 30, 2019 was $85.8 million. Based on current assumptions, including future interest rates, we estimate that minimum pension contributions to our U.S. and non-U.S. pension plans will be in the range of approximately $24 million to $28 million annually in fiscal 2021 through 2024. See “Note 5. Retirement Plans” of the Notes to Consolidated Financial Statements. See also Item 1A. “Risk Factors -Our Pension Plans Will Likely Require Additional Cash Contributions”. In the normal course of business, we evaluate our potential exposure to MEPPs, including with respect to potential withdrawal liabilities. In fiscal 2018, we submitted formal notification to withdraw from two plans and recorded an aggregate estimated withdrawal liability of $184.2 million, nearly all of which was for PIUMPF. In September 2019, we received a demand from PIUMPF asserting that we owe $170.3 million on an undiscounted basis (approximately $0.7 million per month for the next 20 years) with respect to our withdrawal liability. The demand did not address any assertion of liability for PIUMPF’s accumulated funding deficiency. In October 2019, we received two additional demand letters from PIUMPF related to a subsidiary asserting that we owe $2.3 million on an undiscounted basis to be paid over 20 years with respect to the subsidiary’s withdrawal liability and $2.0 million for its accumulated funding deficiency. We are evaluating each of these demands. We expect to challenge the accumulated funding deficiency. We expect to begin making monthly payments for these withdrawal liabilities in fiscal 2020. See “Note 5. Retirement Plans - Multiemployer Plans” of the Notes to Consolidated Financial Statements for additional information. See also Item 1A. “Risk Factors - We May Incur Withdrawal Liability and/or Increased Funding Requirements in Connection with MEPPs”. In November 2019, our board of directors declared a quarterly dividend of $0.465 per share, representing a 2.2% increase from the prior $0.455 per share quarterly dividend and an annual dividend of $1.86 per share. During fiscal 2019 and 2018, we paid an annual dividend of $1.82 per share and $1.72 per share, respectively. In July 2015, our board of directors authorized a repurchase program of up to 40.0 million shares of our Common Stock, representing approximately 15% of our outstanding Common Stock as of July 1, 2015. Shares of our Common Stock may be purchased from time to time in open market or privately negotiated transactions. The timing, manner, price and amount of repurchases will be determined by management at its discretion based on factors, including the market price of our Common Stock, general economic and market conditions and applicable legal requirements. The repurchase program may be commenced, suspended or discontinued at any time. In fiscal 2019, we repurchased approximately 2.1 million shares of our Common Stock for an aggregate cost of $88.6 million. In fiscal 2018, we repurchased approximately 3.4 million shares of our Common Stock for an aggregate cost of $195.1 million. As of September 30, 2019, we had approximately 19.1 million shares of Common Stock available for repurchase under the program. We anticipate that we will be able to fund our capital expenditures, interest payments, dividends and stock repurchases, pension payments, working capital needs, note repurchases, restructuring activities, repayments of current portion of long-term debt and other corporate actions for the foreseeable future from cash generated from operations, borrowings under our credit facilities, proceeds from our A/R Sales Agreement, proceeds from the issuance of debt or equity securities or other additional long-term debt financing, including new or amended facilities. In addition, we continually review our capital structure and conditions in the private and public debt markets in order to optimize our mix of indebtedness. In connection with these reviews, we may seek to refinance existing indebtedness to extend maturities, reduce borrowing costs or otherwise improve the terms and composition of our indebtedness. Contractual Obligations We summarize our enforceable and legally binding contractual obligations at September 30, 2019, and the effect these obligations are expected to have on our liquidity and cash flow in future periods in the following table. Certain amounts in this table are based on management’s estimates and assumptions about these obligations, including their duration, the possibility of renewal, anticipated actions by third parties and other factors, including estimated minimum pension plan contributions and estimated benefit payments related to postretirement obligations, supplemental retirement plans and deferred compensation plans. Because these estimates and assumptions are subjective, the enforceable and legally binding obligations we actually pay in future periods may vary from those presented in the table. (1) Includes only principal payments owed on our debt assuming that all of our long-term debt will be held to maturity, excluding scheduled payments. We have excluded $163.5 million of fair value of debt step-up, deferred financing costs and unamortized bond discounts from the table to arrive at actual debt obligations. See “Note 13. Debt” of the Notes to Consolidated Financial Statements for information on the interest rates that apply to our various debt instruments. (2) See “Note 15. Operating Leases” of the Notes to Consolidated Financial Statements for additional information. (3) The fair value step-up of $16.9 million is excluded. See “Note 13. Debt - Capital Lease and Other Indebtedness” of the Notes to Consolidated Financial Statements for additional information. (4) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provision; and the approximate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. (5) We have included in the table future estimated minimum pension plan contributions and estimated benefit payments related to postretirement obligations, supplemental retirement plans and deferred compensation plans. Our estimates are based on factors, such as discount rates and expected returns on plan assets. Future contributions are subject to changes in our underfunded status based on factors such as investment performance, discount rates, returns on plan assets and changes in legislation. It is possible that our assumptions may change, actual market performance may vary or we may decide to contribute different amounts. We have excluded $237.2 million of multiemployer pension plan withdrawal liabilities recorded as of September 30, 2019, including our estimate of the accumulated funding deficiency, due to lack of definite payout terms for certain of the obligations. See “Note 5. Retirement Plans - Multiemployer Plans” of the Notes to Consolidated Financial Statements for additional information. (6) We have not included the following items in the table: • An item labeled “other long-term liabilities” reflected on our consolidated balance sheet because these liabilities do not have a definite pay-out scheme. • $284.7 million for certain provisions of the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) 740, “Income Taxes” associated with liabilities for uncertain tax positions due to the uncertainty as to the amount and timing of payment, if any. In addition to the enforceable and legally binding obligations presented in the table above, we have other obligations for goods and services and raw materials entered into in the normal course of business. These contracts, however, are subject to change based on our business decisions. Expenditures for Environmental Compliance See Item 1. “Business - Governmental Regulation - Environmental and Other Matters”, “Business - Governmental Regulation - CERCLA and Other Remediation Costs”, and “Business - Governmental Regulation - Climate Change” for a discussion of our expenditures for environmental compliance. Critical Accounting Policies and Estimates We have prepared our accompanying consolidated financial statements in conformity with GAAP, which requires management to make estimates that affect the amounts of revenues, expenses, assets and liabilities reported. Certain significant accounting policies are described in “Note 1. Description of Business and Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements. See also

<s>[INST] Overview We are a multinational provider of paper and packaging solutions for consumer and corrugated packaging markets. We partner with our customers to provide differentiated paper and packaging solutions that help them win in the marketplace. Our team members support customers around the world from our operating and business locations in North America, South America, Europe, Asia and Australia. Organization WestRock was formed on March 6, 2015 for the purpose of effecting the Combination and, prior to the Combination, did not conduct any activities other than those incidental to its formation and the matters contemplated by the Business Combination Agreement. On July 1, 2015, pursuant to the Business Combination Agreement, RockTenn and MWV completed a strategic combination of their respective businesses and RockTenn and MWV each became whollyowned subsidiaries of WestRock. RockTenn was the accounting acquirer in the Combination. On April 6, 2017, we completed the HH&B Sale. We used the proceeds from the HH&B Sale in connection with the MPS Acquisition. We recorded a pretax gain on sale of HH&B of $192.8 million in fiscal 2017. See “Note 1. Description of Business and Summary of Significant Accounting Policies Description of Business” of the Notes to Consolidated Financial Statements for additional information. On June 6, 2017, we completed the MPS Acquisition. MPS is reported in our Consumer Packaging segment. On November 2, 2018, we completed the KapStone Acquisition. As a result, among other things, the Company became the ultimate parent of WRKCo, KapStone and their respective subsidiaries, and the Company changed its name to “WestRock Company” and WRKCo changed its name to “WRKCo Inc.”. See “Note 3. Acquisitions and Investment” of the Notes to Consolidated Financial Statements for additional information. Presentation Effective in the first quarter of fiscal 2019, we aligned our financial results for all periods presented to move our merchandising displays operations from our Consumer Packaging segment to our Corrugated Packaging segment and to allocate certain previously nonallocated costs and certain pension and other postretirement nonservice income (expense) to our reportable segments. Separately, in the first quarter of fiscal 2019, we began conducting our recycling operations primarily as a procurement function. Since then, recycling net sales have not been recorded and the margin from these operations has reduced cost of goods sold. Following the realignment, we report our financial results of operations in the following three reportable segments: Corrugated Packaging, which consists of our containerboard mills, corrugated packaging and distribution operations, as well as our merchandising displays and recycling procurement operations; Consumer Packaging, which consists of our consumer mills, food and beverage and partition operations; and Land and Development, which sells real estate, primarily in the Charleston, SC region. Prior to the HH&B Sale, our Consumer Packaging segment included HH&B. A detailed discussion of the fiscal 2019 yearoveryear changes can be found below and a detailed discussion of fiscal 2018 yearoveryear changes can be found in “Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Exhibit 99.1 of our Current Report on Form 8K filed with the Securities and Exchange Commission on May 9, 2019 (the “May 9, 2019 Form 8K”), which was, as disclosed therein, filed to provide revisions to the Company’s consolidated financial statements, and the notes thereto for the three years ended September 30, 2018 and other related disclosures. Acquisitions and Investments During fiscal 2019 and 2018, we completed acquisitions that expanded our product and geographic scope, allowed us to increase our integration levels and impacted our comparative financials. We expect to continue to evaluate similar potential acquisitions in the future, although the size of individual acquisitions may vary. Below we summarize certain [/INST] Positive. </s>

Leo Holdings Corp.

2019-03-29

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS References to “we,” “us,” “our” or the “company” are to Leo Holdings Corp., except where the context requires otherwise. The following discussion should be read in conjunction with our condensed financial statements and related notes thereto included elsewhere in this report. Cautionary Note Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Overview We are a blank check company incorporated on November 29, 2017 as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or sector for purposes of consummating a Business Combination, we focus our search on companies in the consumer sector. We consummated our Initial Public Offering on February 15, 2018. If we are unable to complete a Business Combination within 24 months from the closing of the Initial Public Offering, or the Combination Period, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest earned on the funds held in the trust account and not previously released to us to pay its income taxes (less up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the company’s remaining shareholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. Results of Operations All activity during the year ended December 31, 2018 was in preparation for our Initial Public Offering, and since the closing of the offering, our activity has been limited to the search for a prospective initial business combination, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2018, we had net income of approximately $2.6 million, which consisted of approximately $3.1 million of interest income, offset by approximately $490,000 of general and administrative costs. For the period from November 29, 2017 (inception) to December 31, 2017, we had net loss of approximately $8,800, which consisted of $11 in interest income, offset by approximately $8,800 in general and administrative costs. Going Concern Consideration As indicated in the accompanying audited financial statements, at December 31, 2018, we had approximately $550,000 in our operating bank account, approximately $3.1 million of interest income available in the trust account to pay for taxes, and working capital of approximately $585,000. Through December 31, 2018, our liquidity needs have been satisfied through receipt of a $25,000 capital contribution from the sponsor in exchange for the issuance of the founder shares to the sponsor, $325,000 in loans from the sponsor, and the net proceeds from the consummation of the private placement not held in the trust account. In addition, in order to finance transaction costs in connection with a Business Combination, the sponsor or an affiliate of the sponsor, or certain of the company’s officers and directors may, but are not obligated to, loan the company funds as may be required (the “Working Capital Loans”) of up to $1.5 million. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account (less taxes payable and deferred underwriting commissions), to complete our initial Business Combination. We may withdraw interest income (if any) to pay our income taxes, if any. Our annual income tax obligations will depend on the amount of interest and other income earned on the amounts held in the trust account. We expect the interest income earned on the amount in the trust account (if any) will be sufficient to pay our income taxes. To the extent that our equity or debt is used, in whole or in part, as consideration to complete our initial Business Combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. In connection with the company’s assessment of going concern considerations in accordance with Financial Accounting Standard Board’s Accounting Standards Update 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” management has determined that the mandatory liquidation and subsequent dissolution raises substantial doubt about the company’s ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should the company be required to liquidate after February 15, 2020. Related Party Transactions Founder Shares On December 8, 2017, the sponsor purchased 8,625,000 shares of the company’s Class B ordinary shares, par value $0.0001, for an aggregate price of $25,000. In February 2018, the sponsor effected a surrender of 2,875,000 founder shares to us for no consideration, resulting in a decrease in the total number of founder shares from 8,625,000 to 5,750,000. The founder shares will automatically convert into Class A ordinary shares at the time of our initial Business Combination and are subject to certain transfer restrictions. The sponsor had agreed to forfeit up to 750,000 founder shares to the extent that the over-allotment option was not exercised in full by the underwriter. On March 29, 2018, the over-allotment option expired and an aggregate of 750,000 shares were subsequently forfeited by the sponsor. The sponsor and our officers and directors have agreed, subject to limited exceptions, not to transfer, assign or sell any of their founder shares until the earlier to occur of: (A) one year after the completion of the initial Business Combination or (B) subsequent to the initial Business Combination, (x) if the last sale price of the Class A ordinary shares equals or exceeds $12.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial Business Combination, or (y) the date on which the company completes a liquidation, merger, capital stock exchange or other similar transaction that results in all of the company’s shareholders having the right to exchange their ordinary shares for cash, securities or other property. Private Placement Warrants Concurrently with the closing of the Initial Public Offering, the sponsor purchased 4,000,000 private placement Warrants at $1.50 per private placement Warrant, generating gross proceeds of $6.0 million in the private placement. The sponsor had agreed that if the over-allotment option were exercised, the sponsor would have purchased an additional 400,000 private placement Warrants at a price of $1.50 per private placement Warrant. Each private placement Warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. A portion of the proceeds from the sale of the private placement Warrants were added to the proceeds from the Initial Public Offering and deposited in the trust account. If the company does not complete a Business Combination within the Combination Period, the private placement Warrants will expire worthless. The private placement Warrants will be non-redeemable and exercisable on a cashless basis so long as they are held by the sponsor or its permitted transferees. The sponsor and our officers and directors had agreed, subject to limited exceptions, not to transfer, assign or sell any of their private placement Warrants until 30 days after the completion of the initial Business Combination. Related Party Loans The sponsor and its affiliate had loaned us an aggregate of $300,000 to cover expenses related to the Initial Public Offering pursuant to a promissory note. This loan was non-interest bearing and became payable upon the completion of the Initial Public Offering. We repaid $300,000 on February 15, 2018. In addition, the sponsor and its affiliate loaned us another $25,000 for working capital. We fully repaid this amount on February 20, 2018. In addition, in order to finance transaction costs in connection with a Business Combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a Business Combination, we would repay the Working Capital Loans out of the proceeds of the trust account released to the company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the trust account. In the event that a Business Combination does not close, we may use a portion of the proceeds held outside the trust account to repay the Working Capital Loans but no proceeds held in the trust account would be used to repay the Working Capital Loans. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a Business Combination, without interest, or, at the lender’s discretion, up to $1.5 million of such Working Capital Loans may be convertible into warrants of the post Business Combination entity at a price of $1.50 per warrant. The warrants would be identical to the private placement Warrants. As of December 31, 2018 and 2017, no Working Capital Loans were outstanding. Administrative Support Agreement We have agreed, commencing on the effective date of the Initial Public Offering in February 2018 through the earlier of our consummation of a Business Combination and our liquidation, to pay an affiliate of the sponsor a total of $10,000 per month for office space, utilities and secretarial and administrative support. During the year ended December 31, 2018, an aggregate of $105,000 in connection with such services was recorded in general and administrative expenses in the accompanying Statements of Operations. As of December 31, 2018, the full amount of $105,000 was accrued on the accompanying balance sheets (the “Balance Sheets”). Critical Accounting Policies and Estimates This management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to fair value of financial instrument and accrued expenses. We base our estimates on historical experience, known trends and events and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe there have been no significant changes in our critical accounting policies as discussed in our final prospectus relating to our Initial Public Offering and our Current Report on Form 8-K filed with the SEC on February 14, 2018 and February 22, 2018, respectively. Off-Balance Sheet Arrangements and Contractual Obligations As of December 31, 2018 and 2017, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations. JOBS Act The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We will qualify as an “emerging growth company” and under the JOBS Act will be allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. Additionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements This Annual Report on Form 10K includes forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have based these forwardlooking statements on our current expectations and projections about future events. These forwardlooking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forwardlooking statements. In some cases, you can identify forwardlooking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Overview We are a blank check company incorporated on November 29, 2017 as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or sector for purposes of consummating a Business Combination, we focus our search on companies in the consumer sector. We consummated our Initial Public Offering on February 15, 2018. If we are unable to complete a Business Combination within 24 months from the closing of the Initial Public Offering, or the Combination Period, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a pershare price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest earned on the funds held in the trust account and not previously released to us to pay its income taxes (less up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the company’s remaining shareholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. Results of Operations All activity during the year ended December 31, 2018 was in preparation for our Initial Public Offering, and since the closing of the offering, our activity has been limited to the search for a prospective initial business combination, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2018, we had net income of approximately $2.6 million, which consisted of approximately $3.1 million of interest income, offset by approximately $490,000 of general and administrative costs. For the period from November 29, 2017 (inception) to December 31, 2017, we had net loss of approximately $8,800, which consisted of $11 in interest income, offset by approximately $8,800 in general and administrative costs. Going Concern Consideration As indicated in the accompanying audited financial statements, at December 31, 2018, we had approximately $550,000 in our operating bank account, approximately $3.1 million of interest income available in the trust account to pay for taxes, and working capital of approximately $585,000. Through December 31, 2018, our liquidity needs have been satisfied through [/INST] Negative. </s>

Leo Holdings Corp.

2020-03-13

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS References to “we,” “us,” “our” or the “company” are to Leo Holdings Corp., except where the context requires otherwise. The following discussion should be read in conjunction with our condensed financial statements and related notes thereto included elsewhere in this report. Cautionary Note Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Overview We are a blank check company incorporated on November 29, 2017 as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or sector for purposes of consummating a business combination, we focus our search on companies in the consumer sector. We consummated our Initial Public Offering on February 15, 2018. If we are unable to complete a business combination within 24 months from the closing of the Initial Public Offering, or the Combination Period, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest earned on the funds held in the trust account and not previously released to us to pay its income taxes (less up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the company’s remaining shareholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. Proposed Business Combination On February 6, 2020, we announced that we signed a term sheet and are working on a Business Combination Agreement with DMS. In connection with the Proposed Business Combination, we have obtained $100 million in commitments from a number of institutional investors to purchase common equity in the post-combination company at $10.00 per share in support of the Proposed Business Combination. Once the Proposed Business Combination closes, the post-combination company is expected to trade on the NYSE under ticker “DMS.” The DMS management team owns 54% of DMS with private equity funds managed by Clairvest Group, Inc. (TSX: CVG), owning the remaining 46%. Our board of directors has unanimously approved the Proposed Business Combination. Clairvest is supportive of management and the Proposed Business Combination. The sellers are expected to retain a significant continuing equity interest in the post-combination company, representing over 40% of the company on a combined basis. This percentage is subject to change depending on the number of our Class A ordinary shares that are redeemed by our public shareholders. The completion of the Proposed Business Combination is subject to the negotiation and execution of a Business Combination Agreement, providing for the Proposed Business Combination, satisfaction of the closing conditions included therein and approval of the Proposed Business Combination by our shareholders and Clairvest’s board of directors. Accordingly, there can be no assurance that a Business Combination Agreement will be entered into or that the Proposed Business Combination will be consummated. Extension Meeting We mailed to our shareholders of record as of January 17, 2020, a definitive proxy statement for a special meeting of shareholders to be held on February 11, 2020 to approve an extension of time for us to complete an initial business combination through July 31, 2020. The Extension Proposal was approved, providing our shareholders with more time to evaluate our Proposed Business Combination. In connection with the vote to approve the Extension Proposal, the holders of 687,193 Class A ordinary shares properly exercised their right to redeem their shares for cash at a redemption price of approximately $10.38 per share, for an aggregate redemption amount of approximately $7.13 million. As such, only approximately 3.4% of the Class A ordinary shares were redeemed and approximately 96.6% of the Class A ordinary shares remain outstanding. After the satisfaction of such redemptions, the balance in our trust account will be approximately $200.4 million. Results of Operations All activity during the year ended December 31, 2019 was in preparation for our Initial Public Offering, and since the closing of the offering, our activity has been limited to the search for a prospective initial business combination, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2019, we had net loss of approximately $1.3 million, which consisted of approximately $4.1 million of interest income, offset by approximately $5.4 million of general and administrative expenses. For the year ended December 31, 2018, we had net income of approximately $2.6 million, which consisted of approximately $3.1 million of interest income, offset by approximately $490,000 of general and administrative costs. Going Concern Consideration The accompanying consolidated financial statements have been prepared assuming we will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the normal course of business. As of December 31, 2019, we had approximately $200 in our operating bank account, approximately $7.2 million of interest income available in the trust account to pay for taxes, and a working capital deficit of approximately $4.8 million. Further, we have incurred and expect to continue to incur significant costs in pursuit of our acquisition plans. Through December 31, 2019, our liquidity needs have been satisfied through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the founder shares to our sponsor, $325,000 in loans from our sponsor, and the net proceeds from the consummation of the private placement not held in the trust account. We fully repaid the loans from our sponsor on February 20, 2018. During the year ended December 31, 2019, our sponsor also paid for certain general and administrative expenses of approximately $387,000 on behalf of our company. These advances were due on demand, non-interest bearing, and were fully outstanding as of December 31, 2019. In addition, in order to finance transaction costs in connection with a business combination, our sponsor or an affiliate of our sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (the “Working Capital Loans”) of up to $1.5 million. We intend to use substantially all of the funds held in the trust account, including any amounts representing interest earned on the trust account (less taxes payable and deferred underwriting commissions), to complete our initial business combination. We may withdraw interest income (if any) to pay our income taxes, if any. Our annual income tax obligations will depend on the amount of interest and other income earned on the amounts held in the trust account. We expect the interest income earned on the amount in the trust account (if any) will be sufficient to pay our income taxes. To the extent that our equity or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. In connection with our assessment of going concern considerations in accordance with FASB Accounting Standards Update (“ASU”) 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” management has determined that the working capital deficit, mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate after July 31, 2020. Related Party Transactions Founder Shares On December 8, 2017, the sponsor purchased 8,625,000 shares of the company’s Class B ordinary shares, par value $0.0001, for an aggregate price of $25,000. In February 2018, the sponsor effected a surrender of 2,875,000 founder shares to us for no consideration, resulting in a decrease in the total number of founder shares from 8,625,000 to 5,750,000. The founder shares will automatically convert into Class A ordinary shares at the time of our initial business combination and are subject to certain transfer restrictions. The sponsor had agreed to forfeit up to 750,000 founder shares to the extent that the over-allotment option was not exercised in full by the underwriter. On March 29, 2018, the over-allotment option expired and an aggregate of 750,000 shares were subsequently forfeited by the sponsor. The sponsor and our officers and directors have agreed, subject to limited exceptions, not to transfer, assign or sell any of their founder shares until the earlier to occur of: (A) one year after the completion of the initial business combination or (B) subsequent to the initial business combination, (x) if the last sale price of the Class A ordinary shares equals or exceeds $12.00 per share (as adjusted for share subdivisions, share dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial business combination, or (y) the date on which the company completes a liquidation, merger, share exchange or other similar transaction that results in all of the company’s shareholders having the right to exchange their ordinary shares for cash, securities or other property. Private Placement Warrants Concurrently with the closing of the Initial Public Offering, the sponsor purchased 4,000,000 private placement Warrants at $1.50 per private placement warrant, generating gross proceeds of $6.0 million in the private placement. The sponsor had agreed that if the over-allotment option were exercised, the sponsor would have purchased an additional 400,000 private placement warrants at a price of $1.50 per private placement warrant. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. A portion of the proceeds from the sale of the private placement warrants were added to the proceeds from the Initial Public Offering and deposited in the trust account. If the company does not complete a business combination within the Combination Period, the private placement warrants will expire worthless. The private placement warrants will be non-redeemable and exercisable on a cashless basis so long as they are held by the sponsor or its permitted transferees. The sponsor and our officers and directors had agreed, subject to limited exceptions, not to transfer, assign or sell any of their private placement warrants until 30 days after the completion of the initial business combination. Related Party Loans The sponsor and its affiliate had loaned us an aggregate of $300,000 to cover expenses related to the Initial Public Offering pursuant to a promissory note. This loan was non-interest bearing and became payable upon the completion of the Initial Public Offering. We repaid $300,000 on February 15, 2018. In addition, the sponsor and its affiliate loaned us another $25,000 for working capital. We fully repaid this amount on February 20, 2018. During the year ended December 31, 2019, our sponsor also paid for certain general and administrative expenses on behalf of our company. These advances were due on demand and were non-interest bearing. As of December 31, 2019 and 2018, approximately $387,000 and $0 for these advances were recorded on the accompanying balance sheets, respectively. In addition, in order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete a business combination, we would repay the Working Capital Loans out of the proceeds of the trust account released to the company. Otherwise, the Working Capital Loans would be repaid only out of funds held outside the trust account. In the event that a business combination does not close, we may use a portion of the proceeds held outside the trust account to repay the Working Capital Loans but no proceeds held in the trust account would be used to repay the Working Capital Loans. Except for the foregoing, the terms of such Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. The Working Capital Loans would either be repaid upon consummation of a business combination, without interest, or, at the lender’s discretion, up to $1.5 million of such Working Capital Loans may be convertible into warrants of the post business combination entity at a price of $1.50 per warrant. The warrants would be identical to the private placement warrants. As of December 31, 2019 and 2018, no Working Capital Loans were outstanding. Administrative Support Agreement We have agreed, commencing on the effective date of the Initial Public Offering in February 2018 through the earlier of our consummation of a business combination and our liquidation, to pay an affiliate of the sponsor a total of $10,000 per month for office space, utilities and secretarial and administrative support. During the years ended December 31, 2019 and 2018, an aggregate of $120,000 and $105,000 in connection with such services was recorded in general and administrative expenses in the accompanying Statements of Operations. As of December 31, 2019 and 2018, $50,000 and $105,000 were accrued on the accompanying balance sheets, respectively. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. The Company has identified the following as its critical accounting policies: Net Income (Loss) Per Ordinary Share We comply with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” Net income (loss) per ordinary share is computed by dividing net income applicable to ordinary shareholders by the weighted average number of ordinary shares outstanding for the period. We have not considered the effect of the warrants sold in the initial public offering and private placement to purchase an aggregate of 14,000,000 Class A ordinary shares in the calculation of diluted earnings per share, since their inclusion would be anti-dilutive under the treasury stock method. As a result, diluted earnings per ordinary share is the same as basic earnings per ordinary share for the periods presented. Our statements of operations include a presentation of income (loss) per share for ordinary shares subject to redemption in a manner similar to the two-class method of income per share. Net income per ordinary share, basic and diluted for Class A ordinary shares is calculated by dividing the interest income earned on the trust account, by the weighted average number of Class A ordinary shares outstanding for the periods. Net loss per ordinary share, basic and diluted for Class B ordinary shares is calculated by dividing the net income, less income attributable to Class A ordinary shares and any Working Capital Loans, by the weighted average number of Class B ordinary shares outstanding for the periods presented. Class A Ordinary Shares Subject to Possible Redemption We account for its Class A ordinary shares subject to possible redemption in accordance with the guidance in FASB ASC Topic 480 “Distinguishing Liabilities from Equity.” Class A ordinary shares subject to mandatory redemption (if any) are classified as liability instruments and are measured at fair value. Conditionally redeemable Class A ordinary shares (including Class A ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, Class A ordinary shares are classified as shareholders’ equity. Our Class A ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to the occurrence of uncertain future events. Accordingly, at December 31, 2019 and 2018, 19,034,909 and 19,166,628 Class A ordinary shares subject to possible redemption at the redemption amount are presented as temporary equity, outside of the shareholders’ equity section of our balance sheets, respectively. Off-Balance Sheet Arrangements and Contractual Obligations As of December 31, 2019 and 2018, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations. JOBS Act The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We will qualify as an “emerging growth company” and under the JOBS Act will be allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. Additionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company,” we choose to rely on such exemptions we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis) and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the CEO’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements This Annual Report on Form 10K includes forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We have based these forwardlooking statements on our current expectations and projections about future events. These forwardlooking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forwardlooking statements. In some cases, you can identify forwardlooking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Overview We are a blank check company incorporated on November 29, 2017 as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or sector for purposes of consummating a business combination, we focus our search on companies in the consumer sector. We consummated our Initial Public Offering on February 15, 2018. If we are unable to complete a business combination within 24 months from the closing of the Initial Public Offering, or the Combination Period, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a pershare price, payable in cash, equal to the aggregate amount then on deposit in the trust account including interest earned on the funds held in the trust account and not previously released to us to pay its income taxes (less up to $100,000 of interest to pay dissolution expenses), divided by the number of then outstanding public shares, which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidating distributions, if any), subject to applicable law, and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the company’s remaining shareholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Cayman Islands law to provide for claims of creditors and the requirements of other applicable law. Proposed Business Combination On February 6, 2020, we announced that we signed a term sheet and are working on a Business Combination Agreement with DMS. In connection with the Proposed Business Combination, we have obtained $100 million in commitments from a number of institutional investors to purchase common equity in the postcombination company at $10.00 per share in support of the Proposed Business Combination. Once the Proposed Business Combination closes, the postcombination company is expected to trade on the NYSE under ticker “DMS.” The DMS management team owns 54% of DMS with private equity funds managed by Clairvest Group, Inc. (TSX: CVG), owning the remaining 46%. Our board of directors has unanimously approved the Proposed Business Combination. Clairvest is supportive of management and the Proposed Business Combination. The sellers are expected to retain a significant continuing equity interest in the postcombination company, representing over 40% of the company on a combined basis. This percentage is subject to change depending on the number of our Class A ordinary shares that are redeemed by our public shareholders. The completion of the Proposed Business Combination is subject to the negotiation and execution of a Business Combination Agreement, providing for the Proposed Business Combination, satisfaction of the closing conditions included therein and approval of the Proposed Business Combination by our shareholders and Clairvest’s board of directors. Accordingly [/INST] Positive. </s>

Charah Solutions, Inc.

2019-03-28

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the historical financial statements and the related notes included elsewhere herein. This discussion contains “forward-looking statements” reflecting our current expectations, estimates, and assumptions concerning events and financial trends that may affect our future operating results or financial position. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors. Factors that could cause or contribute to such differences include, but are not limited to, capital expenditures, economic and competitive conditions, regulatory changes, and other uncertainties, as well as those factors discussed below and elsewhere herein. Please read Cautionary Note Regarding Forward-Looking Statements. Also, please read the risk factors and other cautionary statements described under “Item 1A. Risk Factors” included elsewhere herein. We assume no obligation to update any of these forward-looking statements. Charah Solutions, Inc. Charah Solutions was formed in January 2018 and did not conduct any material business operations prior to the transactions described under “-Initial Public Offering.” In connection with the closing of our initial public offering (the “IPO”), and pursuant to the terms and conditions of the master reorganization agreement, dated June 13, 2018, Charah Management and Allied Power Holdings, LLC, a Delaware limited liability company (“Allied Power Holdings”), became wholly owned subsidiaries of the Company. Through our ownership of Charah Management and Allied Power Holdings, we own the outstanding equity interests in Charah and Allied, the subsidiaries through which we operate our businesses. Overview We were formed in January 2018 in anticipation of the IPO to be a holding company for Charah Management and Allied Power Holdings. The historical financial data presented herein as of December 31, 2018 and for periods after the June 18, 2018 corporate reorganization is that of Charah and Allied on a consolidated basis, and on a combined basis for periods prior to the June 18, 2018 corporate reorganization. Allied was formed in May 2017 and did not commence operations until July 2017. We are a leading provider of mission-critical environmental and maintenance services to the power generation industry, enabling our customers to address challenges related to the remediation of ash ponds and landfills at open and closed power plant sites while continuously operating and providing necessary electric power to communities nationwide. We offer a suite of coal ash management and recycling, environmental remediation, and outage maintenance services. We also design and implement solutions for complex environmental projects (such as coal ash pond closures) and facilitate coal ash recycling through byproduct sales and other beneficial use services. We operate in over 20 states, resulting in an overall footprint and density in key markets that we believe is difficult to replicate. We are an environmental remediation and maintenance company and conduct our operations through two segments: Environmental Solutions and Maintenance and Technical Services. Environmental Solutions. Our Environmental Solutions segment includes remediation and compliance services, as well as byproduct sales offerings. Remediation and compliance services are associated with our customers’ need for multi-year environmental improvement and sustainability initiatives, whether driven by proactive engagement, by power generation customers, by regulatory requirements, or by consumer expectations and standards. Byproduct sales support both our power generation customers’ desire to profitably recycle recurring and historic volumes of CCRs and our ultimate end customers’ need for high-quality, cost-effective raw material substitutes. Maintenance and Technical Services. Our Maintenance and Technical Services segment includes fossil services and, from and after May 2017 when Allied was created, nuclear services. Fossil services are the recurring and mission-critical management of coal ash and the routine maintenance, outage services and staffing solutions for coal-fired power generation facilities. Nuclear services, which we market under the Allied Power brand name, include routine maintenance, outage services, facility maintenance, and staffing solutions for nuclear power generation facilities. The Maintenance and Technical Services segment offerings are most closely associated with the ongoing operations of power plants, whether in the form of daily environmental management or required maintenance services (typically during planned outages). Initial Public Offering On June 18, 2018, we completed the IPO of 7,352,941 shares of the Company’s common stock, par value $0.01 per share. The net proceeds of the IPO to us prior to offering expenses were approximately $59.2 million. We used a portion of the IPO proceeds to pay off approximately $40.0 million of the borrowings outstanding under the Term Loan, and any remaining net proceeds were used to pay offering expenses or for general corporate purposes. How We Evaluate Our Operations We use a variety of financial and operational metrics to assess the performance of our operations, including: • Revenues; • Gross Profit; • Operating Income; • Adjusted EBITDA; and • Adjusted EBITDA Margin. Revenues We analyze our revenues by comparing actual revenues to our internal projections for a given period and to prior periods to assess our performance. We believe that revenues are a meaningful indicator of the demand and pricing for our services. Gross Profit We analyze our gross profit, which we define as revenues less cost of sales, to measure our financial performance. We believe gross profit is a meaningful metric because it provides insight on financial performance of our revenue streams without consideration of Company overhead. When analyzing gross profit, we compare actual gross profit to our internal projections for a given period and to prior periods to assess our performance. Operating Income We analyze our operating income, which we define as revenues less cost of sales and general and administrative expenses, to measure our financial performance. We believe operating income is a meaningful metric because it provides insight on profitability and operating performance based on the cost basis of our assets. We also compare operating income to our internal projections for a given period and to prior periods. Adjusted EBITDA and Adjusted EBITDA Margin We view Adjusted EBITDA and Adjusted EBITDA Margin, which are non-GAAP financial measures, as an important indicator of performance. We define Adjusted EBITDA as net income before interest expense, net, depreciation and amortization, equity-based compensation, and income taxes, elimination of certain legacy expenses, amounts from a non-acquired business line, and transaction related expenses and other items. Adjusted EBITDA margin represents the ratio of Adjusted EBITDA to total revenues. See “-Non-GAAP Measures” for more information and reconciliations of Adjusted EBITDA to net income, the most directly comparable financial measure calculated and presented in accordance with GAAP. Key Factors Affecting Our Business and Financial Statements Ability to Capture New Contracts and Opportunities Our ability to grow revenue and earnings is dependent on maintaining and increasing our market share, renewing existing contracts, and obtaining additional contracts from proactive bidding on contracts with new and existing customers. We proactively work with existing customers ahead of contract end dates to attempt to secure contract renewals. We also leverage the embedded long-term nature of our customer relationships to obtain insight into and to capture new business opportunities across our platform. Seasonality of Business Based on historic trends, we expect our operating results to vary seasonally. Nuclear power generators perform turnaround and outages in the off-peak months when demand is lower and generation capacity is less constrained. As a result, our nuclear services offerings may have higher revenue volume in the spring and fall months. Variations in normal weather patterns can also cause changes in the consumption of energy, which may influence demand and timing of associated services for our fossil services offerings. Inclement weather can impact construction-related activities associated with pond and landfill remediation, which affects the timing of revenue generation within remediation and compliance services. Byproduct sales are also impacted during winter months when the utilization of cement and cement products is generally lower. Project-Based Nature of Environmental Remediation Mandates We believe there is a significant pipeline of coal ash ponds and landfills that will require remediation and/or closure in the future. Due to their scale and complexity, these environmental remediation projects are typically completed over longer periods of time. As a result, our revenues from these projects can fluctuate over time. Some of our revenues from projects are recognized using percentage of completion accounting for GAAP purposes. This method of revenue recognition is determined by estimating the percentage of completion on a project and the ultimate estimated gross profit margin on the project. The timing of revenues recorded for financial reporting purposes may differ from actual billings to customers, sometimes resulting in costs and billing in excess of actual revenues. Because of the risks in estimating long-term projects, actual results may differ from these estimates. Byproduct Recycling Market Dynamics There is a growing demand for recycled coal ash across a variety of applications, in addition to the market forces and governmental regulations driving the need to dispose of coal ash in an environmentally sensitive manner. Pricing of byproduct sales is driven by supply and demand market dynamics, in addition to the chemical and physical properties of the ash. As demand increases for the end products that use recycled coal-fired power generation waste byproducts (i.e., concrete for construction and infrastructure projects), the demand for recycled coal ash also typically rises. These fluctuations affect the relative demand for our byproduct sales offerings. In recessionary periods, construction and infrastructure spending and the corresponding need for concrete may decline. However, this unfavorable effect may be partially offset by an increase in the demand for recycled coal ash during a recessionary period given coal ash is more cost-effective than other alternatives. Power Generation Industry Spend on Environmental Liability Management and Regulatory Requirements The power generation industry has increased annual spending on environmental liability management. We believe this is the result of not only regulatory and consumer pressure, but also the industry’s increasing focus on environmental stewardship. Continued increases in spending on environmental liability management by our customers should result in increased demand for services across our platform. Cost Management and Capital Investment Efficiency Our main operating costs consist of labor and material costs and equipment maintenance. We maintain a focus on cost management and efficiency, including monitoring labor costs, both in terms of wage rates and headcount, along with other costs such as materials and equipment. We maintain a disciplined approach to capital expenditure decisions, which are typically associated with specific contract requirements. Furthermore, we strive to extend the useful life of our equipment through the application of a well-planned routine maintenance program. How We Generate Revenues The Environmental Solutions segment generates revenue through our remediation and compliance services, as well as byproduct sales offerings. Our remediation and compliance services offerings primarily consist of designing, constructing, managing, remediating, and closing ash ponds and landfills on customer-owned sites. Our byproduct sales offerings include the recycling of recurring and contracted volumes of coal-fired power generation waste byproducts, such as bottom ash, fly ash, and gypsum byproduct, each of which can be used for various industrial purposes. Our platform of services is contracted for terms generally ranging from 18 months to five years, thereby reducing financial volatility. In excess of 90% of our services work is structured as time and materials, cost reimbursable, or unit price contracts, which significantly reduces the risk of loss on contracts and provides gross margin visibility. Revenue from management contracts is recognized when the ash is hauled to the landfill or the management services are provided. Revenue from the sales of ash is recognized when it is delivered to the customer. The Maintenance and Technical Services segment generates revenue through our fossil services and nuclear services offerings. Maintenance and Technical Services segment offerings are most closely associated with the ongoing operations of power plants, whether in the form of daily environmental management or required maintenance services (typically during planned outages). Our fossil services offerings focus on recurring and mission-critical management of coal ash and routine maintenance, outage services and staffing solutions for coal-fired power generation facilities to fulfill an environmental service need of our customers in handling their waste byproducts. Our nuclear services operations, which we market under the Allied Power brand name, consists of a broad platform of mission-critical professional, technical, and craft services spanning the entire asset life cycle of a nuclear power generator. The services are performed on the customer’s site and the contract terms typically range from three to five years. Revenues are billed and paid during the periods of time work is being executed. Our nuclear services revenues tend to be seasonal and may experience significant increases during periods of shutdowns of generators. This combination of the maintenance and environmental-related services deepens customer connectivity and drives long-term relationships which we believe is critical for renewing existing contracts, winning incremental business from existing customers at new sites, and adding new customers. Over the last five years, we have achieved an approximately 90% renewal rate for contracts in our fossil services offerings up for renewal. Factors Impacting the Comparability of Results of Operations Public Company Costs As a new public company, we expect to incur incremental recurring and certain non-recurring costs related to our transition to a publicly traded and taxable corporation, including the costs of the IPO and the costs associated with the initial implementation of our Sarbanes-Oxley Section 404 internal control implementation and testing. We also expect to incur additional significant and recurring expenses as a publicly traded company, including costs associated with the employment of additional personnel, compliance under the Exchange Act, annual and quarterly reports to common stockholders, registrar and transfer agent fees, national stock exchange fees, audit fees, incremental director and officer liability insurance costs, and director and officer compensation. Income Taxes Charah Solutions is a “C” Corporation under the Internal Revenue Code of 1986, as amended (the “Code”), and, as a result, is subject to U.S. federal, state, and local income taxes. In connection with the IPO, Charah and Allied, which previously were flow-through entities for income tax purposes and were indirect subsidiaries of two partnerships, Charah Management and Allied Power Holdings, respectively, became indirect subsidiaries of the Company. Prior to the contribution, Charah and Allied passed through their taxable income to the owners of the partnerships for U.S. federal and other state and local income tax purposes and, thus, were not subject to U.S. federal income taxes or other state or local income taxes, except for franchise tax at the state level (at less than 1% of modified pre-tax earnings). Accordingly, the financial data attributable to Charah and Allied prior to the contribution on June 18, 2018 contains no provision for U.S. federal income taxes or income taxes in any state or locality other than franchise taxes. Operations of Allied Power Management, LLC Allied was formed in May 2017 and commenced operations in July 2017. Our results of operations for the year ended December 31, 2017 reflect the results of Allied only from the commencement of its operations in July 2017. As a result, our historical financial and operating information for the year ended December 31, 2018 may not be comparable to the historical financial and operating information for the year ended December 31, 2017. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 The table below sets forth our selected operating data for the years ended December 31, 2018 and 2017. The successor columns below represent the consolidated financial information of Charah Solutions for the year ended December 31, 2018 and the combined financial information of Charah and Allied for the period from January 13, 2017 through December 31, 2017, and the predecessor column below represents the financial information of Charah for the period from January 1, 2017 through January 12, 2017, each as reflected in our audited financial statements included elsewhere herein. The dollar amount and percentage change information below reflects the difference between results in the year ended December 31, 2018 as compared to the combined results for the period from January 1, 2017 through January 12, 2017 and the period from January 13, 2017 through December 31, 2017. (1) Adjusted EBITDA and Adjusted EBITDA margin are non-GAAP financial measures. For a definition of Adjusted EBITDA and Adjusted EBITDA margin, as well as a reconciliation to our most directly comparable financial measures calculated and presented in accordance with GAAP, please read “-Non-GAAP Measures” below. Overview of Financial Results: 2018 was a transitional year as we moved from a private to a public company with the IPO in June 2018. We continued to grow our operations with increased work in the nuclear power maintenance industry and improved our byproduct sales offerings with the acquisition of SCB in March 2018. Additionally, we resolved a significant legal matter that existed prior to the IPO. Additional information regarding the results of operations follows below. Revenues. Revenues increased $310.1 million, or 72.1%, for the year ended December 31, 2018 to $740.5 million as compared to $430.4 million for the year ended December 31, 2017. The increase in revenues by segment was as follows: Environmental Solutions Revenues. Environmental Solutions segment revenues increased $103.1 million, or 42.9%, for the year ended December 31, 2018 to $343.1 million as compared to $240.0 million for the year ended December 31, 2017. The increase was primarily attributable to $45.8 million of revenue associated with the addition of SCB that occurred in March 2018, in addition to a net overall increase in revenue from our remediation and compliance services offerings. Maintenance and Technical Services Revenues. Maintenance and Technical Services segment revenues increased $207.0 million, or 108.8%, for the year ended December 31, 2018 to $397.4 million as compared to $190.3 million for the year ended December 31, 2017. The increase was primarily attributable to the addition of our nuclear services offerings, which did not have a full year of operations in 2017. Gross Profit. Gross profit increased $13.6 million, or 16.1%, for the year ended December 31, 2018 to $97.7 million as compared to $84.2 million for the year ended December 31, 2017. As a percentage of revenue, gross profit was 13.2% and 19.6% for the years ended December 31, 2018 and 2017, respectively. The increase in gross profit by segment was as follows: Environmental Solutions Gross Profit. Gross profit for our Environmental Solutions segment increased $3.6 million, or 5.5%, for the year ended December 31, 2018 to $69.5 million as compared to $65.8 million for the year ended December 31, 2017. The increase was primarily attributable to the early completion of the Brickhaven ash remediation contract, which accelerated revenues and expenses related to this contract into 2018 and had a net positive impact on gross profit for the year. Under the terms of the Brickhaven contract, we expect to receive a significant cash payment from our customer in 2019, subject to the customer's final confirmation of the contract's early completion pursuant to the terms of the contract. Gross profit for the year ended December 31, 2018 also included $5.4 million attributable to the addition of SCB. Maintenance and Technical Services Gross Profit. Gross profit for our Maintenance and Technical Services segment increased $9.9 million, or 54.3%, for the year ended December 31, 2018 to $28.3 million as compared to $18.3 million for the year ended December 31, 2017. The increase was primarily attributable to the addition of our nuclear services offerings, which did not have a full year of operations in 2017. General and Administrative Expenses. General and administrative expenses increased $25.1 million, or 48.6%, for the year ended December 31, 2018 to $76.8 million as compared to $51.7 million for the year ended December 31, 2017. The increase was primarily attributable to additional general and administrative expenses associated with our nuclear services offerings, including some non-recurring legal costs and accruals, as disclosed in our Adjusted EBITDA calculation included herein, in addition to increased expenses due to the addition of SCB. Interest Expense, Net. Interest expense, net increased $13.9 million, or 75.8%, for the year ended December 31, 2018 to $32.2 million as compared to $18.3 million for the year ended December 31, 2017. The increase was primarily attributable to $12.5 million of costs incurred in conjunction with the refinance of our debt, consisting of a $10.4 million write-off of non-cash debt issuance costs and a $2.1 million prepayment penalty, in addition to an increase in our debt balances. We incurred $4.1 million of costs associated with debt retirement in conjunction with BCP’s investment in us, which was recorded during the period from January 1, 2017 through January 12, 2017. Income from Equity Method Investment. Income from equity method investment increased $1.5 million, or 178.6%, for the year ended December 31, 2018 to $2.4 million as compared to $0.9 million for the year ended December 31, 2017. The increase was primarily attributable to a price increase of the products sold through this joint venture and an increase in ash volumes generated by the utility and available for sale by us. Net Income (Loss). Net income decreased $21.4 million, or 142.7%, for the year ended December 31, 2018 to $(6.4) million as compared to $15.0 million for the year ended December 31, 2017. The decrease was primarily attributable to the increase in general and administrative expenses and interest expense, net, as disclosed above, offset by an income tax benefit of $2.4 million and increases in revenues and gross profit as disclosed above. Adjusted EBITDA and Adjusted EBITDA Margin. Adjusted EBITDA increased $22.8 million, or 29.9%, for the year ended December 31, 2018 to $98.8 million as compared to $76.0 million for the year ended December 31, 2017, and our Adjusted EBITDA margin for the year ended December 31, 2018 was 13.3%, a decrease of 4.3% from 17.7% for the year ended December 31, 2017. The increase in Adjusted EBITDA was primarily attributable to the gross profit increase described above and the early completion of the Brickhaven contract. For a definition of Adjusted EBITDA and the calculation of Adjusted EBITDA margin, as well as a reconciliation to the most directly comparable GAAP measure, see “-Non-GAAP Measures.” Impact of Brickhaven Accelerated Depreciation. As noted above, the accelerated completion of the Brickhaven ash remediation contract was an important factor in our third and fourth quarter 2018 results. Brickhaven is very different from our other remediation projects because we purchased, developed and permitted the site several years ago, requiring significant capital investment by us. We did this in conjunction with a contract under which our customer would supply ash that we would store at the Brickhaven site and an adjacent mine owned by us, and we would be reimbursed for our costs, including a return, on a per-ton basis. Riverbend is a retired power plant that is one of two from which we sourced ash but the contract contemplated follow-on sites, aggregating to approximately 20 million tons of ash that would be supplied to these mines. Due to a change in North Carolina law, the customer determined that it would not supply ash to these mines once Riverbend was completed. Under the terms of the contract, we expect to receive a significant payment from the customer for unrecovered project development costs and expected site closing costs. The early completion of the Brickhaven contract affected our 2018 results in two significant ways: • First, under percentage of completion accounting, we accelerated revenues and expenses (including depreciation and amortization) related to this project from 2019 into the third and fourth quarters of 2018. This had a net benefit to gross profit but the benefit to Adjusted EBITDA was significantly greater because of the capital-intensive nature of the Brickhaven asset and the acceleration of depreciation. Of the $49 million of depreciation expense related to property, plant, and equipment we recorded in 2018, approximately $38 million was for Brickhaven and related equipment. Had we not had an early completion of the project, depreciation would have been significantly less. We also recorded $15 million of amortization of a purchase option liability related to Brickhaven, which reduced general and administrative expenses. Net of this negative amortization, total depreciation and amortization associated with Brickhaven was $23 million. Because the Riverbend project was completed in March 2019, the amount of revenues and depreciation associated with Brickhaven in 2019 will be substantially lower. Going forward, we expect that cost of goods sold will be more closely aligned with cash costs, consistent with the less capital-intensive nature that is typical of most of our remediation projects. • Second, we had an increase of unbilled costs on our balance sheet, shown as costs and estimated earnings in excess of billings, or CIE, which reduced operating cash flow by $79 million and thereby resulted in cash flow used in operations of $13.6 million for the year ended December 31, 2018. As we expect to substantially recover this amount in 2019, these working capital balances will reverse and generate significant cash flow. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 The table below sets forth our selected operating data for the years ended December 31, 2017 and 2016. The successor column below represents the combined financial information of Charah and Allied for the period from January 13, 2017 through December 31, 2017 and the predecessor columns below represent the financial information of Charah for the year ended December 31, 2016 and the period from January 1, 2017 through January 12, 2017, each as reflected in our audited financial statements included elsewhere herein. The dollar amount and percentage change information below reflects the difference between the combined results for the period from January 1, 2017 through January 12, 2017 and the period from January 13, 2017 through December 31, 2017, and the results for the year ended December 31, 2016. (1) Adjusted EBITDA and Adjusted EBITDA margin are non-GAAP financial measures. For a definition of Adjusted EBITDA and Adjusted EBITDA margin, as well as a reconciliation to the most directly comparable financial measures calculated and presented in accordance with GAAP, please read “-Non-GAAP Measures” below. Revenues. Revenues increased $165.3 million, or 62.4%, for the year ended December 31, 2017 to $430.4 million as compared to $265.1 million for the year ended December 31, 2016. The increase in revenues by segment was as follows: Environmental Solutions Revenues. Environmental Solutions segment revenues increased $22.0 million, or 10.1%, for the year ended December 31, 2017 to $240.0 million as compared to $218.1 million for the year ended December 31, 2016. The increase was primarily attributable to an increase in revenues from our remediation and compliance services offerings in the amount of $26.3 million, partially offset by a reduction in revenues related to our non-acquired business line of $5.0 million. Maintenance and Technical Services Revenues. Maintenance and Technical Services segment revenues increased $143.3 million, or 304.8%, for the year ended December 31, 2017 to $190.3 million as compared to $47.0 million for the year ended December 31, 2016. The increase was primarily attributable to the addition of our nuclear services offerings in the amount of $136.2 million, in addition to the net increase in revenues on fossil services projects of $7.1 million. Gross Profit. Gross profit increased $22.3 million, or 36.1%, for the year ended December 31, 2017 to $84.2 million as compared to $61.8 million for the year ended December 31, 2016. As a percentage of revenue, gross profit was 19.6% and 23.3% for the years ended December 31, 2017 and 2016, respectively. The increase in gross profit by segment was as follows: Environmental Solutions Gross Profit. Gross profit for our Environmental Solutions segment increased $14.6 million, or 28.4%, for the year ended December 31, 2017 to $65.8 million as compared to $51.3 million for the year ended December 31, 2016. The increase was primarily attributable to an increase in gross profit from our remediation and compliance services and byproduct sales offerings in the amount of $12.4 million and the elimination of negative gross profit associated with our non-acquired business line of $2.4 million. Maintenance and Technical Services Gross Profit. Gross profit for our Maintenance and Technical Services segment increased $7.8 million, or 73.5%, for the year ended December 31, 2017 to $18.3 million as compared to $10.6 million for the year ended December 31, 2016. The increase was primarily attributable to the addition of our nuclear services offerings, in addition to the net increase in gross profit on fossil services projects. General and Administrative Expenses. General and administrative expenses increased $16.5 million, or 46.9%, for the year ended December 31, 2017 to $51.7 million as compared to $35.2 million for the year ended December 31, 2016. The increase was primarily attributable to $18.9 million of additional expenses associated with our nuclear services offerings, including $14.8 million of non-recurring and non-operating legal costs (including legal costs associated with outstanding litigation as disclosed in Note 18 to our audited financial statements included herein) and non-recurring startup costs, as disclosed in our Adjusted EBITDA calculation included herein. Interest Expense, Net. Interest expense, net, increased $12.1 million, or 193.5%, for the year ended December 31, 2017 to $18.3 million as compared to $6.2 million for the year ended December 31, 2016. We incurred $4.1 million of costs associated with debt retirement in conjunction with BCP’s investment, which was recorded during the period from January 1, 2017 through January 12, 2017. During the period from January 13, 2017 to December 31, 2017, $6.1 million of non-cash debt issuance costs were expensed primarily due to the refinancing of our debt in October 2017. Additionally, we had higher interest costs associated with the increase in our debt balances in 2017. Income from Equity Method Investment. Income from equity method investment decreased $1.8 million, or 68.0%, for the year ended December 31, 2017 to $0.9 million as compared to $2.7 million for the year ended December 31, 2016. The decrease was primarily attributable to a reduction in ash volumes generated by the utility and available for sale by us. Net Income (Loss). Net income decreased $8.1 million, or 35.0%, for the year ended December 31, 2017 to $15.0 million as compared to $23.1 million for the year ended December 31, 2016. The decrease was primarily attributable to the increase in general and administrative expenses noted above, along with an increase in interest expense, net, offset by increases in revenues and gross profit associated with our projects, including the addition of our nuclear services offerings. Adjusted EBITDA and Adjusted EBITDA Margin. Adjusted EBITDA increased $17.0 million, or 28.9%, for the year ended December 31, 2017 to $76.0 million as compared to $59.0 million for the year ended December 31, 2016, and our Adjusted EBITDA margin for the year ended December 31, 2017 was 17.7%, a decrease of 5.0% from 22.7% for the year ended December 31, 2016. For a definition of Adjusted EBITDA and the calculation of Adjusted EBITDA margin, as well as a reconciliation to the most directly comparable GAAP measure, see “-Non-GAAP Measures.” Liquidity and Capital Resources Capital Requirements and Sources of Liquidity Our capital spending consists primarily of equipment costs associated with performance and completion of our contracts, including the replacement of dated and obsolete equipment, and the rollout of technology units that were acquired as part of our acquisition of SCB. However, the amount and timing of these capital expenditures is largely discretionary and within our control. We could choose to defer or increase a portion of these planned capital expenditures depending on a variety of factors, including, but not limited to, additional contracts awarded above and beyond our projections, and/or the increase or decrease in the useful life of our equipment. As we pursue growth, we monitor which capital resources, including equity and debt financings, are available to us to meet our future financial obligations, planned capital expenditure activities, and liquidity requirements. Based upon the current industry outlook, we believe that our cash flow from operations and borrowings under our Syndicated Credit Facility will be sufficient to fund our operations for at least the next 12 months. However, future cash flows are subject to a number of variables, including the ability to maintain existing contracts, to obtain new contracts, and to manage our operating expenses. The failure to achieve anticipated revenue and cash flows from operations could result in a reduction in future capital spending. We cannot assure you that operations and other needed capital will be available on acceptable terms or at all. In the event we make additional acquisitions and the amount of capital required is greater than the amount we have available for acquisitions at that time, we could be required to reduce the expected level of capital expenditures or to seek additional capital. We cannot assure you that needed capital will be available on acceptable terms or at all. As of December 31, 2018, we had total liquidity of approximately $50 million, comprised of $6.9 million of cash on hand, $18 million availability under the Revolving Loan and $25 million of delayed draw availability under the Term Loan. Cash Flows Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 The table below sets forth our cash flows for the years indicated. The successor columns below represent the consolidated financial information of Charah Solutions for the year ended December 31, 2018 and the combined financial information of Charah and Allied for the period from January 13, 2017 through December 31, 2017, and the predecessor column below represents the financial information of Charah for the period from January 1, 2017 through January 12, 2017, each as reflected in our audited financial statements included elsewhere herein. Operating Activities Net cash provided by (used in) operating activities decreased $67.0 million, or 125.5%, for the year ended December 31, 2018 to $(13.6) million from $53.4 million for the year ended December 31, 2017. The change in cash flows used in operating activities was primarily attributable to a $21.4 million decrease in net income as explained above, a $73.0 million decrease in cash resulting from the increase in costs and estimated earnings in excess of billings primarily related to Brickhaven, a $30.4 million decrease in cash resulting from the decrease in billings in excess of costs and estimated earnings, and an $8.4 million increase in accounts receivable, offset by an increase in depreciation and amortization of $23.3 million, an increase in asset retirement obligation of $24.8 million, an increase in accrued expenses of $10.8 million, and an increase in accounts payable of $8.0 million. Investing Activities Net cash used in investing activities increased $33.1 million, or 455.3%, for the year ended December 31, 2018 to $40.4 million from $7.3 million for the year ended December 31, 2017. The change in cash flows used in investing activities was primarily attributable to the $20.0 million used in 2018 for business acquisitions, net of cash received, and an increase in cash purchases of property and equipment. Financing Activities Net cash provided by (used in) financing activities increased $43.5 million, or 293.0%, for the year ended December 31, 2018 to $28.6 million from $(14.8) million for the year ended December 31, 2017. The change in cash flows provided by financing activities was primarily attributable to the $59.2 million in proceeds from the issuance of our common stock, which was used to make $40.0 million of principal payments towards our term loan and also pay $8.9 million of costs associated with the IPO. The change in cash flows provided by financing activities was also impacted by the refinancing of debt that occurred in the third quarter of 2018 and the first quarter of 2017, the acquisition of Charah by BCP in the first quarter of 2017, and a reduction in distributions to members in 2018. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 The table below sets forth our cash flows for the years indicated. The successor column below represents the combined financial information of Charah and Allied for the period from January 13, 2017 through December 31, 2017 and the predecessor columns below represent the financial information of Charah for the period from January 1, 2017 through January 12, 2017 and the year ended December 31, 2016, each as reflected in our audited financial statements included elsewhere herein. Operating Activities Net cash provided by operating activities increased $45.0 million, or 539.1%, for the year ended December 31, 2017 to $53.4 million from $8.4 million for the year ended December 31, 2016. The change in cash flows used in operating activities was primarily attributable to the increase in net change in working capital of $41.0 million and other items. Investing Activities Net cash used in investing activities decreased $8.6 million, or 54.2%, for the year ended December 31, 2017 to $7.3 million from $15.9 million for the year ended December 31, 2016. The change in cash flows used in investing activities was attributable to the elimination of a restricted cash requirement associated with one of our projects, an increase in purchases of property and equipment, net of sales, and other investing cash outflows in 2016 that did not recur in 2017. Financing Activities Net cash provided by (used in) financing activities decreased $22.1 million, or 303.4%, for the year ended December 31, 2017 to $(14.8) million from $7.3 million for the year ended December 31, 2016. The change in cash flows provided by financing activities was attributable to net proceeds from loan financings of $114.0 million and capital contributions of $10.0 million, offset by distributions to members of $136.0 million. Working Capital Our working capital, which we define as total current assets less total current liabilities, totaled $74.1 million and $12.3 million at December 31, 2018 and 2017, respectively. This increase in working capital for the year ended December 31, 2018 was primarily the result of a $78.8 million increase in costs and estimated earnings in excess of billings, a $24.1 million increase in inventory, a $14.5 million decrease in billings in excess of costs and estimated earnings, and a $13.5 million increase in accounts receivable, offset by a $25.4 million decrease in cash, a $25.0 million increase in asset retirement obligation, a $14.5 million increase in accrued expenses, a $9.6 million increase in accounts payable, and a $5.1 million increase in purchase option liability. Our Debt Agreements Revolving Credit Agreement On October 25, 2017, we entered into a credit agreement (the “Revolving Credit Agreement”) by and among us, the lenders party thereto from time to time, and Regions Bank, as administrative agent. The Revolving Credit Agreement provided for a revolving credit facility (the “Credit Facility”), with a principal amount of up to $45.0 million. The Credit Facility permitted extensions of credit up to the lesser of $45.0 million and a borrowing base that was calculated by us based upon a percentage of the value of our eligible accounts receivable and eligible inventory, and approved by the administrative agent. The interest rates per annum applicable to the loans under the Credit Facility were based on a fluctuating rate of interest measured by reference to, at our election, either (i) an adjusted London inter-bank offered rate (“LIBOR”) plus a 2.00% borrowing margin, or (ii) an alternative base rate plus a 1.00% borrowing margin. Customary fees were payable in respect of the Credit Facility and included (i) commitment fees in an amount equal to 0.50% of the daily unused portions of the Credit Facility, and (ii) a 2.00% fee on outstanding letters of credit. The Credit Facility contained various representations and warranties, and restrictive covenants. If excess availability under the Credit Facility fell below the greater of 15% of the loan cap amount or $6.75 million, we were required to comply with a minimum fixed charge coverage ratio of 1.0 to 1.0. The Credit Facility did not otherwise contain financial maintenance covenants. The Credit Facility had a scheduled maturity date of October 25, 2022; however, all amounts outstanding were repaid in September 2018 as a result of the refinancing discussed below. Term Loan On October 25, 2017, we entered into a credit agreement (the “Term Loan Credit Agreement”) by and among us, the lenders party thereto from time to time, and Credit Suisse AG, Cayman Islands Branch, as administrative agent, providing for a term loan (the “CS Term Loan”) with an initial commitment of $250.0 million. The CS Term Loan provided that we had the right at any time to request incremental term loans up to the greater of (i) the excess, if any, of $25.0 million over the aggregate amount of all incremental Credit Facility commitments and incremental term loan commitments previously utilized, and (ii) such other amount so long as such amount at such time could be incurred without causing the pro forma consolidated secured leverage ratio to exceed 3.25 to 1.00. The interest rates per annum applicable to the loans under the CS Term Loan were based on a fluctuating rate of interest measured by reference to, at our election, either (i) LIBOR plus a 6.25% borrowing margin, or (ii) an alternative base rate plus a 5.25% borrowing margin. The CS Term Loan contained various representations and warranties, and restrictive covenants. In addition, we were required to comply with a maximum senior secured net leverage ratio of 5.00 to 1.00 beginning March 31, 2018, decreasing to 4.50 to 1.00 as of March 31, 2019, and further decreasing to 4.00 to 1.00 as of March 31, 2020 and thereafter. The principal amount of the CS Term Loan amortized at a rate of 7.5% per annum with all remaining outstanding amounts under the CS Term Loan due on the CS Term Loan maturity date. We received net proceeds from the IPO of $59.2 million prior to deducting offering expenses. We used these net proceeds to pay offering expenses and to pay off $40.0 million of the borrowings outstanding under the CS Term Loan, which would otherwise have been required through June 2020. The CS Term Loan had a maturity date of October 25, 2024; however, all amounts outstanding were repaid in September 2018 as a result of the refinancing discussed above. On September 21, 2018, we entered into the Syndicated Credit Facility, providing for a Term Loan with an initial commitment of $205.0 million. The proceeds from the Term Loan were used to repay amounts outstanding under the CS Term Loan. As of December 31, 2018, we had $202.4 million outstanding under the Term Loan. Syndicated Credit Facility On September 21, 2018, we entered into a credit agreement (the “Syndicated Credit Facility”) by and among us, the lenders party thereto from time to time, and Bank of America, N.A., as administrative agent. The Syndicated Credit Facility includes: •A revolving loan not to exceed $50.0 million (the “Revolving Loan”); •A term loan of $205.0 million (the “Term Loan”); and •A commitment to loan up to a further $25.0 million, which expires in March 2020. The interest rates per annum applicable to the loans under the Syndicated Credit Facility are based on a fluctuating rate of interest measured by reference to, at our election, either (i) the LIBOR rate, or (ii) an alternative base rate. Various margins are added to the interest rate based upon our consolidated net leverage ratio. Customary fees are payable in respect of the Syndicated Credit Facility and include (i) commitment fees (ranging from 0.25% to 0.35% based upon our consolidated net leverage ratio) for unused portions of the Syndicated Credit Facility, and (ii) fees on outstanding letters of credit (ranging from 1.30% to 2.10% based upon our consolidated net leverage ratio). Amounts borrowed under the Syndicated Credit Facility are secured by essentially all assets of the Company. The Syndicated Credit Facility contains various representations and warranties, and restrictive covenants that, among other things and subject to specified exceptions, restrict the ability of us and our restricted subsidiaries to grant liens, incur indebtedness (including guarantees), make investments, engage in mergers and acquisitions, make dispositions of assets, make restricted payments, or change the nature of our or our subsidiaries’ business. The Syndicated Credit Facility contains financial covenants related to the consolidated net leverage ratio and the fixed charge coverage ratio (of 1.20 to 1.00). We are required to comply with a consolidated net leverage ratio of 3.75 to 1.00 through March 30, 2020, decreasing to 3.50 to 1.00 as of March 31, 2020, further decreasing to 3.25 to 1.00 as of March 31, 2021, and finally decreasing to 3.00 to 1.00 as of March 31, 2022 and thereafter. The Syndicated Credit Facility also contains certain affirmative covenants, including reporting requirements (such as delivery of financial statements, certificates, and notices of certain events), maintaining insurance, and providing additional guarantees and collateral in certain circumstances. As of December 31, 2018, we were in compliance with all covenants related to the Syndicated Credit Facility. The Syndicated Credit Facility includes customary events of default, including non-payment of principal, interest, or fees, violation of covenants, inaccuracy of representations or warranties, cross default to certain other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests, material judgments, and change of control. The Revolving Loan provides a principal amount of up to $50.0 million reduced by outstanding letters of credit. As of December 31, 2018, $19.8 million was outstanding on the Revolving Loan and $12.5 million of letters of credit were outstanding. Equipment Financing Facilities We have entered into various equipment financing arrangements to finance the acquisition of certain equipment (the “Equipment Financing Facilities”). As of December 31, 2018, we had equipment lines of credit allowing borrowings of $22.0 million, of which $17.9 million was utilized. In addition, we had $17.2 million of equipment notes outstanding as of December 31, 2018. Each of the Equipment Financing Facilities include non-financial covenants, and, as of December 31, 2018, we were in compliance with all such covenants. Contractual and Commercial Commitments The following table summarizes our contractual obligations and commercial commitments as of December 31, 2018: (1) We lease equipment and office facilities under non-cancellable operating leases. (2) Uncertain tax positions, the purchase option liability, contingent payments for acquisitions, and the asset retirement obligation are not included in the table above because timing of such payments is uncertain. Non-GAAP Measures Adjusted EBITDA Adjusted EBITDA and Adjusted EBITDA margin are not financial measures determined in accordance with GAAP. We define Adjusted EBITDA as net income (loss) before interest expense, net, income taxes, depreciation and amortization, equity-based compensation, elimination of certain legacy expenses, amounts from a non-acquired business line, non-recurring legal and startup costs, and transaction related expenses and other items. Adjusted EBITDA margin represents the ratio of Adjusted EBITDA to total revenues (which for the year ended December 31, 2016 was less revenues ($5,045) of a non-acquired business line). We believe Adjusted EBITDA and Adjusted EBITDA margin are useful performance measures because they allow for an effective evaluation of our operating performance when compared to our peers, without regard to our financing methods or capital structure. We exclude the items listed above from net income in arriving at Adjusted EBITDA because these amounts are either non-recurring or can vary substantially within our industry depending upon accounting methods and book values of assets, capital structures and the method by which the assets were acquired. Adjusted EBITDA should not be considered as an alternative to, or more meaningful than, net income determined in accordance with GAAP. Certain items excluded from Adjusted EBITDA are significant components in understanding and assessing a company’s financial performance, such as a company’s cost of capital and tax structure, as well as the historic costs of depreciable assets, none of which are reflected in Adjusted EBITDA. Our presentation of Adjusted EBITDA should not be construed as an indication that our results will be unaffected by the items excluded from Adjusted EBITDA. Our computations of Adjusted EBITDA may not be identical to other similarly titled measures of other companies. We use Adjusted EBITDA margin to measure the success for our business in managing our cost base and improving profitability. The following tables present reconciliations of Adjusted EBITDA to net income (loss), our most directly comparable financial measure calculated and presented in accordance with GAAP, along with our Adjusted EBITDA margin. The successor columns below represent the consolidated financial information of Charah Solutions for the year ended December 31, 2018 and the combined financial information of Charah and Allied for the period from January 13, 2017 through December 31, 2017, and the predecessor column below represents the financial information of Charah for the period from January 1, 2017 through January 12, 2017, each as reflected in our audited financial statements included elsewhere herein. (1) Represents non-recurring legal costs and expenses, which amounts are not representative of those that we historically incur in the ordinary course of our business. (2) Represents non-recurring startup costs associated with the startup of Allied and our nuclear services offerings, including the setup of financial operations systems and modules, pre-contract expenses to obtain initial contracts, and the hiring of operational staff. Because these costs are associated with the initial setup of the Allied business to initiate the operations involved in our nuclear services offerings, these costs are non-recurring in the normal course of our business. (3) Primary components include a change in charitable giving and other business expense policies associated with the BCP investment. (4) Non-acquired business line item adjusts for a legacy operation of Charah that was transferred to a stockholder of CEP Holdings, Inc. in January 2017 prior to the BCP investment. (5) Adjusted EBITDA margin is a non-GAAP financial measure that represents the ratio of Adjusted EBITDA to total revenues (which for the year ended December 31, 2016 were less revenues ($5,045) of a non-acquired business line). We use Adjusted EBITDA margin to measure the success of our businesses in managing our cost base and improving profitability. Critical Accounting Policies and Estimates Our financial statements are prepared in accordance with GAAP. In connection with preparing our financial statements, we are required to make assumptions and estimates about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue, expense, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends and other factors that management believes to be relevant at the time we prepare our consolidated and combined financial statements. On a regular basis, management reviews the accounting policies, assumptions, estimates, and judgments to ensure that our consolidated combined financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ materially from our assumptions and estimates. Our significant accounting policies are discussed in our audited historical consolidated and combined financial statements included elsewhere herein. We believe that the Company’s primary critical accounting policy is its policy regarding accounting for long-term contracts. This policy is the most critical to fully understand and evaluate our reported financial results, and requires management’s most difficult, subjective, or complex judgments, resulting from the need to make estimates about the effect of matters that are inherently uncertain. Revenue and Cost Recognition on Construction Contracts Accounting for construction contracts involves management judgment in estimating total contract revenues and costs. Contract revenues are largely determined by negotiated contract prices and quantities, modified by our assumptions regarding contract options, change orders, and price adjustment clauses (such as inflation or index-based clauses). Contract costs are incurred over a period of time, which can be several years, and the estimation of these costs requires management judgment. Cost estimates are largely based on negotiated or estimated purchase contract terms, historical performance trends, and other economic projections. Significant factors that influence these estimates include inflationary trends, technical and schedule risk, internal and subcontractor performance trends, business volume assumptions, and asset utilization. We have a process in which management reviews the progress and performance of our contracts. As part of this process, management reviews information, including any outstanding key contract matters, progress toward completion and the related project timeline, and the related changes in estimates of revenues and costs. Anticipated losses on long-term contracts are recognized when such losses become evident. In 2018, we had an accrual of $0.7 million for anticipated losses on long-term contracts. Revenues from contract claims are recognized when invoiced. Revenues from contract change orders are recognized when it is probable that the change order will be approved, the amount can be reasonably estimated, and the work has been completed. The asset, “Costs and estimated earnings in excess of billings” represents revenues recognized in excess of amounts billed on uncompleted contracts. The liability, “Billings in excess of costs and estimated earnings” represents billings in excess of revenues recognized. Asset Acquisition and Business Combinations On January 13, 2017, Charah Management completed a transaction with BCP, a previously unrelated third party. The acquisition was accounted for under the acquisition method of accounting in accordance with Accounting Standards Codification (“ASC”) Topic 805, Business Combinations. The purchase price was allocated to the assets acquired and liabilities assumed based on the estimated fair value at the date of acquisition. By the application of “push-down” accounting, Charah’s assets, liabilities and equity were accordingly adjusted to fair value. The fair value estimates used reflect our best estimates for the highest and best use by market participants. On March 31, 2018, Charah Management completed a transaction with SCB and affiliated entities, a previously unrelated third party, pursuant to which Charah acquired certain assets and liabilities of SCB. The acquisition was accounted for under the acquisition method of accounting in accordance with ASC Topic 805, Business Combinations. The purchase price was allocated to the assets acquired and liabilities assumed based on the estimated fair value at the date of acquisition. For more information on the business combination, see Note 2 to our consolidated and combined financial statements included elsewhere herein. Determining the fair value of these items requires management’s judgment and the utilization of independent valuation experts and involves the use of significant estimates and assumptions with respect to the timing and amounts of future cash inflows and outflows, discount rates, market prices, and asset lives, among other items. The judgments made in the determination of the estimated fair value assigned to the assets acquired, the liabilities assumed, as well as the estimated useful life of each asset and the duration of each liability, can materially impact the consolidated and combined financial statements in periods after acquisition, such as through depreciation and amortization. Goodwill Goodwill represents the cost of an acquisition purchase price over the fair value of acquired net assets, and such amounts are reported separately as goodwill on our consolidated and combined balance sheets. Our total goodwill resulted from the application of “push-down” accounting associated with BCP’s January 2017 acquisition of a controlling equity position in Charah Management and the acquisition of certain assets and liabilities of SCB. Goodwill is not amortized, but instead is tested for impairment at least annually, as of October 1st of each year, or more often if events or circumstances indicate that goodwill might be impaired. Goodwill is tested at the reporting unit level. We may elect to perform a qualitative assessment for our reporting units to determine whether it is more likely than not that the fair value of the reporting unit is greater than its carrying value. If a qualitative assessment is not performed, or if as a result of a qualitative assessment it is not more likely than not that the fair value of a reporting unit exceeds its carrying value, then the reporting unit’s fair value is compared to its carrying value. Fair value is typically estimated using an income approach based on discounted cash flows. However, when appropriate, we may also use a market approach. The income approach is based on the long-term projected future cash flows of the reporting units. We discount the estimated cash flows to present value using a weighted average cost of capital that considers factors such as market assumptions, the timing of the cash flows, and the risks inherent in those cash flows. We believe that this approach is appropriate because it provides a fair value estimate based upon the reporting units’ expected long-term performance considering the economic and market conditions that generally affect our business. The market approach estimates fair value by measuring the aggregate market value of publicly traded companies with similar characteristics to our business as a multiple of their reported earnings. We then apply that multiple to the reporting units’ earnings to estimate their fair values. We believe that this approach may also be appropriate in certain circumstances because it provides a fair value estimate using valuation inputs from entities with operations and economic characteristics comparable to our reporting units. Fair value is computed using several factors, including projected future operating results, economic projections, anticipated future cash flows, comparable marketplace data, and the cost of capital. There are inherent uncertainties related to these factors and to our judgment in applying them in our analysis. However, we believe our methodology for estimating the fair value of our reporting units is reasonable. If the carrying value of a reporting unit exceeds its fair value, goodwill is written down to its implied fair value. The Company performed quantitative assessments of its Environmental Solutions and Maintenance and Technical Services reporting units as of October 1, 2018. The Environmental Solutions and Maintenance and Technical Services reporting units' fair values, as calculated, were approximately 7.0% and 130.1%, respectively, greater than their book values as of October 1, 2018. Recent Accounting Pronouncements Please see Note 2, “Summary of Significant Accounting Policies-Recently Adopted Accounting Pronouncements” and “Summary of Significant Accounting Policies-Recently Issued Accounting Pronouncements” to our historical consolidated and combined financial statements as of and for the years ended December 31, 2018 and 2017, included elsewhere herein, for a discussion of recent accounting pronouncements. Under the JOBS Act, we meet the definition of an “emerging growth company,” which allows us to have an extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act. We intend to take advantage of all of the reduced reporting requirements and exemptions, including the longer phase-in periods for the adoption of new or revised financial accounting standards under Section 107 of the JOBS Act until we are no longer an emerging growth company.

<s>[INST] Charah Solutions, Inc. Charah Solutions was formed in January 2018 and did not conduct any material business operations prior to the transactions described under “Initial Public Offering.” In connection with the closing of our initial public offering (the “IPO”), and pursuant to the terms and conditions of the master reorganization agreement, dated June 13, 2018, Charah Management and Allied Power Holdings, LLC, a Delaware limited liability company (“Allied Power Holdings”), became wholly owned subsidiaries of the Company. Through our ownership of Charah Management and Allied Power Holdings, we own the outstanding equity interests in Charah and Allied, the subsidiaries through which we operate our businesses. Overview We were formed in January 2018 in anticipation of the IPO to be a holding company for Charah Management and Allied Power Holdings. The historical financial data presented herein as of December 31, 2018 and for periods after the June 18, 2018 corporate reorganization is that of Charah and Allied on a consolidated basis, and on a combined basis for periods prior to the June 18, 2018 corporate reorganization. Allied was formed in May 2017 and did not commence operations until July 2017. We are a leading provider of missioncritical environmental and maintenance services to the power generation industry, enabling our customers to address challenges related to the remediation of ash ponds and landfills at open and closed power plant sites while continuously operating and providing necessary electric power to communities nationwide. We offer a suite of coal ash management and recycling, environmental remediation, and outage maintenance services. We also design and implement solutions for complex environmental projects (such as coal ash pond closures) and facilitate coal ash recycling through byproduct sales and other beneficial use services. We operate in over 20 states, resulting in an overall footprint and density in key markets that we believe is difficult to replicate. We are an environmental remediation and maintenance company and conduct our operations through two segments: Environmental Solutions and Maintenance and Technical Services. Environmental Solutions. Our Environmental Solutions segment includes remediation and compliance services, as well as byproduct sales offerings. Remediation and compliance services are associated with our customers’ need for multiyear environmental improvement and sustainability initiatives, whether driven by proactive engagement, by power generation customers, by regulatory requirements, or by consumer expectations and standards. Byproduct sales support both our power generation customers’ desire to profitably recycle recurring and historic volumes of CCRs and our ultimate end customers’ need for highquality, costeffective raw material substitutes. Maintenance and Technical Services. Our Maintenance and Technical Services segment includes fossil services and, from and after May 2017 when Allied was created, nuclear services. Fossil services are the recurring and missioncritical management of coal ash and the routine maintenance, outage services and staffing solutions for coalfired power generation facilities. Nuclear services, which we market under the Allied Power brand name, include routine maintenance, outage services, facility maintenance, and staffing solutions for nuclear power generation facilities. The Maintenance and Technical Services segment offerings are most closely associated with the ongoing operations of power plants, whether in the form of daily environmental management or required maintenance services (typically during planned outages). Initial Public Offering On June 18, 2018, we completed the IPO of 7,352,941 shares of the Company’s common stock, par value $0.01 per share. The net proceeds of the IPO to us prior to offering expenses were approximately $59.2 million. We used a portion of the IPO proceeds to pay off approximately $40.0 million of the borrowings outstanding under the Term Loan, and any remaining net proceeds were used to pay offering expenses or for general corporate purposes. How We Evaluate Our Operations We use a variety of financial and operational metrics to assess the performance of our operations, including: Revenues; Gross Profit; Operating Income; Adjusted EBITDA; and Adjusted EBITDA Margin. Revenues We analyze our revenues by comparing actual revenues to our internal projections for a given [/INST] Negative. </s>

Charah Solutions, Inc.

2020-03-27

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the historical financial statements and the related notes included in Part II Item 8. Financial Statements and Supplementary Data. The following Management Discussion and Analysis of Financial Condition and Results of Operations included in this report provides an analysis of our financial condition and results of operations and reasons for material changes therein for the year ended December 31, 2019 as compared to the year ended December 31, 2018 ("2018"). Discussion regarding our financial condition and results of operation for 2018 as compared to the year ended December 31, 2017 is included in Part II, Item 7 Management's Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for 2018 filed with the SEC on March 27, 2019. This discussion contains “forward-looking statements” reflecting our current expectations, estimates, and assumptions concerning events and financial trends that may affect our future operating results or financial position. Actual results and the timing of events may differ materially from those contained in these forward-looking statements due to a number of factors. Factors that could cause or contribute to such differences include, but are not limited to, capital expenditures, economic and competitive conditions, regulatory changes, and other uncertainties, as well as those factors discussed below and elsewhere herein. Please read Cautionary Note Regarding Forward-Looking Statements. Also, please read the risk factors and other cautionary statements described under “Item 1A. Risk Factors” included elsewhere herein. We assume no obligation to update any of these forward-looking statements. Charah Solutions, Inc. Charah Solutions, Inc. (together with its subsidiaries, “Charah Solutions,” the “Company,” “we,” “us” or “our”) was formed as a Delaware corporation in January 2018 in anticipation of the IPO to be a holding company for Charah Management and Allied Power Holdings. We did not conduct any material business operations before the transactions described below under “-Initial Public Offering” other than certain activities related to the initial public offering (the “IPO”), which was completed on June 18, 2018. In connection with the closing of the IPO and pursuant to the terms and conditions of the master reorganization agreement dated June 13, 2018, Charah Management LLC, a Delaware limited liability company (“Charah Management”), and Allied Power Holdings, LLC, a Delaware limited liability company (“Allied Power Holdings”), became our wholly owned subsidiaries. Through our ownership of Charah Management and Allied Power Holdings, we own the outstanding equity interests in Charah, LLC, a Delaware limited liability company (“Charah”) and Allied Power Management, LLC, a Delaware limited liability company (“Allied”), the subsidiaries through which we operate our businesses. Overview The historical financial data presented herein as of December 31, 2019 and for periods after the June 18, 2018 corporate reorganization is that of Charah Solutions, Inc. and its subsidiaries on a consolidated basis including Charah and Allied, and on a combined basis for periods prior to the June 18, 2018 corporate reorganization. Allied was formed in May 2017 and did not commence operations until July 2017. We are a leading provider of mission-critical environmental and maintenance services to the power generation industry. We offer a suite of coal ash management and recycling, environmental remediation, and utility plant outage-related maintenance services. We also design and implement solutions for complex environmental projects (such as coal ash pond closures) and facilitate coal ash recycling through byproduct sales and other beneficial use services. We believe we are a partner-of-choice for the power generation industry due to our quality, safety, domain experience, and compliance record, all of which are key criteria for our customers. In 2019, we performed work at more than 50 coal-fired and nuclear power generation sites nationwide. We are an environmental remediation and maintenance company and we conduct our operations through two segments: Environmental Solutions and Maintenance and Technical Services. Environmental Solutions. Our Environmental Solutions segment includes remediation and compliance services, as well as byproduct sales. Remediation and compliance services are associated with our customers’ need for multi-year environmental improvement and sustainability initiatives, whether driven by regulatory requirements, by power generation customers initiatives, by our proactive engagement or by consumer expectations and standards. Byproduct sales support both our power generation customers’ desire to recycle their recurring and legacy volumes of coal combustion residuals ("CCRs") commonly known as coal ash and our ultimate end customers’ need for high-quality, cost-effective raw material substitutes. Maintenance and Technical Services. Our Maintenance and Technical Services segment includes fossil services and, from and after May 2017 when Allied was created, nuclear services. Fossil services are the recurring and mission-critical management of coal ash and the routine maintenance, outage services and staffing solutions for coal-fired power generation facilities. Nuclear services, which we market under the Allied Power brand name, include routine maintenance, outage services, facility maintenance, and staffing solutions for nuclear power generation facilities. The Maintenance and Technical Services segment offerings are most closely associated with the ongoing operations of power plants, whether in the form of daily environmental management or required maintenance services (typically during planned outages). Initial Public Offering On June 18, 2018, we completed the IPO of 7,352,941 shares of the Company’s common stock, par value $0.01 per share. The net proceeds of the IPO to us prior to offering expenses were approximately $59.2 million. We used a portion of the IPO proceeds to pay off approximately $40.0 million of the borrowings outstanding under the Term Loan, and any remaining net proceeds were used to pay offering expenses or for general corporate purposes. How We Evaluate Our Operations We use a variety of financial and operational metrics to assess the performance of our operations, including: • Revenue; • Gross Profit; • Operating Income; • Adjusted EBITDA; and • Adjusted EBITDA Margin. Revenue We analyze our revenue by comparing actual revenue to our internal projections for a given period and to prior periods to assess our performance. We believe that revenue is a meaningful indicator of the demand and pricing for our services. Gross Profit We analyze our gross profit, which we define as revenue less cost of sales, to measure our financial performance. We believe gross profit is a meaningful metric because it provides insight on financial performance of our revenue streams without consideration of Company overhead. When analyzing gross profit, we compare actual gross profit to our internal projections for a given period and to prior periods to assess our performance. Operating Income We analyze our operating income, which we define as revenue less cost of sales and general and administrative expenses, to measure our financial performance. We believe operating income is a meaningful metric because it provides insight on profitability and operating performance based on the cost basis of our assets. We also compare operating income to our internal projections for a given period and to prior periods. Adjusted EBITDA and Adjusted EBITDA Margin We view Adjusted EBITDA and Adjusted EBITDA Margin, which are non-GAAP financial measures, as an important indicator of performance because they allow for an effective evaluation of our operating performance when compared to our peers, without regard to our financing methods or capital structure. We define Adjusted EBITDA as net (loss) income before interest expense, income taxes, depreciation and amortization, equity-based compensation, non-recurring legal costs and expenses and start-up costs, the Brickhaven contract deemed termination revenue reversal and transaction-related expenses and other items. Adjusted EBITDA margin represents the ratio of Adjusted EBITDA to total revenue. See “-Non-GAAP Financial Measures” below for more information and a reconciliation of Adjusted EBITDA to net (loss) income, the most directly comparable financial measure calculated and presented in accordance with GAAP. Key Factors Affecting Our Business and Financial Statements Ability to Capture New Contracts and Opportunities Our ability to grow revenue and earnings is dependent on maintaining and increasing our market share, renewing existing contracts, and obtaining additional contracts from proactive bidding on contracts with new and existing customers. We proactively work with existing customers ahead of contract end dates to attempt to secure contract renewals. We also leverage the embedded long-term nature of our customer relationships to obtain insight into and to capture new business opportunities across our platform. Seasonality of Business Based on historical trends, we expect our operating results to vary seasonally. Nuclear power generators perform turnaround and outages in the off-peak months when demand is lower and generation capacity is less constrained. As a result, our nuclear services offerings may have higher revenue volume in the spring and fall months. Variations in normal weather patterns can also cause changes in the consumption of energy, which may influence the demand and timing of associated services for our fossil services offerings. Inclement weather can impact construction-related activities associated with pond and landfill remediation, which affects the timing of revenue generation for our remediation and compliance services. Our byproduct sales are also impacted during winter months when the utilization of cement and cement products is generally lower. Project-Based Nature of Environmental Remediation Mandates We believe there is a significant pipeline of coal ash ponds and landfills that will require remediation and/or closure in the future. Due to their scale and complexity, these environmental remediation projects are typically completed over longer periods. As a result, our revenue from these projects can fluctuate over time. Some of our revenue from projects is recognized over time using the cost-to-cost input method of accounting for GAAP purposes, based primarily on contract costs incurred to date compared to total estimated contract costs. This method is the most accurate measure of our contract performance because it depicts the company’s performance in transferring control of goods or services promised to customers according to a reasonable measure of progress toward complete satisfaction of the performance obligation. The timing of revenue recorded for financial reporting purposes may differ from actual billings to customers, sometimes resulting in costs and billing in excess of actual revenue. Because of the risks in estimating gross profit margins for long-term jobs, actual results may differ from these estimates. Byproduct Recycling Market Dynamics There is a growing demand for recycled coal ash across a variety of applications driven by market forces and governmental regulations creating the need to dispose of coal ash in an environmentally sensitive manner. Pricing of byproduct sales is driven by supply and demand market dynamics as well as the chemical and physical properties of the ash. As demand increases for the end-products that use CCRs' (i.e., concrete for construction and infrastructure projects), the demand for recycled coal ash also typically rises. These fluctuations affect the relative demand for our byproduct sales. In recessionary periods, construction and infrastructure spending and the corresponding need for concrete may decline. However, this unfavorable effect may be partially offset by an increase in the demand for recycled coal ash during recessionary periods given that coal ash is more cost-effective than other alternatives. Power Generation Industry Spend on Environmental Liability Management and Regulatory Requirements The power generation industry has increased annual spending on environmental liability management. We believe this is the result of not only regulatory requirements and consumer pressure, but also the industry’s increasing focus on environmental stewardship. Continued increases in spending on environmental liability management by our customers should result in increased demand for services across our platform Cost Management and Capital Investment Efficiency Our main operating costs consist of labor, material and equipment costs and equipment maintenance. We maintain a focus on cost management and efficiency, including monitoring labor costs, both in terms of wage rates and headcount, along with other costs such as materials and equipment. We believe we maintain a disciplined approach to capital expenditure decisions, which are typically associated with specific contract requirements. Furthermore, we strive to extend the useful life of our equipment through the application of a well-planned routine maintenance program. How We Generate Revenue The Environmental Solutions segment generates revenue through our remediation and compliance services, as well as our byproduct sales. Our remediation and compliance services primarily consist of designing, constructing, managing, remediating and closing ash ponds and landfills on customer-owned sites. Our byproduct sales offerings include the recycling of recurring and contracted volumes of coal-fired power generation waste byproducts, such as bottom ash, fly ash and gypsum byproduct, each of which can be used for various industrial purposes. More than 90% of our services work is structured as time and materials, cost reimbursable or unit price contracts, which significantly reduces the risk of loss on contracts and provides gross margin visibility. Revenue from management contracts is recognized when the ash is hauled to the landfill or the management services are provided. Revenue from the sale of ash is recognized when it is delivered to the customer. Revenue from construction contracts is recognized using the cost-to-cost input method. The Maintenance and Technical Services segment generates revenue through our fossil services and nuclear services offerings. Maintenance and Technical Services segment offerings are most closely associated with the ongoing operations of power plants, whether in the form of daily environmental management or required maintenance services (typically during planned outages). Our fossil services offerings focus on recurring and mission-critical management of coal ash and routine maintenance, outage services and staffing solutions for coal-fired power generation facilities to fulfill the environmental service need of our customers in handling their waste byproducts. Over the last five years, our renewal rate for fossil services contracts has been approximately 90%. Our nuclear services operations, which we market under the Allied Power brand name, consist of a broad platform of mission-critical professional, technical and craft services spanning the entire asset life cycle of a nuclear power generator. The services are performed on the customer’s site and the contract terms typically range from three to five years. Revenue is billed and paid during the periods of time work is being executed. This combination of the maintenance and environmental-related services deepens customer connectivity and drives long-term relationships which we believe are critical for renewing existing contracts, winning incremental business from existing customers at new sites and adding new customers. Factors Impacting the Comparability of Results of Operations Public Company Costs We have incurred, and expect to continue to incur, incremental recurring and certain non-recurring costs related to our transition to a publicly-traded and taxable corporation, including the costs of the IPO and the costs associated with the initial implementation and testing of our Sarbanes-Oxley Section 404 internal controls. We also have incurred, and expect to incur, additional significant and recurring expenses as a publicly-traded company, including costs associated with the employment of additional personnel, compliance under the Exchange Act, annual and quarterly reports to security holders, registrar and transfer agent fees, national stock exchange fees, audit fees, incremental director and officer liability insurance costs, and director and officer compensation Income Taxes Charah Solutions is a “C” corporation under the Internal Revenue Code of 1986, as amended, and, as a result, is subject to U.S. federal, state and local income taxes. In connection with the IPO, Charah and Allied, which previously were flow-through entities for income tax purposes and were indirect subsidiaries of two partnerships, Charah Management and Allied Power Holdings, respectively, became indirect subsidiaries of Charah Solutions. Prior to the contribution, Charah and Allied passed through their taxable income to the owners of the partnerships for U.S. federal and other state and local income tax purposes and, thus, were not subject to U.S. federal income taxes or other state or local income taxes, except for franchise tax at the state level (at less than 1% of modified pre-tax earnings). Accordingly, the financial data attributable to Charah and Allied prior to the contribution on June 18, 2018 contains no provision for U.S. federal income taxes or income taxes in any state or locality other than franchise taxes. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 The table below sets forth our selected operating data for the years ended December 31, 2019 and 2018. Overview of Financial Results Delays in new work awards resulting from increased project scope and complexity, the $10.0 million revenue reversal associated with the Brickhaven contract payment (as discussed below) and unanticipated cost increases at three remediation sites led to our disappointing financial performance for the year ended December 31, 2019. As a result of long sales cycles, driven by the increase in the size, scope and complexity of remediation and compliance projects that we are bidding on, the volume of new awards in 2018 was not sufficient to offset the impact of projects completed during 2018 and 2019. The volume of new awards in 2019 on a project revenue basis, increased over those awarded in 2018. Due to project timing, however, the significant majority of revenue contributions from these new awards will be recognized in 2020 and beyond. As remediation and compliance projects have gotten larger and more complex, utility customers are seeking regulatory clarity as well as cost recovery through rate relief. Though this delay adversely impacted our 2019 results, we expect demand for our remediation and compliance services to grow as more than 1,000 ash ponds and landfills still require EPA-mandated closure or remediation. On May 29, 2019, the ash remediation contract for our Brickhaven location was deemed terminated, consistent with our previously communicated expectations. Per the terms of the Brickhaven contract, the customer was obligated to pay us for the recovery of project development costs, expected site closure costs, and post-maintenance costs upon deemed termination. After negotiations with the customer, the amount of the recovered costs was $80 million and the payment of these costs was received during the year ended December 31, 2019. We continue to believe our market opportunities remain strong and are growing as we have won approximately $583 million in new awards during the year ended December 31, 2019 as compared to $106 million in 2018. While the projects were awarded later than anticipated, as previously disclosed, our success rate in winning awards for the year ended December 31, 2019 on a project revenue basis was ahead of the year ended December 31, 2018. Compared to last year, projects awarded in 2018 were considerably smaller in size on the basis of revenue, which negatively impacted our financial results in 2019. We believe we are well-positioned to capture a significant portion of a large and growing addressable market, although the timing of future awards is difficult to determine. Furthermore, we believe recent regulatory developments in Illinois, Indiana, Kentucky, Missouri, North Carolina, Oklahoma, South Carolina and Virginia will have a positive impact on our business operations as states are becoming more prescriptive in their requirements to remediate ash ponds. Finally, customer interest in our MP618TM thermal beneficiation technology continues to be strong, and contracts with utility customers are currently under discussion. Our primary sources of liquidity and capital resources are cash flows generated by operating activities and borrowings under the Credit Facility (as defined below). In part due to longer sales cycles, driven by the increase in the size, scope and complexity of remediation and compliance projects that we are bidding on, we experienced unexpected contract initiation delays and project completion delays, particularly in 2019, which have adversely affected our revenue and overall liquidity. Our lengthy and complex projects require us to expend large sums of working capital, and delays in payment receipts, project commencement or project completion can adversely affect our financial position and the cash flows that normally would fund our expenditures. See “-Liquidity and Capital Resources-Our Debt Agreements-Existing Credit Facility” below for more information about the Credit Facility and the amendments thereto. Revenue. Revenue decreased $185.6 million, or 25.1%, for the year ended December 31, 2019, to $554.9 million as compared to $740.5 million for the year ended December 31, 2018, driven primarily by a decrease in revenue in the Environmental Solutions segment. The change in revenue by segment was as follows: Environmental Solutions Revenue. Environmental Solutions segment revenue decreased $162.7 million, or 47.4%, for the year ended December 31, 2019, to $180.4 million as compared to $343.1 million for the year ended December 31, 2018. The decrease in revenue was primarily attributable to remediation and compliance project completions including the completion of the Brickhaven project resulting from the deemed termination, the $10.0 million revenue reversal associated with the Brickhaven contract payment, and a decrease in the value of projects won in 2018, partially offset by an overall net increase in revenue from our byproduct sales. Maintenance and Technical Services Revenue. Maintenance and Technical Services segment revenue decreased $22.9 million, or 5.8%, for the year ended December 31, 2019, to $374.5 million as compared to $397.4 million for the year ended December 31, 2018. The decrease in revenue was primarily attributable to the reduced scope of nuclear outages services and fewer outages in the year ended December 31, 2019, partially offset by an overall net increase in revenue from our fossil services offerings. Gross Profit. Gross profit decreased $57.4 million, or 58.7%, for the year ended December 31, 2019 to $40.4 million as compared to $97.7 million for the year ended December 31, 2018, driven primarily by a decrease in revenue. As a percentage of revenue, gross profit was 7.3% and 13.2% for the year ended December 31, 2019 and 2018, respectively. The change in gross profit by segment was as follows: Environmental Solutions Gross Profit. Gross profit for our Environmental Solutions segment decreased $58.0 million, or 83.5%, for the year ended December 31, 2019, to $11.5 million as compared to $69.5 million for the year ended December 31, 2018. The decrease in gross profit was primarily driven by remediation and compliance project completions, the $10.0 million revenue reversal associated with the deemed termination of the Brickhaven contract, adverse weather-related impacts and site-specific issues at three remediation sites which resulted in higher than expected costs. Maintenance and Technical Services Gross Profit. Gross profit for our Maintenance and Technical Services segment increased $0.6 million, or 2.2%, for the year ended December 31, 2019, to $28.9 million as compared to $28.3 million for the year ended December 31, 2018. The increase in gross profit overall was primarily attributable to a net increase in gross profit from our fossil services offerings. General and Administrative Expenses. General and administrative expenses decreased $15.9 million, or 20.7%, for the year ended December 31, 2019, to $60.9 million as compared to $76.8 million for the year ended December 31, 2018. The decrease was primarily attributable to a reduction in non-recurring legal costs and expenses, including $20.0 million in reserves incurred in the year ended December 31, 2018, related to legal proceedings during that period, non-recurring start-up costs and equity-based compensation, partially offset by increased expenses due to the acquisition of SCB Materials International, Inc. and affiliated entities (“SCB”) in March 2018, increased transaction-related expenses during the year ended December 31, 2019 associated with an amendment to the Credit Facility and a decrease in amortization expense during the year ended December 31, 2019 related to our purchase option liability. Interest Expense, Net. Interest expense, net decreased $15.4 million, or 47.8%, for the year ended December 31, 2019, to $16.8 million as compared to $32.2 million for the year ended December 31, 2018. The decrease was primarily attributable to a favorable comparison as $12.5 million of costs were incurred in conjunction with the refinancing of our debt during the year ended December 31, 2018, consisting of a $10.4 million non-cash write-off of debt issuance costs and a $2.1 million prepayment penalty, and a reduction in the debt balances using cash received from the Brickhaven deemed termination payment received during the year ended December 31, 2019. These decreases were partially offset by an increase in the mark-to-market expense associated with the change in the fair value of our interest rate swap. Income from Equity Method Investment. Income from equity method investment decreased $0.1 million, or 4.7%, for the year ended December 31, 2019, to $2.3 million as compared to $2.4 million for the year ended December 31, 2018. The slight decrease period-over-period was primarily attributable to a reduction in ash volumes generated by the utility and available for sale by us. Income tax expense (benefit) Income tax expense increased by $6.6 million for the year ended December 31, 2019, to income tax expense of $4.2 million as compared to an income tax benefit of $2.4 million during the year ended December 31, 2018. Based on the available evidence as of December 31, 2019, we were not able to conclude it was more likely than not certain deferred tax assets will be realized. Therefore, a valuation allowance of $12.9 million was recorded against our deferred tax assets. The valuation allowance was partially offset by an income tax benefit associated with the increase in our loss before taxes. Net Loss. Net loss increased $32.8 million for the year ended December 31, 2019, to a loss of $39.2 million as compared to $6.4 million for the year ended December 31, 2018. The increase was primarily attributable to lower gross profit resulting from lower revenue, and an increase in income tax expense, partially offset by the decrease in general and administrative expenses and interest expense, net as discussed above. Consolidated Balance Sheet The following table is a summary of our overall financial position: Assets Total assets decreased $103.1 million driven primarily by a decrease in contract assets from the $80.0 million Brickhaven deemed termination payment received during 2019, a $11.0 million decrease in inventory from improved inventory management, a $8.4 million decrease in intangible assets, net due to amortization, and a $3.6 million decrease in property and equipment, net as depreciation expense and disposal of assets exceeded new additions. Liabilities Total liabilities decreased $63.0 million driven by a $49.5 million net decrease in notes payable and amounts owed under the Revolving Loan (as defined below) as proceeds from the Brickhaven deemed termination payment were used to pay down our debt balances, a $10.9 million decrease in our asset retirement obligation associated with our maintenance and monitoring requirement payments and a $2.9 million decrease in our purchase option liability from amortization. Stockholders' Equity Total stockholders' equity decreased $40.1 million driven primarily by the $39.2 million net loss, a $0.4 million decrease as a result of the adoption of Accounting Standards Codification (“ASC”) 606, Revenue from Contracts with Customers, a decrease of $2.9 million related to distributions to our non-controlling interest, partially offset by an increase of $2.5 million in share-based compensation. Liquidity and Capital Resources Our primary sources of liquidity and capital resources are cash flows generated by operating activities and borrowings under the Credit Facility. In part due to longer sales cycles, driven by the increase in the size, scope and complexity of remediation and compliance projects that we are bidding on, we have experienced unexpected contract initiation delays and project completion delays which have adversely affected our revenue and overall liquidity. Our lengthy and complex projects require us to expend large sums of working capital, and delays in payment receipts, project commencement or project completion can adversely affect our financial position and the cash flows that normally would fund our expenditures. As of December 31, 2019, we had total liquidity of approximately $28.9 million, comprised of $4.9 million of cash on hand, $19.0 million availability under the Revolving Loan and $5.0 million of delayed draw availability under the Term Loan. Cash Flows Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Operating Activities Net cash provided by (used in) operating activities increased $82.3 million for the year ended December 31, 2019, to $68.7 million of net cash provided by operating activities as compared to $13.6 million of net cash used in operating activities for the year ended December 31, 2018. The change in cash flows provided by (used in) operating activities was primarily attributable to the $80.0 million Brickhaven deemed termination payment received during the year ended December 31, 2019, a decrease of $10.8 million in cash paid for interest due to the debt refinancing during the year ended December 31, 2018, a decrease in cash paid for income taxes during the year ended December 31, 2019 of $5 million and improvements in working capital items from the year-over-year change in inventory of $16.8 million. These decreases were partially offset by an increase in net loss of $33.2 million. Investing Activities Net cash used in investing activities decreased $24.6 million for the year ended December 31, 2019, to $15.8 million as compared to $40.4 million for the year ended December 31, 2018. The change in cash flows used in investing activities was primarily attributable to $20.0 million used for business acquisitions during the year ended December 31, 2018, net of cash received, and a decrease in capital expenditures, net of proceeds, of $4.6 million. Financing Activities Net cash (used in) provided by financing activities increased $82.3 million for the year ended December 31, 2019, to $54 million of net cash used in financing activities as compared to $28.6 million of net cash provided by financing activities for the year ended December 31, 2018. The change in cash flows (used in) provided by financing activities was primarily attributable to the $59.2 million in proceeds received during the year ended December 31, 2018 from the issuance of common stock resulting from our IPO. In addition, there was a net increase of $30.5 million in debt related payments during the year ended December 31, 2019. These decreases were partially offset by a $7.5 million reduction in debt and IPO related costs as $1.4 million was paid during the year ended December 31, 2019 as compared to $8.9 million paid during the year ended December 31, 2018. Working Capital Our working capital, which we define as total current assets less total current liabilities, totaled a working capital deficit of $16.1 million and working capital of $74.1 million as of December 31, 2019 and 2018, respectively. This decrease in net working capital for the year ended December 31, 2019 was primarily due to decreases in contract assets from the Brickhaven deemed termination, decreases in inventory resulting from the timing of activities between periods and improved inventory management and increases in notes payable, current maturities, related to the Third Amendment (as discussed below). Our Debt Agreements Former Credit Agreement On October 25, 2017, we entered into a credit agreement (the “2017 Credit Agreement”) by and among us, the lenders party thereto from time to time and Regions Bank, as administrative agent. The 2017 Credit Agreement provided for a revolving credit facility (the “2017 Credit Facility”) with a principal amount of up to $45.0 million. The 2017 Credit Facility permitted extensions of credit up to the lesser of $45.0 million and a borrowing base that was calculated by us based upon a percentage of the value of our eligible accounts receivable and eligible inventory and approved by the administrative agent. The interest rates per annum applicable to the loans under the 2017 Credit Facility were based on a fluctuating rate of interest measured by reference to, at our election, either (i) an adjusted London Inter-bank Offered Rate (“LIBOR”) plus a 2.00% borrowing margin or (ii) an alternative base rate plus a 1.00% borrowing margin. Customary fees were payable in respect of the 2017 Credit Facility and included (a) commitment fees in an amount equal to 0.50% of the daily unused portions of the 2017 Credit Facility and (b) a 2.00% fee on outstanding letters of credit. The 2017 Credit Facility contained various representations and warranties and restrictive covenants. If excess availability under the 2017 Credit Facility fell below the greater of 15% of the loan cap amount or $6.75 million, we were required to comply with a minimum fixed charge coverage ratio of 1.0 to 1.0. The 2017 Credit Facility did not otherwise contain financial maintenance covenants. The 2017 Credit Facility had a scheduled maturity date of October 25, 2022; however, all amounts outstanding were repaid in September 2018 as a result of the refinancing discussed below. Former CS Term Loan On October 25, 2017, we entered into a credit agreement by and among us, the lenders party thereto from time to time and Credit Suisse AG, Cayman Islands Branch, as administrative agent, providing for a term loan (the “2017 CS Term Loan”) with an initial commitment of $250.0 million. The 2017 CS Term Loan provided that we had the right at any time to request incremental term loans up to the greater of (i) the excess, if any, of $25.0 million over the aggregate amount of all incremental 2017 Credit Facility commitments and incremental 2017 CS Term Loan commitments previously utilized and (ii) such other amount so long as such amount at such time could be incurred without causing the pro forma consolidated secured leverage ratio (as defined in the credit agreement governing the 2017 CS Term Loan) to exceed 3.25 to 1.00. The interest rates per annum applicable to the loans under the 2017 CS Term Loan were based on a fluctuating rate of interest measured by reference to, at our election, either (i) LIBOR plus a 6.25% borrowing margin or (ii) an alternative base rate plus a 5.25% borrowing margin. The 2017 CS Term Loan contained various customary representations and warranties and restrictive covenants. In addition, we were required to comply with a maximum senior secured net leverage ratio of 5.00 to 1.00 beginning March 31, 2018, decreasing to 4.50 to 1.00 as of March 31, 2019, and further decreasing to 4.00 to 1.00 as of March 31, 2020 and thereafter. The principal amount of the 2017 CS Term Loan amortized at a rate of 7.5% per annum with all remaining outstanding amounts under the 2017 CS Term Loan due on the 2017 CS Term Loan maturity date. We received net proceeds from the IPO of $59.2 million prior to deducting offering expenses. We used these net proceeds to pay offering expenses and to pay off $40.0 million of the borrowings outstanding under the 2017 CS Term Loan, which would otherwise have been required in June 2020. The 2017 CS Term Loan had a scheduled maturity date of October 25, 2024; however, all amounts outstanding were repaid in September 2018 as a result of the refinancing discussed below. Existing Credit Facility On September 21, 2018, we entered into a credit agreement (the “Credit Facility”) by and among us, the lenders party thereto from time to time, and Bank of America, N.A., as administrative agent (the “Administrative Agent”). The Credit Facility includes: • A revolving loan not to exceed $50.0 million (the “Revolving Loan”); • A term loan of $205.0 million (the “Closing Date Term Loan”); and • A commitment to loan up to a further $25.0 million, which expires in March 2020 (the “Delayed Draw Commitment” and the term loans funded under such Delayed Draw Commitment, the “Delayed Draw Term Loan,” together with the Closing Date Term Loan, the “Term Loan”). After the Third Amendment all amounts associated with the Revolving Loan and the Term Loan under the Credit Facility will mature in July 2022, as discussed more fully below. The interest rates per annum applicable to the loans under the Credit Facility are based on a fluctuating rate of interest measured by reference to, at our election, either (i) the Eurodollar rate, currently LIBOR, or (ii) an alternative base rate. Various margins are added to the interest rate based upon our consolidated net leverage ratio (as defined in the Credit Facility). Customary fees are payable in respect of the Credit Facility and include (i) commitment fees for the unused portions of the Credit Facility and (ii) fees on outstanding letters of credit. Amounts borrowed under the Credit Facility are secured by substantially all of the assets of the Company. The Credit Facility contains various customary representations and warranties, and restrictive covenants that, among other things and subject to specified exceptions, restrict the ability of us and our restricted subsidiaries to grant liens, incur indebtedness (including guarantees), make investments, engage in mergers and acquisitions, make dispositions of assets, make restricted payments or change the nature of our or our subsidiaries' business. The Credit Facility contains financial covenants related to the consolidated net leverage ratio and the fixed charge coverage ratio (as defined in the Credit Facility), which have been modified as described below. The Credit Facility also contains certain affirmative covenants, including reporting requirements, such as the delivery of financial statements, certificates and notices of certain events, maintaining insurance and providing additional guarantees and collateral in certain circumstances. The Credit Facility includes customary events of default, including non-payment of principal, interest or fees as they come due, violation of covenants, inaccuracy of representations or warranties, cross-default to certain other material indebtedness, bankruptcy and insolvency events, invalidity or impairment of guarantees or security interests, material judgments and change of control. The Revolving Loan provides a principal amount of up to $50.0 million, reduced by outstanding letters of credit. As of December 31, 2019, $19.0 million was outstanding on the Revolving Loan and $12.0 million in letters of credit were outstanding. But for Amendment No. 2 to Credit Agreement and Waiver (the “Second Amendment”), as of June 30, 2019, we would not have been in compliance with the requirement to maintain a consolidated net leverage ratio of 3.75 to 1.00 under the Credit Facility. On August 13, 2019, we entered into the Second Amendment, pursuant to which, among other things, the required lenders agreed to waive such non-compliance. In addition, pursuant to the terms of the Second Amendment, the Credit Facility was amended to revise the required financial covenant ratios, which have been modified as described below. As consideration for these accommodations, we agreed that amounts borrowed pursuant to the Delayed Draw Commitment would not exceed $15.0 million at any one time outstanding (without reducing the overall Delayed Draw Commitment amount). Further, the margin of interest charged on all outstanding loans was increased to 4.00% for loans based on LIBOR and 3.00% for loans based on the alternative base rate. The Second Amendment revised the amount of (i) the commitment fees to 0.35% at all times for the unused portions of the Credit Facility and (ii) fees on outstanding letters of credit to 3.35% at all times. The Second Amendment also added a requirement to make two additional scheduled prepayments of outstanding loans under the Credit Facility, including a payment of $50.0 million on or before September 13, 2019 and an additional payment of $40.0 million on or before March 31, 2020. The $50.0 million payment was made before September 13, 2019, using proceeds of the Brickhaven deemed termination payment. The Second Amendment also included revisions to the restrictive covenants, including removing certain exceptions to the restrictions on our ability to make acquisitions, to make investments and to make dividends or other distributions. After giving effect to the Second Amendment, we will not be permitted to make any distributions or dividends to our stockholders without the consent of the required lenders. After the end of our fiscal year, ended December 31, 2019, in March 2020, the Company entered into Amendment No. 3 to Credit Agreement (the “Third Amendment”). Pursuant to the terms of the Third Amendment, the Credit Facility was amended to waive the mandatory $40.0 million prepayment due on or before March 31, 2020, and to revise the required financial covenant ratios such that, after giving effect to the Third Amendment, we are not required to comply with any financial covenants through December 30, 2020. After December 30, 2020, we will be required to comply with a maximum consolidated net leverage ratio of 6.50 to 1.00 from December 31, 2020 through June 29, 2021, decreasing to 6.00 to 1.00 from June 30, 2021 through December 30, 2021, and to 3.50 to 1.00 as of December 31, 2021 and thereafter. After giving effect to the Third Amendment, we will also be required to comply with a minimum fixed charge coverage ratio of 1.00 to 1.00 as of December 31, 2020, increasing to 1.20 to 1.00 as of March 31, 2021 and thereafter. In the event that we are unable to comply in the future with such financial covenants upon delivery of our financial statements pursuant to the terms of the Credit Facility, an Event of Default (as defined in the Credit Facility) will have occurred and the Administrative Agent can then, following a specified cure period, declare the unpaid principal amount of all outstanding loans, all interest accrued and unpaid thereon, and all other amounts payable to be immediately due and payable by the Company. The Third Amendment increased the maximum amount available to be borrowed pursuant to the Delayed Draw Commitment from $15.0 million to $25.0 million, subject to certain quarterly amortization payments. The Third Amendment also included revisions to the restrictive covenants, including increasing the amount of indebtedness that the Company may incur in respect of certain capitalized leases from $50.0 million to $75.0 million. Under the Third Amendment, the Company has agreed to make monthly amortization payments in respect of term loans beginning in April 2020, and to move the maturity date for all loans under the Credit Agreement to July 31, 2022 (the “Maturity Date”). In addition, if at any time after August 13, 2019, the outstanding principal amount of the Delayed Draw Term Loans exceeds $10.0 million, we will incur additional interest at a rate equal to 10.0% per annum on all daily average amounts exceeding $10.0 million payable at March 31, 2020 and the Maturity Date. Further, the Third Amendment requires mandatory prepayments of revolving loans with any cash held by the Company in excess of $10.0 million, which excludes the amount of proceeds received in respect of the Preferred Stock Offering (as defined below) to the extent such funds are used for liquidity and general corporate purposes. The Company has also agreed to an increase of four percent (4%) to the interest rate applicable to the Closing Date Term Loan that will be compounded monthly and paid in kind by adding such portion to the outstanding principal amount. As a condition to entering into the Second Amendment, we are required to pay the Administrative Agent an amendment fee (the “Second Amendment Fee”) in an amount equal to 1.50% of the total credit exposure under the Credit Agreement, immediately prior to the effectiveness of the Second Amendment. Of the Second Amendment Fee, 0.50% was due and paid on October 15, 2019, and 1.00% of such Second Amendment Fee will become due and payable on August 16, 2020 if the facility has not been terminated on or prior to August 15, 2020. We are also required to pay the Administrative Agent an amendment fee associated with the Third Amendment (the “Third Amendment Fee”) in an amount equal to 0.20% of the total credit exposure under the Credit Agreement, immediately prior to the effectiveness of the Third Amendment, with such Third Amendment Fee being due and payable on June 30, 2020. Finally, we will also pay an additional fee with respect to the Third Amendment in the amount of $2.0 million with such fee being due and payable on the Maturity Date; provided that if the facility is terminated by December 31, 2020, 50% of this fee shall be waived. As a condition to the Third Amendment, the Company entered into an agreement with an investment fund affiliated with Bernhard Capital Partners Management, LP ("BCP " or the “Holder”) to sell 26,000 shares of Series A Preferred Stock, par value $0.01 (the “Preferred Stock”) for approximately $25.2 million in a private placement (the “Preferred Stock Offering”). The Preferred Stock will have an initial liquidation preference of $1,000 per share and will pay a dividend at the rate of 10% per annum in cash, or 13% if the Company elects to pay dividends in kind by adding such amount to the liquidation preference. The Company’s intention is to pay dividends in kind for the foreseeable future. Proceeds from the Preferred Stock Offering will be used for liquidity and general corporate purposes. Following the three-month anniversary of the date of issuance, the Preferred Stock may be converted at the option of the holders into shares of the Company’s common stock at a conversion price of $2.77 per share (the “Conversion Price”), which represents a 30% premium to the 20-day volume-weighted average price ended March 4, 2020. Following the third anniversary of the date of issuance, the Company may, subject to certain requirements, give notice to the holders of the Preferred Stock of the Company’s intent to mandatorily convert the Preferred Stock, and the holders of the Preferred Stock will have the option to either agree to such conversion or force the Company to redeem the Preferred Stock for cash. Following the seven-year anniversary of the date of issuance, the holders shall have the right, subject to applicable law, to require the Company at any time to redeem the Preferred Stock, in whole or in part, from any source of funds legally available for such purpose. In connection with certain change of control transactions, the holders of the Preferred Stock will be entitled to cause the Company to repurchase the Preferred Stock for cash in an amount equal to the greater of (i) the liquidation preference plus accrued and unpaid dividends (plus, a make-whole premium equal to the net present value of dividend payments through the third anniversary of the issue date, for any transaction occurring prior to such date, subject to certain limitations) and (ii) the amount each holder would be entitled to receive if the Preferred Stock were converted prior to such transaction. The Company will have the right to redeem the Preferred Stock starting on the third anniversary of the issue date at the greater of (i) the closing sale price multiplied by the number of shares of common stock issuable upon conversion and (ii) certain premiums to the liquidation preference that will decrease each year following the third anniversary of the issuance date. From April 5, 2020, until conversion, the holders of the Preferred Stock will vote together with Company’s common stock on an as-converted basis and will also have rights to vote on certain matters impacting the Preferred Stock. After April 5, 2020, the holders of the Preferred Stock will have the right to either elect one member to the Company’s board of directors or appoint one non-voting board observer. Equipment Financing Facilities We have entered into various equipment financing arrangements to finance the acquisition of certain equipment (the “Equipment Financing Facilities”). As of December 31, 2019, we had $36.3 million of equipment notes outstanding. Each of the Equipment Financing Facilities include non-financial covenants, and, as of December 31, 2019, we were in compliance with all such covenants. Contractual and Commercial Commitments The following table summarizes our contractual obligations and commercial commitments as of December 31, 2019 and reflects the waiver of the mandatory $40.0 million prepayment due on or before March 31, 2020 and the new payment terms noted in the Third Amendment: (1) We lease equipment and office facilities under non-cancellable operating leases. (2) Represents minimum fees required that are not contingent upon potential changes to the Maturity Date. (3) Contingent payments for acquisitions and the asset retirement obligation are not included in the table above because the timing of such payments is uncertain. There are no uncertain tax positions. Non-GAAP Financial Measures Adjusted EBITDA Adjusted EBITDA and Adjusted EBITDA margin are not financial measures determined in accordance with GAAP. We define Adjusted EBITDA as net (loss) income before interest expense, income taxes, depreciation and amortization, equity-based compensation, non-recurring legal costs and expenses and start-up costs, the Brickhaven contract deemed termination revenue reversal, and transaction-related expenses and other items. Adjusted EBITDA margin represents the ratio of Adjusted EBITDA to total revenue. We believe Adjusted EBITDA and Adjusted EBITDA margin are useful performance measures because they allow for an effective evaluation of our operating performance when compared to our peers, without regard to our financing methods or capital structure. We exclude the items listed above from net (loss) income in arriving at Adjusted EBITDA because these amounts are either non-recurring or can vary substantially within our industry depending upon accounting methods and book values of assets, capital structures and the method by which the assets were acquired. Adjusted EBITDA should not be considered as an alternative to, or more meaningful than, net (loss) income determined in accordance with GAAP. Certain items excluded from Adjusted EBITDA are significant components in understanding and assessing a company’s financial performance, such as a company’s cost of capital and tax structure, as well as the historic costs of depreciable assets, none of which are reflected in Adjusted EBITDA. Our presentation of Adjusted EBITDA should not be construed as an indication that our results will be unaffected by the items excluded from Adjusted EBITDA. Our computations of Adjusted EBITDA may not be identical to other similarly titled measures of other companies. We use Adjusted EBITDA margin to measure the success of our business in managing our cost base and improving profitability. The following table presents a reconciliation of Adjusted EBITDA to net (loss) income, our most directly comparable financial measure calculated and presented in accordance with GAAP, along with our Adjusted EBITDA margin. The successor columns below represent the consolidated financial information of Charah Solutions for the years ended December 31, 2019 and 2018 and the combined financial information of Charah and Allied for the period from January 13, 2017 through December 31, 2017, and the predecessor column below represents the financial information of Charah for the period from January 1, 2017, through January 12, 2017, each as reflected in our audited financial statements included elsewhere herein. (1) Represents non-recurring legal costs and expenses, which amounts are not representative of those that we historically incur in the ordinary course of our business. Negative amounts represent insurance recoveries related to these matters. (2) Represents non-recurring start-up costs associated with the start-up of Allied and our nuclear services offerings, including the setup of financial operations systems and modules, pre-contract expenses to obtain initial contracts, and the hiring of operational staff. Because these costs are associated with the initial setup of the Allied business to initiate the operations involved in our nuclear services offerings, these costs are non-recurring in the normal course of our business. (3) Represents SCB transaction expenses, executive severance costs, IPO-related costs, expenses associated with the Amendment to the Credit Facility and other miscellaneous items. (4) Adjusted EBITDA margin is a non-GAAP financial measure that represents the ratio of Adjusted EBITDA to total revenue. We use Adjusted EBITDA margin to measure the success of our businesses in managing our cost base and improving profitability. Critical Accounting Policies and Estimates Our financial statements are prepared in accordance with GAAP. In connection with preparing our financial statements, we are required to make assumptions and estimates about future events, and apply judgments that affect the reported amounts of assets, liabilities, revenue, expense, and the related disclosures. We base our assumptions, estimates, and judgments on historical experience, current trends and other factors that management believes to be relevant at the time we prepare our consolidated and combined financial statements. On a regular basis, management reviews the accounting policies, assumptions, estimates, and judgments to ensure that our consolidated combined financial statements are presented fairly and in accordance with GAAP. However, because future events and their effects cannot be determined with certainty, actual results could differ materially from our assumptions and estimates. Our significant accounting policies are described in Note 2 to our consolidated and combined financial statements included herein. Our critical accounting policies are described below to provide a better understanding of our estimates and assumptions about future events that affect the amounts reported in the consolidated and combined financial statements and accompanying notes. Significant accounting estimates are important to the representation of our financial position and results of operations and involve our most difficult, subjective or complex judgments. We base our estimates on historical experience and on various other assumptions we believe to be reasonable according to the current facts and circumstances through the date of the issuance of our financial statements. Revenue We adopted Accounting Standards Codification Topic 606: Revenue from Contracts with Customers ("ASC 606") on January 1, 2019. Accordingly, we revised our accounting policy on revenue recognition from the policy provided in the notes to our consolidated and combined financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2018. Our revised accounting policy on revenue recognition is provided in Note 2 to our consolidated and combined financial statements for the year ended December 31, 2019 contained herein. To determine revenue recognition for contracts, we evaluate whether two or more contracts should be combined and accounted for as one single contract and whether the combined or single contract should be accounted for as more than one performance obligation. This evaluation requires significant judgment and the decision to combine a group of contracts or separate a combined or single contract into multiple performance obligations could change the amount of revenue and profit recorded in a given period. Contracts are considered to have a single performance obligation if the promise to transfer the individual goods or services is not separately identifiable from other promises in the contracts primarily because we provide a service that involves multiple inter-related and integrated tasks to achieve the completion of a specific, single project. For contracts with multiple performance obligations, we allocate the transaction price to each performance obligation using our best estimate of the stand-alone selling price of each distinct good or service in the contract. For sales and service contracts where we have the right to consideration from the customer in an amount that corresponds directly with the value received by the customer based on our performance to date, revenue is recognized at a point in time when services are performed and contractually billable. Certain service contracts contain provisions dictating fluctuating rates per unit for the certain services in which the rates are not directly related to changes in the Company’s effort to perform under the contract. We recognize revenue based on the stand-alone selling price per unit for such contracts, calculated as the average rate per unit over the term of those contractual rates. This creates a contract asset or liability for the difference between the revenue recognized and the amount billed to the customer. Under the typical payment terms of our services contracts, amounts are billed as work progresses in accordance with agreed-upon contractual terms, at periodic intervals (e.g., weekly, biweekly or monthly). We recognize revenue over time, as performance obligations are satisfied, for substantially all of our construction contracts due to the continuous transfer of control to the customer. For most of our construction contracts, the customer contracts with us to provide a service that involves multiple inter-related and integrated tasks to achieve the completion of a specific, single project and are therefore accounted for as a single performance obligation. We recognize revenue using the cost-to-cost input method, based primarily on contract costs incurred to date compared to total estimated contract costs. This method is the most accurate measure of our contract performance because it depicts the company’s performance in transferring control of goods or services promised to customers according to a reasonable measure of progress toward complete satisfaction of the performance obligation. Contract costs include all direct material, labor and subcontractor costs and indirect costs related to contract performance. For costs incurred that do not relate directly to transferring a service to the customer, they are excluded from the input method used to recognize revenue. Project mobilization costs are generally charged to the project as incurred when they are an integrated part of the performance obligation being transferred to the client. Pre-contract costs are expensed as incurred unless they are expected to be recovered from the client. It is common for our contracts to contain contract provisions that give rise to variable consideration such as unpriced change orders or volume discounts that may either increase or decrease the transaction price. We estimate the amount of variable consideration at the expected value or most likely amount, depending on which is determined to be more predictive of the amount to which the Company will be entitled. Variable consideration is included in the transaction price when it is probable that a significant reversal of cumulative revenue recognized will not occur or when the uncertainty associated with the variable consideration is resolved. Our estimates of variable consideration and determination of whether to include such amounts in the transaction price are based largely on our assessment of legal enforceability, anticipated performance, industry business practices, and any other information (historical, current or forecasted) that is reasonably available to us. Variable consideration associated with unapproved change orders is included in the transaction price only to the extent of costs incurred. We provide limited warranties to customers for work performed under our contracts. Such warranties are not sold separately, provide assurance that the services comply with the agreed-upon specifications and legal requirements and do not provide customers with a service in addition to assurance of compliance with agreed-upon specifications. Accordingly, these types of warranties are not considered to be separate performance obligations. Historically, warranty claims have not resulted in material costs incurred by the Company. Due to the nature of the work required to be performed on many of our performance obligations, the estimation of total revenue and cost at completion is complex, subject to many variables and requires significant judgment. As a significant change in one or more of these estimates could affect the profitability of our contracts, we routinely review and update our contract-related estimates through a disciplined project review process in which management reviews the progress and execution of our performance obligations and the estimated costs at completion. As part of this process, management reviews information including, but not limited to, outstanding contract matters, progress towards completion, program schedule and the associated changes in estimates of revenue and costs. Management must make assumptions and estimates regarding the availability and productivity of labor, the complexity of the work to be performed, the availability and cost of materials, the performance of subcontractors, and the availability and timing of funding from the customer, along with other risks inherent in performing services under all contracts where we recognize revenue over-time using the cost-to-cost method. We recognize changes in contract estimates on a cumulative catch-up basis in the period in which the changes are identified. Such changes in contract estimates can result in the recognition of revenue in a current period for performance obligations which were satisfied or partially satisfied in prior periods. Changes in contract estimates may also result in the reversal of previously recognized revenue if the current estimate differs from the previous estimate. If at any time the estimate of contract profitability indicates an anticipated loss on the contract, we recognize the total loss in the period it is identified. Contracts are often modified to account for changes in contract specifications and requirements. Most of our contract modifications are for goods or services that are not distinct from existing contracts due to the significant integration provided in the context of the contract and are accounted for as if they were part of the original contract. The effect of a contract modification on the transaction price and our measure of progress for the performance obligation to which it relates, is recognized as an adjustment to revenue (either as an increase in or a reduction of revenue) on a cumulative catch-up basis. We account for contract modifications when the modification results in the promise to deliver additional goods or services that are distinct and the increase in the price of the contract is for the same amount as the stand-alone selling price of the additional goods or services included in the modification. We evaluate our contracts whether we are acting as the principal or as the agent when providing services, which we consider in determining if revenue should be reported on a gross or net basis. We determine the Company to be a principal if we control the specified service before that service is transferred to a customer. Billing practices are governed by the contract terms of each project based upon costs incurred, the achievement of milestones or predetermined schedules. Billings do not necessarily correlate with revenue recognized over time using the cost-to-cost input method. Contract assets include unbilled amounts typically resulting from revenue under long-term contracts when the revenue recognized exceeds the amount billed to the customer. Contract liabilities consist of advance payments and billings in excess of revenue recognized as well as deferred revenue. Contract assets also include retainage, which represents amounts withheld by our clients from billings pursuant to provisions in the contracts and may not be paid to us until the completion of specific tasks or the completion of the project and, in some instances, for even longer periods. Our contract assets and liabilities are reported in a gross position on a contract-by-contract basis at the end of each reporting period. We include in current assets and liabilities contract assets and liabilities, which may extend beyond one year. Goodwill Goodwill represents the cost of an acquisition purchase price over the fair value of acquired net assets, and such amounts are reported separately as goodwill on our consolidated and combined balance sheets. Our total goodwill resulted from the application of “push-down” accounting associated with BCP’s January 2017 acquisition of a controlling equity position in Charah Management and the acquisition of certain assets and liabilities of SCB. Goodwill is not amortized, but instead is tested for impairment at least annually, as of October 1st of each year, or more often if events or circumstances indicate that goodwill might be impaired. Goodwill is tested at the reporting unit level. We may elect to perform a qualitative assessment for our reporting units to determine whether it is more likely than not that the fair value of the reporting unit is greater than its carrying value. If a qualitative assessment is not performed, or if as a result of a qualitative assessment it is not more likely than not that the fair value of a reporting unit exceeds its carrying value, then the reporting unit’s fair value is compared to its carrying value. Fair value is typically estimated using an income approach based on discounted cash flows. However, when appropriate, we may also use a market approach. The income approach is based on the long-term projected future cash flows of the reporting units. We discount the estimated cash flows to present value using a weighted average cost of capital that considers factors such as market assumptions, the timing of the cash flows, and the risks inherent in those cash flows. We believe that this approach is appropriate because it provides a fair value estimate based upon the reporting units’ expected long-term performance considering the economic and market conditions that generally affect our business. The market approach estimates fair value by measuring the aggregate market value of publicly traded companies with similar characteristics to our business as a multiple of their reported earnings. We then apply that multiple to the reporting units’ earnings to estimate their fair values. We believe that this approach may also be appropriate in certain circumstances because it provides a fair value estimate using valuation inputs from entities with operations and economic characteristics comparable to our reporting units. Fair value is computed using several factors, including projected future operating results, economic projections, anticipated future cash flows, comparable marketplace data, and the cost of capital. There are inherent uncertainties related to these factors and to our judgment in applying them in our analysis. However, we believe our methodology for estimating the fair value of our reporting units is reasonable. If the carrying value of a reporting unit exceeds its fair value, goodwill is written down to its implied fair value. The Company performed quantitative assessments of its Environmental Solutions and Maintenance and Technical Services reporting units as of October 1, 2019. The Environmental Solutions and Maintenance and Technical Services reporting units' fair values, as calculated, were approximately 6.8% and 143.3%, respectively, greater than their book values as of October 1, 2019. The valuation used to test goodwill for impairment is dependent upon a number of significant estimates and assumptions, including macroeconomic conditions, growth rates, competitive activities, cost containment, margin expansion and the Company's business plans. We believe these estimates and assumptions are reasonable. However, future changes in the judgments, assumptions and estimates that are used in our impairment testing for goodwill, including discount and tax rates or future cash flow projections, could result in significantly different estimates of the fair values. As a result of these factors and the related cushion as of the date of the previous annual impairment test, goodwill for the Environmental Solutions reporting unit is more susceptible to impairment risk. The most significant assumptions utilized in the determination of the estimated fair value of the Environmental Solutions reporting unit are the net sales and earnings growth rates (including residual growth rates) and the discount rate. The residual growth rate represents the rate at which the reporting unit is expected to grow beyond the shorter-term business planning period. The residual growth rate utilized in our fair value estimate is consistent with the reporting unit operating plans and approximates expected long-term category market growth rates and inflation. The discount rate, which is consistent with a weighted average cost of capital that is likely to be expected by a market participant, is based upon industry required rates of return, including consideration of both debt and equity components of the capital structure. Our discount rate may be impacted by adverse changes in the macroeconomic environment, volatility in the equity and debt markets or other factors. While management can and has implemented strategies to address these events, changes in operating plans or adverse changes in the future could reduce the underlying cash flows used to estimate fair values and could result in a decline in fair value that would trigger future impairment charges of the reporting unit's goodwill balance. The table below provides a sensitivity analysis for the Environmental Solutions reporting unit, utilizing reasonably possible changes in the assumptions for the shorter-term revenue and residual growth rates and the discount rate, to demonstrate the potential impacts to the estimated fair values. The table below provides, in isolation, the estimated fair value impacts related to (i) a 50-basis point increase to the discount rate assumption and (ii) a 50-basis point decrease to our shorter-term revenue and residual growth rates assumptions, both of which would result in impairment charges. Deferred Taxes, Valuation Allowance As discussed in Note 18 to our consolidated and combined financial statements, deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in our consolidated and combined financial statements or tax returns. We record a valuation allowance to reduce certain deferred tax assets to amounts that are more-likely-than-not to be realized. We evaluate the realizability of our deferred tax assets by assessing the valuation allowance and by adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization include our forecast of future taxable income exclusive of reversing temporary differences and carryforwards, future reversals of existing taxable temporary differences and available tax planning strategies that could be implemented to realize the net deferred tax assets. Based on the available evidence as of December 31, 2019, we were not able to conclude it is more likely than not certain deferred tax assets will be realized. Therefore, a valuation allowance of $12.9 million was recorded against our deferred tax assets. We will continue to evaluate the need for a valuation allowance on our deferred tax assets in future periods. Recent Accounting Pronouncements Please see Note 2, “Summary of Significant Accounting Policies-Recently Adopted Accounting Pronouncements” and “Summary of Significant Accounting Policies-Recently Issued Accounting Pronouncements” to our historical consolidated and combined financial statements as of and for the years ended December 31, 2019 and 2018, included elsewhere herein, for a discussion of recent accounting pronouncements. Under the JOBS Act, we meet the definition of an “emerging growth company,” which allows us to have an extended transition period for complying with new or revised accounting standards pursuant to Section 107(b) of the JOBS Act. We intend to take advantage of all of the reduced reporting requirements and exemptions, including the longer phase-in periods for the adoption of new or revised financial accounting standards under Section 107(b) of the JOBS Act until we are no longer an emerging growth company.

<s>[INST] Charah Solutions, Inc. Charah Solutions, Inc. (together with its subsidiaries, “Charah Solutions,” the “Company,” “we,” “us” or “our”) was formed as a Delaware corporation in January 2018 in anticipation of the IPO to be a holding company for Charah Management and Allied Power Holdings. We did not conduct any material business operations before the transactions described below under “Initial Public Offering” other than certain activities related to the initial public offering (the “IPO”), which was completed on June 18, 2018. In connection with the closing of the IPO and pursuant to the terms and conditions of the master reorganization agreement dated June 13, 2018, Charah Management LLC, a Delaware limited liability company (“Charah Management”), and Allied Power Holdings, LLC, a Delaware limited liability company (“Allied Power Holdings”), became our wholly owned subsidiaries. Through our ownership of Charah Management and Allied Power Holdings, we own the outstanding equity interests in Charah, LLC, a Delaware limited liability company (“Charah”) and Allied Power Management, LLC, a Delaware limited liability company (“Allied”), the subsidiaries through which we operate our businesses. Overview The historical financial data presented herein as of December 31, 2019 and for periods after the June 18, 2018 corporate reorganization is that of Charah Solutions, Inc. and its subsidiaries on a consolidated basis including Charah and Allied, and on a combined basis for periods prior to the June 18, 2018 corporate reorganization. Allied was formed in May 2017 and did not commence operations until July 2017. We are a leading provider of missioncritical environmental and maintenance services to the power generation industry. We offer a suite of coal ash management and recycling, environmental remediation, and utility plant outagerelated maintenance services. We also design and implement solutions for complex environmental projects (such as coal ash pond closures) and facilitate coal ash recycling through byproduct sales and other beneficial use services. We believe we are a partnerofchoice for the power generation industry due to our quality, safety, domain experience, and compliance record, all of which are key criteria for our customers. In 2019, we performed work at more than 50 coalfired and nuclear power generation sites nationwide. We are an environmental remediation and maintenance company and we conduct our operations through two segments: Environmental Solutions and Maintenance and Technical Services. Environmental Solutions. Our Environmental Solutions segment includes remediation and compliance services, as well as byproduct sales. Remediation and compliance services are associated with our customers’ need for multiyear environmental improvement and sustainability initiatives, whether driven by regulatory requirements, by power generation customers initiatives, by our proactive engagement or by consumer expectations and standards. Byproduct sales support both our power generation customers’ desire to recycle their recurring and legacy volumes of coal combustion residuals ("CCRs") commonly known as coal ash and our ultimate end customers’ need for highquality, costeffective raw material substitutes. Maintenance and Technical Services. Our Maintenance and Technical Services segment includes fossil services and, from and after May 2017 when Allied was created, nuclear services. Fossil services are the recurring and missioncritical management of coal ash and the routine maintenance, outage services and staffing solutions for coalfired power generation facilities. Nuclear services, which we market under the Allied Power brand name, include routine maintenance, outage services, facility maintenance, and staffing solutions for nuclear power generation facilities. The Maintenance and Technical Services segment offerings are most closely associated with the ongoing operations of power plants, whether in the form of daily environmental management or required maintenance services (typically during planned outages). Initial Public Offering On June 18, 2018, we completed the IPO of 7,352,941 shares of the Company’s common stock, par value $0.01 per share. The net proceeds of the IPO to us prior to offering expenses were approximately $59.2 million. We used a portion of the IPO proceeds to pay off approximately $40 [/INST] Negative. </s>

UroGen Pharma Ltd.

2019-02-28

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion contains management’s discussion and analysis of our financial condition and results of operations and should be read together with “Selected Financial Data” and the historical consolidated financial statements and the notes thereto included in “Financial Statements and Supplementary Data”. This discussion contains forward-looking statements that reflect our plans, estimates and beliefs and involve numerous risks and uncertainties, including but not limited to those described in the “Risk Factors” section of this Annual Report. Actual results may differ materially from those contained in any forward-looking statements. You should carefully read “Special Note Regarding Forward-Looking Statements” and “Risk Factors.” Overview We are a clinical stage biopharmaceutical company focused on developing novel therapies designed to change the standard of care for urological pathologies. We have an innovative and broad pipeline of product candidates that we believe can overcome the deficiencies of current treatment options for a variety of urological conditions with a focus on uro-oncology. Our lead product candidates, UGN-101 and UGN-102, are proprietary formulations of the chemotherapy drug mitomycin, a generic drug, which is currently used off-label for urothelial cancer treatment only in a water-based formulation as an adjuvant, or supplemental post-surgery, therapy. We are developing our product candidates as chemoablation agents, which means they are designed to remove tumors by non-surgical means, to treat several forms of non-muscle invasive urothelial cancer, including low-grade upper tract urothelial carcinoma, or LG UTUC, and low-grade bladder cancer, including non-muscle invasive bladder cancer, or LG NMIBC. We believe that UGN-101 and UGN-102, which are both local drug therapies, have the potential to significantly improve patients’ quality of life by replacing costly, sub-optimal and burdensome tumor resection and kidney removal surgeries as the first-line standard of care. UGN-101 and UGN-102 may also reduce the need for bladder and upper urinary tract surgeries, including removal of the upper urinary tract, which are major surgical procedures typically performed when local endoscopic tumor resection fails to control the disease progression. Additionally, we believe that our product candidates, which are based on novel formulations of previously approved drugs, may qualify for streamlined regulatory pathways to market approval. We estimate that the prevalence of LG UTUC in the United States is approximately 6,000 to 8,000; the prevalence of LG NMIBC is approximately 80,000; and the prevalence of carcinoma in situ (CIS) bladder cancer is approximately 2,000. Our lead product candidates, UGN-101 and UGN-102, are formulated using our proprietary reverse thermally triggered hydrogel, or RTGel, technology. We believe that RTGel-based drug formulations, which provide for the sustained release of an active drug, may improve the efficacy of treatment of various types of urothelial cancer without compromising the safety of the patient or interfering with the natural flow of fluids from the urinary tract to the bladder. Our formulations are designed to achieve this by increasing the dwell time as well as the tissue coverage of the active drug throughout the organ. Consequently, we believe that RTGel-based drug formulations may enable us to overcome the anatomical and physiological challenges that have historically contributed to the lack of drug development for the treatment of urothelial cancer. No drugs have been approved by the U.S. Food and Drug Administration, or the FDA, for the treatment of non-muscle invasive bladder cancer, or NMIBC, in more than 15 years. Our clinical stage pipeline also includes UGN-201, our proprietary immunotherapy product candidate for the treatment of high-grade NMIBC, which may include Carcinoma in Situ, or CIS. UGN-201 is a novel, liquid formulation of Imiquimod, a generic toll-like receptor 7, or TLR7, agonist. Toll-like receptor agonists play a key role in initiating the innate immune response system. We believe that the combination of UGN-201 with additional immunotherapy drugs, such as immune checkpoint inhibitors or chemotherapy drugs like UGN-102, could represent a valid alternative to the current standard of care for the post-TURBT adjuvant treatment of high-grade NMIBC. BotuGel is our proprietary novel RTGel-based formulation of BOTOX, a branded drug, that we believe can potentially serve as an effective treatment option for patients suffering from overactive bladder. In October 2016, we announced the licensing of the worldwide rights to RTGel in combination with neurotoxins, including BOTOX, to Allergan Pharmaceuticals International Limited, or Allergan, a wholly owned subsidiary of Allergan plc, or the Allergan Agreement. In August 2017, we announced that Allergan had submitted an IND to the FDA in order to be able to commence clinical trials in the United States using the RTGel in combination with BOTOX. In October 2017, Allergan commenced a Phase 2 clinical trial of BotuGel for the treatment of overactive bladder. Our Research and Development and License Agreements We entered into an exclusive license agreement with Allergan Pharmaceuticals International Limited, or Allergan, a wholly owned subsidiary of Allergan plc in October 2016, which we refer to as the Allergan Agreement. Allergan paid us a nonrefundable upfront license fee of $17.5 million, and we are eligible to receive additional milestone payments upon the successful completion of certain development, regulatory and commercial milestones. Under the Allergan Agreement, Allergan is solely responsible, at its expense, for developing, obtaining regulatory approvals for and commercializing, on a worldwide basis, pharmaceutical products that contain RTGel and clostridial toxins (including BOTOX), alone or in combination with certain other active ingredients, which we refer to collectively as the Licensed Products. Allergan is obligated to pay us a tiered royalty in the low single digits based on worldwide annual net sales of Licensed Products, subject to certain reductions for the market entry of competing products and/or loss of our patent coverage of Licensed Products. We are responsible for payments to any third party for certain RTGel-related third-party intellectual properties. In July 2017, Allergan notified us that they had submitted their Investigational New Drug, or IND, application for BotuGel, our proprietary novel RTGel-based formulation of BOTOX for the treatment of overactive bladder, to the FDA. The submission of the IND triggered the second milestone under the Allergan Agreement, pursuant to which we received a payment of $7.5 million in August 2017. Allergan commenced a Phase 2 clinical trial of BotuGel in October 2017, pursuant to Allergan Agreement. For additional information regarding our research and development and license agreements, see Note 6 to our financial statements appearing elsewhere in this Annual Report. Components of Operating Results Revenues We do not currently have any products approved for sale and, to date, we have not recognized any revenues from sales of UGN-101, UGN-102 or UGN-201. For the year ended December 31, 2018, we recognized revenues of $1.1 million from RTGel sales under the Allergan Agreement. For the year ended December 31, 2017, we recognized revenues of $7.5 million under the Allergan Agreement upon the achievement of a milestone in August 2017 as well as sales of RTGel to Allergan, per the Allergan Agreement. In the future, we may generate revenue from a combination of product sales, reimbursements, up-front payments, milestone payments and royalties in connection with the Allergan Agreement and future collaborations. We expect that any revenue we generate will fluctuate from quarter to quarter as a result of the timing and amount of license fees, milestone and other payments, and the amount and timing of payments that we receive upon the sale of our products, to the extent any are successfully commercialized. If we fail to achieve clinical success and/or to obtain regulatory approval of any of our product candidates in a timely manner, our ability to generate future revenue will be impaired. Research and Development Expenses, Net Research and development expenses consist primarily of: • salaries and related costs, including share-based compensation expense, for our personnel in research and development functions; • expenses incurred under agreements with third parties, including CROs, subcontractors, suppliers and consultants, preclinical studies and clinical trials; • expenses incurred to acquire, develop and manufacture preclinical study and clinical trial materials; and • facility and equipment costs, including depreciation expense, maintenance and allocated direct and indirect overhead costs. We expense all research and development costs as incurred. In light of the fact that our employees and internal resources may be engaged in projects for multiple programs at any time, our focus is on total research and development expenditures, and we do not allocate our internal research and development expenses by project. We estimate preclinical study and clinical trial expenses based on the services performed pursuant to contracts with research institutions and contract research organizations that conduct and manage preclinical studies and clinical trials on our behalf based on actual time and expenses incurred by them. We accrue for costs incurred as the services are being provided by monitoring the status of the trial or project and the invoices received from our external service providers. We adjust our accrual as actual costs become known. Where at risk contingent milestone payments are due to third parties under research and development and collaboration agreements, the milestone payment obligations are expensed when the milestone results are achieved. We have received grants under the Israeli Law for the Encouragement of Industrial Research, Development and Technological Innovation, 5754-1984, or the R&D Law, from the Israel Innovation Authority in Israel, or the IIA, formerly known as the Office of the Chief Scientist of the Ministry of Economy and Industry, an independent and impartial public entity, for some of our development programs. Through December 31, 2018, we had received grants in the aggregate amount of $2.1 million. The IIA may also impose certain conditions on any arrangement under which it permits us to transfer IIA-funded technology outside of the State of Israel. Furthermore, the consideration available to our shareholders in a transaction involving the transfer outside of the State of Israel of IIA-funded technology (such as a merger or similar transaction) may be reduced by any amounts that we are required to pay to IIA. The restrictions under the R&D Law will continue to apply even after we have repaid the full amount of royalties due to the IIA. If we fail to satisfy the conditions of the R&D Law, we may be required to refund the amounts of the grants previously received, together with interest and penalties. A recipient of a grant from the IIA is obligated to pay royalties generally at a rate of 3% to 5% on revenues from sales of products developed in whole or in part with IIA-funded technology, up to the amount of the grant related to any such products plus accrued interest. As of December 31, 2018, we have accrued $0.8 million in royalties due to the IIA, which has been recorded in cost of revenues in our results of operations for the year ended December 31, 2018. Under the R&D Law, a company that received grants from the IIA may not transfer IIA-funded technology or manufacture products developed with IIA-funded technology outside of the State of Israel without first obtaining the approval of the IIA. We may be required to pay increased royalties of up to 300% of the amount of the original grant and other amounts; if we do not receive such approvals, we may be required to pay significant penalties. Under applicable accounting rules, we deduct the IIA grants from research and development expenses as the applicable costs are incurred. We also had a preclinical collaboration for BotuGel with Allergan into which we initially entered into in February 2014. We deduct amounts received from the preclinical collaboration with Allergan from our research and development expenses as the applicable costs are incurred. As a result, our research and development expenses are shown on our financial statements net of the IIA grants and amounts received from the preclinical collaboration. We are currently focused on advancing our product candidates, and our future research and development expenses will depend on their clinical success. Research and development expenses will continue to be significant and will increase over at least the next several years as we continue to develop our product candidates and conduct preclinical studies and clinical trials of our product candidates. Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We do not believe that it is possible at this time to accurately project total expenses required for us to reach commercialization of our product candidates. Due to the inherently unpredictable nature of preclinical and clinical development, we are unable to estimate with certainty the costs we will incur and the timelines that will be required in the continued development and approval of our product candidates. Clinical and preclinical development timelines, the probability of success and development costs can differ materially from expectations. In addition, we cannot forecast which product candidates may be subject to future collaborations, if and when such arrangements will be entered into, if at all, and to what degree such arrangements would affect our development plans and capital requirements. We expect our research and development expenses to increase over the next several years as our clinical programs progress and as we seek to initiate clinical trials of additional product candidates. We also expect to incur increased research and development expenses as we selectively identify and develop additional product candidates. The duration, costs and timing of clinical trials and development of our product candidates will depend on a variety of factors that include, but are not limited to, the following: • per patient trial costs; • the number of patients that participate in the trials; • the number of sites included in the trials; • the countries in which the trials are conducted; • the length of time required to enroll eligible patients; • the number of doses that patients receive; • the drop-out or discontinuation rates of patients; • potential additional safety monitoring or other studies requested by regulatory agencies; • the duration of patient follow-up; and • the efficacy and safety profile of the product candidates. In addition, the probability of success for each product candidate will depend on numerous factors, including competition, manufacturing capability and commercial viability. We will determine which programs to pursue and how much to fund each program in response to the scientific and clinical success of each product candidate, as well as an assessment of each product candidate’s commercial potential. Because UGN-101 and UGN-102 are still in clinical development and the outcome of these efforts is uncertain, we cannot estimate the actual amounts necessary to successfully complete the development and commercialization of product candidates or whether, or when, we may achieve profitability. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of equity or debt financings and collaboration arrangements. General and Administrative Expenses General and administrative expenses consist primarily of personnel costs, including share-based compensation, related to directors, executive, finance, business development, investor relations, and human resource functions, facility costs and external professional service costs, including legal, accounting and audit services and other consulting fees. We anticipate that our general and administrative expenses will increase in the future as we increase our administrative headcount and infrastructure to support our continued research and development programs and the potential approval and commercialization of our product candidates. These increases will likely include increased costs related to the hiring of additional personnel and fees to outside consultants, lawyers and accountants, among other expenses. The increased costs associated with being a public company include expenses related to services associated with maintaining compliance with Nasdaq listing rules and SEC requirements, insurance, executive compensation, investor relations costs, and other costs associated with being a public company. In addition, if any of our product candidates receives regulatory approval and if we invest in building a commercial infrastructure to support the marketing of our products, we expect to incur greater expenses. Finance Expenses, Net Finance expenses, net, consisted primarily of finance expenses on warrants offset by interest income. Income Taxes We have yet to generate taxable income in Israel. We have historically incurred operating losses resulting in carry forward tax losses totaling approximately $72.1 million as of December 31, 2018. We anticipate that we will continue to generate tax losses for the foreseeable future and that we will be able to carry forward these tax losses indefinitely to future taxable years. Accordingly, we do not expect to pay taxes in Israel until we have taxable income after the full utilization of our carry forward tax losses. We have provided a full valuation allowance with respect to the deferred tax assets related to these carry forward losses. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table sets forth our results of operations for the years ended December 31, 2018 and 2017. Revenues Revenues were $1.1 million and $8.2 million for the years ended December 31, 2018 and 2017, respectively. The decrease of $7.0 million was primarily due to the decreased revenue recognized under the Allergan Agreement. Research and Development Expenses Research and development expenses increased by $18.2 million to $36.9 million in the year ended December 31, 2018 from $18.7 million in the year ended December 31, 2017. Approximately $8.1 million of the increase was attributable to share-based compensation, including $2.4 million in modification costs relating to senior management severance packages and $5.7 million in new grants to executive management and employees. The remaining increase of $10.1 million is mainly comprised of $4.1 million in increased headcount and related costs to support increased clinical trial activities, a $2.5 million increase in direct costs associated with the UGN-101 Phase 3 clinical trial, a $2.7 million increase due to increased clinical activity of the UGN-102 Phase 2b clinical trial and approximately a $0.6 million increase in allocated overhead costs to support the growth of our U.S. operations. Total non-cash research and development share-based compensation expense was $12.0 million and $3.9 million for the years ended December 31, 2018 and 2017, respectively. General and Administrative Expenses General and administrative expenses were $39.6 million and $8.8 million for the years ended December 31, 2018 and 2017, respectively. The increase in general and administrative expenses of $30.8 million resulted primarily from an increase in share-based compensation expense of $16.2 million, including $7.5 million in modification costs relating to senior management severance packages and $8.7 million in new grants to executive management and employees. The remaining increase resulted primarily from a $5.3 million increase in payroll and recruitment costs due to headcount and related costs to support our growing business, an increase of $4.4 million in commercial services, an increase of $3.2 million in consultant and directors’ fees and an increase of $1.4 million to support the growth of our U.S. operations. Total non-cash general and administrative share-based compensation expense was $18.6 million and $2.4 million for the years ended December 31, 2018 and 2017, respectively. Finance (Income) Expenses, Net Finance (income) expenses, net was ($1.6 million) and $31,000 for the years ended December 31, 2018 and 2017, respectively. The increase of $1.7 million in finance income was primarily due to increased interest earned on our cash balances. Comparison of the Years Ended December 31, 2017 and 2016 The following table sets forth our results of operations for the years ended December 31, 2017 and 2016. Revenues Our total revenues decreased by $9.3 million to $8.2 million in the year ended December 31, 2017 from $17.5 million in the year ended December 31, 2016. This decrease is mainly due to the difference in proceeds of $7.5 million and $17.5 million received from Allergan upon the achievement of certain milestones under the Allergan Agreement in each of the years ended December 31, 2017 and 2016, respectively. Research and Development Expenses Research and development expenses increased by $8.4 million to $18.7 million in the year ended December 31, 2017 from $10.3 million in the year ended December 31, 2016. The increase was attributable mainly to an increase in direct costs associated with the UGN-101 Phase 3 clinical trial of approximately $3.1 million, an increase of approximately $2.8 million of share-based compensation expenses related to an increase in personnel and the grant date fair value of ordinary shares, and an increase of approximately $2.5 million in headcount, consulting and related costs to support increased clinical trial activities. Total non-cash research and development share-based compensation expense for the year ended December 31, 2017 was $3.9 million. General and Administrative Expenses General and administrative expenses increased by approximately $2.4 million to $8.8 million in the year ended December 31, 2017 from $6.4 million in the year ended December 31, 2016. The increase in general and administrative expenses resulted primarily from an increase in share-based compensation expense of approximately $1.6 million related to an increase in personnel and the grant date fair value of ordinary shares, an increase of $1.3 million in payroll and recruitment costs due to headcount and related costs to support our growing business, an increase of $0.9 million in professional service expenses, commercial services, director and officer insurance premiums, and other costs associated with being a public company, and an increase of $0.3 million in rent and office maintenance related to our new office in New York. These increases were offset by $1.7 million of initial public offering, or IPO, expenses in the statement of operations in 2016. Total non-cash general and administrative share-based compensation expense for the year ended December 31, 2017 was $2.4 million. Finance Expenses, Net Finance expenses, net were $31,000 and $2.7 million for the years ended December 31, 2017 and 2016, respectively. The decrease in finance expenses, net, was primarily due to the recording of the increase in fair value of the Preferred A-1 warrants to the income statement in 2016. The warrants converted to Preferred A-1 shares upon the closing of the IPO in May 2017. There was minimal change in the fair value of the warrants in 2017 prior to conversion. Liquidity and Capital Resources As of December 31, 2018, we had $101.3 million in cash, cash equivalents, and marketable securities. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation, and is held primarily in U. S. dollars. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating and capital expenditure requirements for at least the next 12 months. Through December 31, 2018, we funded our operations primarily through public equity offerings, private placements of equity securities and through the upfront payment received under the Allergan Agreement. In May 2017, we raised $60.8 million, net of issuance costs and underwriting discounts and commissions, in our IPO on the Nasdaq Global Market. In August 2017, we received $7.5 million from Allergan upon the achievement of a milestone under the Allergan Agreement. In addition, during the year ended December 31, 2016, we recorded $1.7 million in general and administrative expenses related to IPO costs, in accordance with SEC staff Bulletin Topic 5A. In January 2018, we completed an underwritten public offering of 1,682,926 of our ordinary shares, including 219,512 shares sold pursuant to the full exercise of the underwriters’ option to purchase additional shares, at a price to the public of $41.00 per share. The net proceeds to us from the offering were approximately $64.0 million, after deducting the underwriting discounts and commissions and payment of other offering expenses. In January 2019, we completed an underwritten public offering of 4,207,317 of our ordinary shares, including 548,780 shares sold pursuant to the full exercise of the underwriters’ option to purchase additional shares, at a price to the public of $41.00 per share. The net proceeds to us from the offering were approximately $161.8 million, after deducting the underwriting discounts and commissions and payment of other offering expenses. We have incurred losses since our inception and negative cash flows from our operations, and as of December 31, 2018 we had an accumulated deficit of $122.9 million. We anticipate that we will continue to incur losses for at least the next several years. Our primary uses of capital are, and we expect will continue to be, research and development expenses, including third-party clinical research and development services, laboratory and related supplies, clinical costs, including manufacturing costs, legal and other regulatory expenses and general and administrative costs. Because UGN-101 and UGN-102 are still in clinical development and the outcome of these efforts is uncertain, we cannot estimate the actual amounts necessary to successfully complete the development and commercialization of product candidates or whether, or when, we may achieve profitability. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of equity or debt financings and collaboration arrangements. Cash Flows The following table sets forth the significant sources and uses of cash for the periods set forth below: Operating Activities Net cash used in operating activities was $37.3 million during the year ended December 31, 2018, compared to $9.6 million during the year ended December 31, 2017. The $27.7 million increase was attributable primarily to the increase of $55.7 million in the net loss for the year, partly offset by a $24.3 million increase in share-based compensation expense and a net increase in operating assets and liabilities of $3.6 million. Net cash used in operating activities was $9.6 million during the year ended December 31, 2017, compared to $4.2 million provided by operating activities during the year ended December 31, 2016. The increase in cash used in operating activities was attributable primarily to the receipt of the different milestone payments from Allergan of $7.5 million in 2017 and $17.5 million in 2016 and an increase in expenditures related to the UGN-101 Phase 3 clinical trial of approximately $3.1 million, as well as an increase in personnel related costs to support our growing business and service provider costs related to becoming a public company. These increases were offset by the recording of $1.7 million of IPO expenses in 2016. Investing Activities Net cash provided by investing activities was $35.3 million during the year ended December 31, 2018, compared to $36.3 million used in investing activities during the year ended December 31, 2017. The increase of $71.6 million is primarily related to our investment in highly liquid, short term money market funds. Net cash used in investing activities was $36.3 million during the year ended December 31, 2017, compared to $0.7 million during the year ended December 31, 2016. The increase of $35.6 million is primarily related to our investment in highly liquid, short term money market funds. Financing Activities Net cash provided by financing activities was $66.4 million during the year ended December 31, 2018, compared to $61.6 million during the year ended December 31, 2017. The increase is primarily related to the increased net proceeds received from our January 2018 underwritten offering as compared to the net proceeds received from our IPO in May 2017. Net cash provided by financing activities was $61.6 million during the year ended December 31, 2017, compared to cash used in financing activities of $0.1 million during the year ended December 31, 2016. The difference is primarily related to the net proceeds received from our IPO in May 2017. Funding Requirements Our present and future funding requirements will depend on many factors, including, among other things: • the progress, timing and completion of clinical trials for UGN-101 and UGN-102; • preclinical studies and clinical trials for UGN-201 or any of our other product candidates; • the costs related to obtaining regulatory approval for UGN-101, UGN-102 and UGN-201 and any of our other product candidates, and any delays we may encounter as a result of regulatory requirements or adverse clinical trial results with respect to any of these product candidates; • selling, marketing and patent-related activities undertaken in connection with the commercialization of UGN-101 and UGN-102 and any of our other product candidates, and costs involved in the development of an effective sales and marketing organization; • the costs involved in filing and prosecuting patent applications and obtaining, maintaining and enforcing patents or defending against claims or infringements raised by third parties, and license royalties or other amounts we may be required to pay to obtain rights to third party intellectual property rights; • potential new product candidates we identify and attempt to develop; and • revenues we may derive either directly or in the form of royalty payments from future sales of UGN-101, UGN-102, UGN-201, BotuGel and any other product candidates. Furthermore, we expect to continue to incur additional costs associated with operating as a public company. Accordingly, we will need to obtain substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we would be forced to delay, reduce or eliminate our research and development programs or future commercialization efforts. Until such time, if ever, as we can generate substantial product revenue, we may finance our cash needs through a combination of equity offerings, debt financings, collaborations, strategic alliances and licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest will be diluted, and the terms of any additional securities may include liquidation or other preferences that adversely affect your rights as a shareholder. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through additional collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. For more information as to the risks associated with our future funding needs, see “Item 1.A - Risk Factors.” We will require substantial additional financing to achieve our goals, and a failure to obtain this capital when needed and on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product development, commercialization efforts or other operations.” Contractual Obligations and Commitments The obligations detailed below do not include grants received from the IIA pursuant to which we will owe royalties or reimbursement upon commercialization of our product candidates. As of December 31, 2018, the maximum royalty amount payable by us under these funding arrangements is $2.1 million, excluding interest. Under the R&D Law, a company that received grants from the IIA may not transfer IIA-funded technology or manufacture products developed with IIA-funded technology outside of the State of Israel without first obtaining the approval of the IIA. We may be required to pay increased royalties of up to 300% of the amount of the original grant and other amounts; if we do not receive such approvals, we may be required to pay significant penalties. The following summarizes our significant contractual obligations as of December 31, 2018: (1) Operating lease obligations consist of payments pursuant to lease agreements for our Israeli offices and laboratory facility and our New York offices. In November 2014, we entered into a lease agreement for our Israeli offices effective from February 1, 2015 for a period of three years, with an option to extend the lease agreement by an additional three years. In April 2016, we signed an addendum to the November 2014 lease agreement in order to increase the office space rented and extend the rental period. In November 2017, we signed an additional addendum to the November 2014 lease agreement in order to increase the office space rented. The lease agreement is effective until September 2019. In September 2017, Urogen Pharma, Inc. entered into a new lease agreement for its current New York office for a period of approximately 41 months, which period commenced in October 2017. The new lease agreement will terminate on February 1, 2021, unless earlier terminated in accordance with its terms. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities as of the dates of the balance sheets and the reported amounts of revenue and expenses during the reporting periods. In accordance with GAAP, we base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances at the time such estimates are made. Actual results may differ materially from our estimates and judgments under different assumptions or conditions. We periodically review our estimates in light of changes in circumstances, facts and experience. The effects of material revisions in estimates, if any, are reflected in our financial statements prospectively from the date of the change in estimate. We define our critical accounting policies as those accounting principles generally accepted in the United States that require us to make subjective estimates and judgments about matters that are uncertain and are likely to have a material impact on our financial condition and results of operations, as well as the specific manner in which we apply those principles. While our significant accounting policies are more fully described in Note 3 to our financial statements appearing elsewhere in this Annual Report, we believe the following are the critical accounting policies used in the preparation of our financial statements that require significant estimates and judgments. Revenues We derive virtually all of our revenues from a license and supply agreement with Allergan. Under the agreement, we grant Allergan an exclusive license to develop, commercialize, and otherwise exploit products that contain RTGel and agrees to supply Allergan with pre-clinical and clinical quantities of the RTGel product, also referred to as the RTGel vials. The license agreement contains up-front license fees, future supply fees, development, regulatory, and sales-based milestone payments, and sales-based royalty payments. We determined that Allergan is our customer and the license and supply agreements are in scope of accounting standards codification (“ASC”) 606, which we adopted as of January 1, 2018. We adopted ASC 606 under the modified retrospective method, which did not have a material impact on the Consolidated Statements of Operations. Previously, we analyzed revenues under ASC 605, which states that revenue is recognized only when all of the following conditions have been met: (i) there is persuasive evidence of an arrangement; (ii) delivery has occurred: (iii) the fee is fixed or determinable: and (iv) collectability of the fee is reasonably assured. The adoption of ASC 606 did not have a material impact on the timing and manner of recognized revenues. Under ASC 606, in determining the appropriate amount of revenue to be recognized as it fulfills its obligations under the agreements with Allergan, we performed the following steps: 1) Identification of the contract; 2) Determination of whether the promised goods or services are performance obligations including whether they are distinct in the context of the contract; 3) Measurement of the transaction price, including the constraint on variable consideration; 4) Allocation of the transaction price to the performance obligations; 5) Recognition of revenue when or as the Company satisfies each performance obligation. The license agreement contains two performance obligations: (a) the license component and (b) Allergan’s right to require supply services of RTGel vials from us. The license component has standalone value (and therefore is accounted for separately from the supply services) since Allergan can use the license for its intended purposes without the Company’s supply services. In an arrangement with multiple goods and services, a good or service that is promised to a customer shall be considered a separate performance obligation if all of the following criteria are met: 1) The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct); and 2) The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract). Allocating the Consideration in the Arrangement Since the license to our intellectual property was determined to be functional and distinct from the other performance obligations identified in the arrangement, we recognized revenues from non-refundable, up-front fees allocated to the license when the license was transferred to Allergan and Allergan was able to use and benefit from the license. During the year ended December 31, 2016, we received consideration in an amount of $17.5 million for both the license of the intellectual property as well as Allergan’s right to future supply services (which would be provided in consideration for future payments to us according to the pricing stipulated in the supply agreement). We determined that the pricing of the supply services represented their standalone selling price. Accordingly, we allocated the entire upfront fee of $17.5 million to the license performance obligation. Development and Regulatory Milestone Payments At the inception of an arrangement that includes development milestone payments, we evaluate whether the development milestones are considered probable of being reached and estimates the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant revenue reversal would not occur, the associated development milestone value is included in the transaction price. Development milestone payments that are not within our control or the licensee, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. The milestones are allocated entirely to the license performance obligation, as (1) the terms of milestone and royalty payments relate specifically to the license and (2) allocating milestones and royalties to the license performance obligation is consistent with the overall allocation objective, because management’s estimate of the supply fee approximates the standalone selling price for RTGel vials and management’s estimate of milestones and royalties approximates the standalone selling price of the license. During the year ended December 31, 2017, we recognized revenue of $7.5 million related to a development milestone payment resulting from Allergan’s submission of an IND application for our RTGel in combination with Allergan’s BOTOX for the treatment of overactive bladder to the U.S. FDA. Royalties Based on Allergan’s Revenue We are also entitled to royalties based on Allergan’s revenue from its product, however, these amounts would only be recognized when the conditions are met. Supply of RTGel We recognize revenue related to the supply of RTGel at a point in time, upon delivery to Allergan. During the years ended December 31, 2018 and 2017, we recognized $1.1 million and $0.7 million of revenue related to RTGel vials supplied to Allergan, respectively. There were no material RTGel vial sales during the year ended December 31, 2016. Shipping and handling costs associated with supply of RTGel vials are accounted for as a fulfillment cost and are in included in cost of revenues. See Note 6 appearing elsewhere in this Annual Report for further discussion regarding revenue recognized during the year ended December 31, 2018. Research and Development Research and development costs are expensed as incurred and consist primarily of the cost of salaries, share-based compensation expenses, payroll taxes and other employee benefits, subcontractors and materials used for research and development activities, including preclinical studies, clinical trials, manufacturing costs and professional services. The costs of services performed by others in connection with the research and development activities of an entity, including research and development conducted by others on behalf of the entity, shall be included in research and development costs. Grants received from the Israel Innovation Authority, f/k/a the Office of the Chief Scientist of Israel’s Ministry of Industry, Trade and Labor (the “IIA”) are recognized when the grant becomes receivable, provided there is reasonable assurance that we will comply with the conditions attached to the grant and there is reasonable assurance the grant will be received. The grant is deducted from the research and development expenses as the applicable costs are incurred. In the year ended December 31, 2016, research and development expenses increased by $0.2 million as a result of our decision not to pursue one of its research programs that had been approved as a result of other financing opportunities. For the year ended December 31, 2016 an amount of $0.1 million was received from Allergan, in connection with the pre-clinical collaboration agreement signed in August 2015 and deducted from the research and development expenses. The costs of intangibles that are purchased from others for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred. Share-Based Compensation We account for employees’ and directors’ share-based payment awards classified as equity awards using the grant-date fair value method. The fair value of share-based payment transactions is recognized as an expense over the requisite service period. As of December 31, 2016, we have early adopted the policy to account for forfeitures as they occur according to the FASB’s Accounting Standards Update (ASU) 2016-09, Improvements to Employee Share-Based Payment Accounting. The adjustment for the beginning of the period was not material and therefore it was not reflected in the consolidated statements of changes in shareholders’ equity. We elected to recognize compensation costs for awards conditioned only on continued service that have a graded vesting schedule using the straight-line method and to value the awards based on the single-option award approach. Performance based awards are expensed over the requisite service period when the achievement of performance criteria is probable. Equity awards granted to non-employees are re-measured at each reporting period at fair value until the commitment date had been reached which is usually the date the service is completed. The fair value of equity awards is charged to the statement of operations over the service period using the straight-line method. Off-Balance Sheet Arrangements During the periods presented, we did not have, nor do we currently have, any off-balance sheet arrangements as defined under SEC rules.

<s>[INST] Overview We are a clinical stage biopharmaceutical company focused on developing novel therapies designed to change the standard of care for urological pathologies. We have an innovative and broad pipeline of product candidates that we believe can overcome the deficiencies of current treatment options for a variety of urological conditions with a focus on urooncology. Our lead product candidates, UGN101 and UGN102, are proprietary formulations of the chemotherapy drug mitomycin, a generic drug, which is currently used offlabel for urothelial cancer treatment only in a waterbased formulation as an adjuvant, or supplemental postsurgery, therapy. We are developing our product candidates as chemoablation agents, which means they are designed to remove tumors by nonsurgical means, to treat several forms of nonmuscle invasive urothelial cancer, including lowgrade upper tract urothelial carcinoma, or LG UTUC, and lowgrade bladder cancer, including nonmuscle invasive bladder cancer, or LG NMIBC. We believe that UGN101 and UGN102, which are both local drug therapies, have the potential to significantly improve patients’ quality of life by replacing costly, suboptimal and burdensome tumor resection and kidney removal surgeries as the firstline standard of care. UGN101 and UGN102 may also reduce the need for bladder and upper urinary tract surgeries, including removal of the upper urinary tract, which are major surgical procedures typically performed when local endoscopic tumor resection fails to control the disease progression. Additionally, we believe that our product candidates, which are based on novel formulations of previously approved drugs, may qualify for streamlined regulatory pathways to market approval. We estimate that the prevalence of LG UTUC in the United States is approximately 6,000 to 8,000; the prevalence of LG NMIBC is approximately 80,000; and the prevalence of carcinoma in situ (CIS) bladder cancer is approximately 2,000. Our lead product candidates, UGN101 and UGN102, are formulated using our proprietary reverse thermally triggered hydrogel, or RTGel, technology. We believe that RTGelbased drug formulations, which provide for the sustained release of an active drug, may improve the efficacy of treatment of various types of urothelial cancer without compromising the safety of the patient or interfering with the natural flow of fluids from the urinary tract to the bladder. Our formulations are designed to achieve this by increasing the dwell time as well as the tissue coverage of the active drug throughout the organ. Consequently, we believe that RTGelbased drug formulations may enable us to overcome the anatomical and physiological challenges that have historically contributed to the lack of drug development for the treatment of urothelial cancer. No drugs have been approved by the U.S. Food and Drug Administration, or the FDA, for the treatment of nonmuscle invasive bladder cancer, or NMIBC, in more than 15 years. Our clinical stage pipeline also includes UGN201, our proprietary immunotherapy product candidate for the treatment of highgrade NMIBC, which may include Carcinoma in Situ, or CIS. UGN201 is a novel, liquid formulation of Imiquimod, a generic tolllike receptor 7, or TLR7, agonist. Tolllike receptor agonists play a key role in initiating the innate immune response system. We believe that the combination of UGN201 with additional immunotherapy drugs, such as immune checkpoint inhibitors or chemotherapy drugs like UGN102, could represent a valid alternative to the current standard of care for the postTURBT adjuvant treatment of highgrade NMIBC. BotuGel is our proprietary novel RTGelbased formulation of BOTOX, a branded drug, that we believe can potentially serve as an effective treatment option for patients suffering from overactive bladder. In October 2016, we announced the licensing of the worldwide rights to RTGel in combination with neurotoxins, including BOTOX, to All [/INST] Positive. </s>

UroGen Pharma Ltd.

2020-03-02

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion contains management’s discussion and analysis of our financial condition and results of operations and should be read together with “Selected Financial Data” and the historical consolidated financial statements and the notes thereto included in “Financial Statements and Supplementary Data”. This discussion contains forward-looking statements that reflect our plans, estimates and beliefs and involve numerous risks and uncertainties, including but not limited to those described in the “Risk Factors” section of this Annual Report. Actual results may differ materially from those contained in any forward-looking statements. You should carefully read “Special Note Regarding Forward-Looking Statements” and “Risk Factors.” Overview We are a biopharmaceutical company dedicated to building and commercializing novel solutions that treat specialty cancers and urologic diseases. We have developed RTGel™ reverse-thermal hydrogel, a proprietary sustained release, hydrogel-based platform technology that has the potential to improve therapeutic profiles of existing drugs. Our technology is designed to enable longer exposure of the urinary tract tissue to medications, making local therapy a potentially more effective treatment option. Our lead investigational candidates, UGN-101 (mitomycin gel) for instillation, and UGN-102 (mitomycin gel) for intravesical instillation, are designed to ablate tumors by non-surgical means and to treat several forms of non-muscle invasive urothelial cancer, including low-grade upper tract urothelial carcinoma, or LG UTUC, and low-grade non-muscle invasive bladder cancer, or LG NMIBC, respectively. We estimate that the annual treatable population of LG UTUC in the United States is approximately 6,000 to 7,000; the annual treatable population of LG Intermediate Risk NMIBC is approximately 80,000. We believe that RTGel-based drug formulations, which provide for the sustained release of an active drug, may improve the efficacy of treatment of various types of urothelial cancer with an acceptable safety profile that permits the natural flow of fluids from the kidney via the urinary tract to the bladder. Our formulations are designed to achieve this by increasing the dwell time in the kidney and bladder to maximize tissue exposure of the active drug. Consequently, we believe that RTGel-based drug formulations may enable us to overcome the anatomical and physiological challenges that have historically contributed to the lack of drug development for the treatment of urothelial cancer and other urological pathologies. In December 2019, the FDA accepted for filing and granted priority review for our New Drug Application, or NDA, for UGN-101 (mitomycin gel) for instillation as a potential treatment for patients with LG UTUC. If approved, UGN-101 would be the first non-surgical treatment option for LG UTUC. We are on track for the potential launch of UGN-101 by mid-year 2020. The FDA previously granted Orphan Drug, Fast Track, and Breakthrough Therapy Designations to UGN-101 for the treatment of LG UTUC. The NDA is supported by the positive results from the pivotal Phase 3 OLYMPUS clinical trial. Results from a final analysis of the primary endpoint showed that UGN-101 demonstrated a complete response rate of 59% in patients with LG UTUC. In addition, the durability of response was estimated to be 89% at six months and 84% at 12 months by Kaplan Meier analysis. Median time to recurrence was estimated to be 13 months. The most commonly reported treatment emergent adverse events were ureteric stenosis (43.7%), urinary tract infection (32.4%), haematuria (31.0%), flank pain (29.6%) nausea (23.9%), dysuria (21.1%), renal impairment (19.7%) and vomiting (19.7%). The majority of these adverse events were mild to moderate, with 8.5% of patients having events of ureteric stenosis reported as severe. In addition, we are evaluating the safety and efficacy of UGN-102 (mitomycin gel) for intravesical instillation, our novel sustained-release high dose formulation of mitomycin, for the treatment of LG NMIBC. In September 2019, we reported the interim data of our Phase 2b OPTIMA II trial of investigational UGN-102 (mitomycin gel) for intravesical instillation for patients with LG Intermediate Risk NMIBC, defined as those with one or two of the following criteria: multifocal disease, large tumors and rapid rates of recurrence. The single-arm, open label study trial recently completed enrollment of 63 patients at clinical sites across the U.S. and Israel. Patients are treated with six weekly instillations of UGN-102 and undergo assessment of complete response, or CR (the primary endpoint) four to six weeks following the last instillation. In an interim cohort of 32 patients, 63% (20/32) achieved a CR. We also intend to pursue a 505(b)(2) regulatory pathway for UGN-102. We believe that UGN-102 has the potential to be a new therapeutic option for the treatment of LG Intermediate Risk NMIBC patients. We believe that urothelial cancer, which is comprised of bladder cancer and UTUC, affects a large and underserved patient population. Annual expenditures for Medicare alone in the United States for the treatment of urothelial cancer were estimated to have been at least $4.0 billion in 2010 and are projected to be at least $5.0 billion in 2020. The majority of the expenditures are spent on tumor resection surgeries such as transurethral resection of bladder tumor, or TURBT. In 2015, the estimated prevalence of urothelial cancer in the United States was 700,000 with an annual incidence of approximately 80,000. The prevalence of each of LG NMIBC and LG UTUC in the United States was approximately 343,000 and 14,500, respectively. Our clinical stage pipeline also includes UGN-201, our proprietary immunotherapy product candidate, a toll-like receptor 7/8, or TLR 7/8, agonist which have been evaluated for the treatment of high-grade NMIBC, which may include carcinoma in situ, or CIS. UGN-201 is a novel, liquid formulation of imiquimod, a generic TLR7/8, agonist. Toll-like receptor agonists play a key role in initiating the innate immune response system. We believe that the combination of UGN-201 with additional immunotherapy drugs, such as immune checkpoint inhibitors could represent a valid alternative to the current standard of care for the post-TURBT adjuvant treatment of high-grade NMIBC. In the fourth quarter of 2019, we entered into a worldwide license agreement with Agenus Inc. to develop and commercialize zalifrelimab (UGN-301, anti-CTLA-4 antibody) via intravesical delivery in combination with UGN-201 (together UGN-302) for the treatment of urinary tract cancers, initially in high-grade non-muscle invasive bladder cancer (HG NMIBC). The combination treatment makes local therapy a potentially more effective treatment option while minimizing systemic exposure and potential side effects. In October 2016, we granted an exclusive worldwide license to Allergan Pharmaceuticals International Limited, or Allergan, a wholly owned subsidiary of Allergan plc, to research, develop, manufacture, and commercialize pharmaceutical products formulated with our RTGel technology platform and clostridial toxins, including BOTOX®, a branded drug, that we believe can potentially serve as an effective treatment option for patients suffering from overactive bladder, or OAB. In August 2017, we announced that Allergan had submitted an IND to the FDA in order to be able to commence clinical trials in the U.S. using RTGel in combination with BOTOX. In October 2017, Allergan commenced a Phase 2 clinical trial of BOTOX/RTGel for the treatment of OAB, with the potential to evolve from multiple injections of BOTOX into the bladder to a single instillation of the novel formulation. Our Research and Development and License Agreements In October 2016, we entered into the Allergan Agreement and granted Allergan an exclusive worldwide license to research, develop, manufacture and commercialize pharmaceutical products that contain RTGel and clostridial toxins (including BOTOX), alone or in combination with certain other active ingredients, referred to as the Licensed Products, which are approved for the treatment of adults with overactive bladder who cannot use or do not adequately respond to anticholinergics. Additionally, we granted Allergan a non-exclusive, worldwide license to use certain of our trademarks as required for Allergan to practice its exclusive license with respect to the Licensed Products. Under the Allergan Agreement, Allergan is solely responsible, at its expense, for developing, obtaining regulatory approvals for and commercializing, on a worldwide basis, pharmaceutical products that contain RTGel and clostridial toxins (including BOTOX), alone or in combination with certain other active ingredients, collectively, the Licensed Products. Allergan is obligated to pay us a tiered royalty in the low single digits based on worldwide annual net sales of Licensed Products, subject to certain reductions for the market entry of competing products and/or loss of our patent coverage of Licensed Products. We are responsible for payments to any third party for certain RTGel-related third-party intellectual properties. Agenus Agreement On November 8, 2019, we entered into a license agreement with Agenus Inc. Pursuant to the agreement, Agenus granted us an exclusive, worldwide (not including Argentina, Brazil, Chile, Colombia, Peru, Venezuela and their respective territories and possessions), royalty-bearing, sublicensable license under Agenus’s intellectual property rights to develop, make, use, sell, import and otherwise commercialize products incorporating a proprietary antibody of Agenus known as AGEN1884 for the treatment of cancers of the urinary tract via intravesical delivery. AGEN1884 is an anti-CTLA-4 antagonist that is currently being evaluated by Agenus as a monotherapy in PD-1 refractory patients and in combination with Agenus’ anti-PD-1 antibody in solid tumors. Initially, we plan to develop AGEN1884 in combination with UGN-201 for the treatment of high-grade non-muscle invasive bladder cancer. Pursuant to the terms of the agreement, we paid Agenus an upfront fee of $10.0 million and have agreed to pay Agenus up to $115.0 million upon achieving certain clinical development and regulatory milestones, up to $85.0 million upon achieving certain commercial milestones, and royalties on net sales of licensed products in the 14%-20% range. We will be responsible for all development and commercialization activities. Under the terms of the license agreement, Agenus has agreed to use commercially reasonable efforts to supply AGEN1884 to us for use in preclinical studies or clinical trials. Unless earlier terminated in accordance with the terms of the license agreement, the license agreement will expire on a product-by-product and country-by-country basis at the later of (a) the expiration of the last to expire valid claim of a licensed patent right that covers the licensed product in such country or (b) 15 years after the first commercial sale of the licensed product in such country. We may terminate the license agreement for convenience upon 180 days’ written notice to Agenus. Either party may terminate the license agreement upon 60 days’ notice to the other party if, prior to the first commercial sale of a licensed product, we substantially cease to conduct development activities of the licensed products for nine consecutive months (and during such period, Agenus has complied with its obligations under the license agreement) other than in response to a requirement of an applicable regulatory authority or an event outside of our control. In addition, either party may terminate the license agreement in the event of an uncured material breach of the other party. Early-Stage Feasibility Evaluation with Janssen Research & Development, LLC On April 22, 2019, we entered into an agreement with Janssen to conduct an early-stage feasibility evaluation in a therapeutic area of mutual interest. Both parties will each conduct certain activities under the terms of the agreement, and we will incur the costs of our own efforts related to the feasibility evaluation. For additional information regarding our research and development and license agreements, see Note 8 to our financial statements appearing elsewhere in this Annual Report. Follow-on Public Offering In January 2019, we completed an underwritten public offering of 4,207,317 of our ordinary shares, including 548,780 shares sold pursuant to the full exercise of the underwriters’ option to purchase additional shares, at a price to the public of $41.00 per share. The net proceeds to us from the offering were approximately $161.4 million, after deducting the underwriting discounts and commissions and payment of offering expenses. Components of Operating Results Revenues We do not currently have any products approved for sale and, to date, we have not recognized any revenues from sales of UGN-101, UGN-102 or UGN-201. For the years ended December 31, 2019 and December 31, 2018, we recognized revenues of $18,000 and $1.1 million from RTGel sales under the Allergan Agreement, respectively. For the year ended December 31, 2017, we recognized revenues of $7.5 million under the Allergan Agreement upon the achievement of a milestone in August 2017 as well as sales of RTGel to Allergan, per the Allergan Agreement. In the future, we may generate revenue from a combination of product sales, reimbursements, up-front payments, milestone payments and royalties in connection with the Allergan Agreement and future collaborations. We expect that any revenue we generate will fluctuate from quarter to quarter as a result of the timing and amount of license fees, milestone and other payments, and the amount and timing of payments that we receive upon the sale of our products, to the extent any are successfully commercialized. If we fail to achieve clinical success and/or to obtain regulatory approval of any of our product candidates in a timely manner, our ability to generate future revenue will be impaired. Research and Development Expenses Research and development expenses consist primarily of: • salaries and related costs, including share-based compensation expense, for our personnel in research and development functions; • expenses incurred under agreements with third parties, including CROs, subcontractors, suppliers and consultants, nonclinical studies and clinical trials; • expenses incurred to acquire, develop and manufacture nonclinical study and clinical trial materials; • expenses incurred to purchase active pharmaceutical ingredient, or API, and other related manufacturing costs; and • facility and equipment costs, including depreciation expense, maintenance and allocated direct and indirect overhead costs. We expense all research and development costs as incurred. Since our employees and internal resources may be engaged in projects for multiple programs at any time, our focus is on total research and development expenditures, and we do not allocate our internal research and development expenses by project. We estimate nonclinical study and clinical trial expenses based on the services performed pursuant to contracts with research institutions and contract research organizations that conduct and manage nonclinical studies and clinical trials on our behalf based on actual time and expenses incurred by them. We accrue for costs incurred as the services are being provided by monitoring the status of the trial or project and the invoices received from our external service providers. We adjust our accrual as actual costs become known. Where at risk contingent milestone payments are due to third parties under research and development and collaboration agreements, the milestone payment obligations are expensed when the milestone results are achieved. We have received grants under the Israeli Law for the Encouragement of Industrial Research, Development and Technological Innovation, 5754-1984, or the R&D Law, from the Israel Innovation Authority in Israel, or the IIA, formerly known as the Office of the Chief Scientist of the Ministry of Economy and Industry, an independent and impartial public entity, for some of our development programs. Through December 31, 2019, we had received grants in the aggregate amount of $2.1 million. A recipient of a grant from the IIA is obligated to pay royalties generally at a rate of 3% to 5% on revenues from sales of products developed in whole or in part with IIA-funded technology, up to the amount of the grant related to any such products plus accrued interest. As of December 31, 2018, we had accrued $0.8 million in royalties due to the IIA, which has been recorded in cost of revenues in our results of operations for the year ended December 31, 2018. In January 2020, the IIA approved our request to unwind our obligation to the IIA as a transfer of knowledge. See Note 15 to the Consolidated Financial Statements included in this report for additional information. We are currently focused on advancing our product candidates, and our future research and development expenses will depend on their clinical success. Research and development expenses will continue to be significant and will increase over at least the next several years as we continue to develop our product candidates and conduct nonclinical studies and clinical trials of our product candidates. Research and development activities are central to our business model. Product candidates in later stages of clinical development generally have higher development costs than those in earlier stages of clinical development, primarily due to the increased size and duration of later-stage clinical trials. We do not believe that it is possible at this time to accurately project total expenses required for us to reach commercialization of our product candidates. Due to the inherently unpredictable nature of nonclinical and clinical development, we are unable to estimate with certainty the costs we will incur and the timelines that will be required in the continued development and approval of our product candidates. Clinical and nonclinical development timelines, the probability of success and development costs can differ materially from expectations. In addition, we cannot forecast which product candidates may be subject to future collaborations, if and when such arrangements will be entered into, if at all, and to what degree such arrangements would affect our development plans and capital requirements. We expect our research and development expenses to increase over the next several years as our clinical programs progress and as we seek to initiate clinical trials of additional product candidates. We also expect to incur increased research and development expenses as we selectively identify and develop additional product candidates. The duration, costs and timing of clinical trials and development of our product candidates will depend on a variety of factors that include, but are not limited to, the following: • per patient trial costs; • the number of patients that participate in the trials; • the number of sites included in the trials; • the countries in which the trials are conducted; • the length of time required to enroll eligible patients; • the number of doses that patients receive; • the drop-out or discontinuation rates of patients; • potential additional safety monitoring or other studies requested by regulatory agencies; • the duration of patient follow-up; and • the efficacy and safety profile of the product candidates. In addition, the probability of success for each product candidate will depend on numerous factors, including competition, manufacturing capability and commercial viability. We will determine which programs to pursue and how much to fund each program in response to the scientific and clinical success of each product candidate, as well as an assessment of each product candidate’s commercial potential. Because the NDA for UGN-101is pending review by the FDA and UGN-102 is still in clinical development and the outcome of these efforts is uncertain, we cannot estimate the actual amounts necessary to successfully complete the development and commercialization of product candidates or whether, or when, we may achieve profitability. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of equity or debt financings and collaboration arrangements. License fees and development milestone payments related to in-licensed products and technology are expensed as incurred if it is determined at that point that they have no established alternative future use. We recorded $10.0 million in research and development expenses for the year ended December 31, 2019, comprised of a milestone related to our license agreement with Agenus Inc. The license agreement provides us with an exclusive world-wide, royalty bearing, and sub-licensable license under Agenus’s intellectual property rights to exploit licensed products incorporating AGEN1884 for the treatment of cancers of the urinary tract via intravesical delivery. It also provides us with pre-clinical and clinical supply of AGEN1884. No inventory was purchased on the effective date of the License Agreement and subsequent purchases of pre-clinical and clinical supplies are at arm’s length and are priced at cost plus 30% mark-up. Our acquired right to Agenus’s intellectual property represents a single identifiable asset sourced from the agreement. Therefore, all the fair value associated with the agreement is concentrated in one identifiable asset and is not considered a business in accordance with ASC 805-10-55-5A. Therefore, we have accounted for the right to Agenus’s intellectual property acquired under the license agreement as an asset acquisition of in-process research and development. See Note 8 to the Consolidated Financial Statements for further information. General and Administrative Expenses General and administrative expenses consist primarily of personnel costs (including share-based compensation related to directors, executives, finance, commercial, medical affairs, business development, investor relations, and human resource functions). Other significant costs include commercial, medical affairs, external professional service costs, facility costs, accounting and audit services, legal services, and other consulting fees. We anticipate that our general and administrative expenses will increase in the future as we increase our administrative headcount and infrastructure to support the potential approval and commercialization of our product candidates and our continued research and development programs. These increases will likely include increased costs related to the hiring of additional personnel and fees to outside consultants, lawyers and accountants, among other expenses. Interest and Other (Income) Expenses, Net Interest and other (income) expenses, net, consisted primarily of interest income. Income Taxes We have yet to generate taxable income in Israel. We have historically incurred operating losses resulting in carryforward tax losses totaling approximately $151.9 million as of December 31, 2019. We anticipate that we will continue to generate tax losses for the foreseeable future and that we will be able to carryforward these tax losses indefinitely to future taxable years. Accordingly, we do not expect to pay taxes in Israel until we have taxable income after the full utilization of our carryforward tax losses. We have provided a full valuation allowance with respect to the deferred tax assets related to these carryforward losses. Results of Operations Comparison of the Years Ended December 31, 2019 and 2018 The following table sets forth our results of operations for the years ended December 31, 2019 and 2018. Revenues Revenues were $18,000 and $1.1 million for the years ended December 31, 2019 and 2018, respectively. The decrease of $1.1 million was primarily due to the decreased revenue recognized under the Allergan Agreement. Research and Development Expenses Research and development expenses increased by $12.4 million to $49.3 million in the year ended December 31, 2019 from $36.9 million in the year ended December 31, 2018. Excluding the $10 million milestone payment related to our license agreement with Agenus Inc, research and development expenses increased by $2.4 million. An increase of $2.5 million is mainly comprised of $0.9 million in increased clinical activity of the UGN-102 Phase 2b clinical trial, a $1.1 million increase in headcount and related costs to support clinical trial activities and a $0.5 million increase in nonclinical activity as we advance our pipeline. An additional increase of $3.5 million was attributable to the purchase of API and other manufacturing related activities as we prepare for our UGN-101 product commercial launch, partly offset by a decrease of $3.7 million in share-based compensation. Total non-cash research and development share-based compensation expense was $8.3 million and $12.0 million for the years ended December 31, 2019 and 2018, respectively. General and Administrative Expenses General and administrative expenses were $60.2 million and $39.6 million for the years ended December 31, 2019 and 2018, respectively. The increase in general and administrative expenses of $20.6 million resulted primarily from an $8.1 million increase in headcount and related costs as part of the buildout of the company in anticipation of commercialization of our first product. The remaining increase resulted primarily from a $3.1 million increase in share-based compensation expense due to new grants, an $8.5 million increase in commercial services and a $0.6 million increase in consultant and directors’ fees. Total non-cash general and administrative share-based compensation expense was $21.7 million and $18.6 million for the years ended December 31, 2019 and 2018, respectively. Interest and Other (Income) Expenses, Net Interest and other (income) expenses, net was income of $4.3 million and income of $1.6 million for the years ended December 31, 2019 and 2018, respectively. The increase of $2.7 million was primarily due to increased interest earned on our cash balances and investments in marketable securities. Comparison of the Years Ended December 31, 2018 and 2017 The following table sets forth our results of operations for the years ended December 31, 2018 and 2017. Revenues Our total revenues decreased by $7.0 million to $1.1 million in the year ended December 31, 2018 from $8.2 million in the year ended December 31, 2017. This decrease is due to the proceeds of $7.5 million received from Allergan upon the achievement of a certain milestone under the Allergan Agreement in the year ended December 31, 2017. Research and Development Expenses Research and development expenses increased by $18.2 million to $36.9 million in the year ended December 31, 2018 from $18.7 million in the year ended December 31, 2017. Approximately $8.1 million of the increase was attributable to share-based compensation, including $2.4 million in modification costs relating to senior management severance packages and $5.7 million in new grants to executive management and employees. The remaining increase of $10.1 million is mainly comprised of $4.1 million in increased headcount and related costs to support increased clinical trial activities, a $2.5 million increase in direct costs associated with the UGN-101 Phase 3 clinical trial, a $2.7 million increase due to increased clinical activity of the UGN-102 Phase 2b clinical trial and approximately a $0.6 million increase in allocated overhead costs to support the growth of our U.S. operations. Total non-cash research and development share-based compensation expense was $12.0 million and $3.9 million for the years ended December 31, 2018 and 2017, respectively. General and Administrative Expenses General and administrative expenses were $39.6 million and $8.8 million for the years ended December 31, 2018 and 2017, respectively. The increase in general and administrative expenses of $30.8 million resulted primarily from an increase in share-based compensation expense of $16.2 million, including $7.5 million in modification costs relating to senior management severance packages and $8.7 million in new grants to executive management and employees. The remaining increase resulted primarily from a $5.3 million increase in payroll and recruitment costs due to headcount and related costs to support our growing business, an increase of $4.4 million in commercial services, an increase of $3.2 million in consultant and directors’ fees and an increase of $1.4 million to support the growth of our U.S. operations. Total non-cash general and administrative share-based compensation expense was $18.6 million and $2.4 million for the years ended December 31, 2018 and 2017, respectively. Interest and Other (Income) Expenses, Net Interest and other (income) expenses, net was ($1.6 million) compared to $31,000 for the years ended December 31, 2018 and 2017, respectively. The increase was primarily due to increased interest earned on our cash balances. Liquidity and Capital Resources As of December 31, 2019, we had $195.6 million in cash, cash equivalents, and marketable securities. Cash in excess of immediate requirements is invested in accordance with our investment policy, primarily with a view to liquidity and capital preservation, and is held primarily in U.S. dollars. We believe that our existing cash, cash equivalents and short-term investments will enable us to fund our operating and capital expenditure requirements for at least the next 12 months. Through December 31, 2019, we funded our operations primarily through public equity offerings, private placements of equity securities and through the upfront payment received under the Allergan Agreement. In May 2017, we raised $60.8 million, net of issuance costs and underwriting discounts and commissions, in our IPO on the Nasdaq Global Market. In August 2017, we received $7.5 million from Allergan upon the achievement of a milestone under the Allergan Agreement. In January 2018, we completed an underwritten public offering of 1,682,926 of our ordinary shares, including 219,512 shares sold pursuant to the full exercise of the underwriters’ option to purchase additional shares, at a price to the public of $41.00 per share. The net proceeds to us from the offering were approximately $64.0 million, after deducting the underwriting discounts and commissions and payment of other offering expenses. In January 2019, we completed an underwritten public offering of 4,207,317 of our ordinary shares, including 548,780 shares sold pursuant to the full exercise of the underwriters’ option to purchase additional shares, at a price to the public of $41.00 per share. The net proceeds to us from the offering were approximately $161.4 million, after deducting the underwriting discounts and commissions and payment of other offering expenses. In December 2019, we entered into a sales agreement pursuant to which we may from time to time offer and sell our ordinary shares having an aggregate offering price of up to $100.0 million. The shares are offered and will be sold pursuant to a shelf registration statement on Form S-3 which was declared effective by the SEC on January 2, 2020. No sales have occurred under this agreement as of the date of this filing. We have incurred losses since our inception and negative cash flows from our operations, and as of December 31, 2019 we had an accumulated deficit of $228.0 million. We anticipate that we will continue to incur losses for at least the next several years. Our primary uses of capital are, and we expect will continue to be, commercialization activities, research and development expenses, including third-party clinical research and development services, laboratory and related supplies, clinical costs, including manufacturing costs, legal and other regulatory expenses and general and administrative costs. Because the NDA for UGN-101 is pending review by the FDA and UGN-102 is still in clinical development and the outcome of these efforts is uncertain, we cannot estimate the actual amounts necessary to successfully complete the development and commercialization of product candidates or whether, or when, we may achieve profitability. Until such time, if ever, as we can generate substantial product revenue, we expect to finance our cash needs through a combination of equity or debt financings and collaboration arrangements. Cash Flows The following table sets forth the significant sources and uses of cash for the periods set forth below: Operating Activities Net cash used in operating activities was $71.0 million during the year ended December 31, 2019, compared to $37.3 million used in operating activities during the year ended December 31, 2018. The $33.7 million increase was attributable primarily to the increase of $29.2 million in the net loss for the year and a net increase in operating assets and liabilities of $4.5 million. Net cash used in operating activities was $37.3 million during the year ended December 31, 2018, compared to $9.6 million used in operating activities during the year ended December 31, 2017. The increase in cash used in operating activities was attributable primarily to the increase of $55.7 million in the net loss for the year partially offset by $24.3 million increase in share-based compensation. Investing Activities Net cash used in investing activities was $145.6 million during the year ended December 31, 2019, compared to net cash provided by investing activities of $35.3 million during the year ended December 31, 2018. The decrease of $180.9 million is primarily related to our investment in marketable securities. Net cash provided by investing activities was $35.3 million during the year ended December 31, 2018, compared to net cash used in investing activities of $36.3 million during the year ended December 31, 2017. The increase of $71.6 million is primarily related to our investment in 2017 and subsequent sale in 2018 of a short-term investment. Financing Activities Net cash provided by financing activities was $165.3 million during the year ended December 31, 2019, compared to net cash provided by financing activities of $66.4 million during the year ended December 31, 2018. The increase is primarily related to the increased net proceeds received from our January 2019 financing as compared to our January 2018 financing. Net cash provided by financing activities was $66.4 million during the year ended December 31, 2018, compared to net cash provided by financing activities of $61.6 million during the year ended December 31, 2017. The difference is primarily related to the net proceeds received from our January 2018 financing as compared to our IPO in May 2017. Funding Requirements Our present and future funding requirements will depend on many factors, including, among other things: • the outcome of the FDA’s review of the NDA for UGN-101; • the progress, timing and completion of clinical trials for UGN-102; • nonclinical studies and clinical trials for UGN-201 or any of our other product candidates; • the costs related to obtaining regulatory approval for UGN-101, UGN-102 and UGN-201 and any of our other product candidates, and any delays we may encounter as a result of regulatory requirements or adverse clinical trial results with respect to any of these product candidates; • selling, marketing and patent-related activities undertaken in connection with the commercialization of UGN-101 and UGN-102 and any of our other product candidates, and costs involved in the development of an effective sales and marketing organization; • the costs involved in filing and prosecuting patent applications and obtaining, maintaining and enforcing patents or defending against claims or infringements raised by third parties, and license royalties or other amounts we may be required to pay to obtain rights to third party intellectual property rights; • potential new product candidates we identify and attempt to develop; and • revenues we may derive either directly or in the form of royalty payments from future sales of UGN-101, UGN-102, UGN-201, BOTOX/RTGel reverse thermal hydrogel and any other product candidates. Accordingly, we will need to obtain substantial additional funding in connection with our continuing operations. If we are unable to raise capital when needed or on attractive terms, we would be forced to delay, reduce or eliminate our research and development programs or future commercialization efforts. Until such time, if ever, as we can generate substantial product revenue, we may finance our cash needs through a combination of equity offerings, debt financings, collaborations, strategic alliances and licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest will be diluted, and the terms of any additional securities may include liquidation or other preferences that adversely affect your rights as a shareholder. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through additional collaborations, strategic alliances or licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies, future revenue streams, research programs or product candidates or to grant licenses on terms that may not be favorable to us. If we are unable to raise additional funds through equity or debt financings when needed, we may be required to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market product candidates that we would otherwise prefer to develop and market ourselves. For more information as to the risks associated with our future funding needs, see “Item 1.A - Risk Factors.” We will require substantial additional financing to achieve our goals, and a failure to obtain this capital when needed and on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product development, commercialization efforts or other operations. Contractual Obligations and Commitments The obligations detailed below do not include grants received from the IIA pursuant to which we will owe royalties or reimbursement upon commercialization of our product candidates. As of December 31, 2019, the maximum royalty amount payable by us under these funding arrangements is $2.1 million, excluding interest. Under the R&D Law, a company that received grants from the IIA may not transfer IIA-funded technology or manufacture products developed with IIA-funded technology outside of the State of Israel without first obtaining the approval of the IIA. We may be required to pay increased royalties of up to 300% of the amount of the original grant and other amounts; if we do not receive such approvals, we may be required to pay significant penalties. In January 2020, the IIA approved our request to unwind our obligation to the IIA as a transfer of knowledge. See Note 15 to the Consolidated Financial Statements included in this report for additional information. The following summarizes our significant contractual obligations as of December 31, 2019: (1) Operating lease obligations consist of payments pursuant to lease agreements for our Israeli offices and laboratory facility and our New Jersey, New York and Los Angeles offices. In November 2014, we entered into a lease agreement for our Israeli offices effective from February 1, 2015 for a period of three years, with an option to extend the lease agreement by an additional three years. In April 2016, we signed an addendum to the November 2014 lease agreement in order to increase the office space rented and extend the rental period. In November 2017, we signed an additional addendum to the November 2014 lease agreement in order to increase the office space rented. The lease agreement was extended in September 2019 for three years until September 30, 2022. In September 2017, Urogen Pharma, Inc. entered into a new lease agreement for its current New York office for a period of approximately 41 months, which period commenced in October 2017. The new lease agreement will terminate on February 1, 2021, unless earlier terminated in accordance with its terms. In April 2018, we entered into a new lease agreement for an office in Los Angeles, CA. The lease commencement date was July 10, 2018 and terminates in March 2024. In November 2019, we subleased our offices in Los Angeles, CA. The lease commencement date was January 1, 2020 and terminates in March 2024. The subtenants exercised their early access clause and moved into the premises the end of November 2019. Also, in November 2019, we entered into a new lease agreement, dated effective October 31, 2019, for an office in Princeton, NJ. The lease commencement date was November 29, 2019 and the lease term is 38 months. Critical Accounting Policies and Significant Judgments and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements requires us to make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities as of the dates of the balance sheets and the reported amounts of revenue and expenses during the reporting periods. In accordance with GAAP, we base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances at the time such estimates are made. Actual results may differ materially from our estimates and judgments under different assumptions or conditions. We periodically review our estimates in light of changes in circumstances, facts and experience. The effects of material revisions in estimates, if any, are reflected in our financial statements prospectively from the date of the change in estimate. We define our critical accounting policies as those accounting principles generally accepted in the United States that require us to make subjective estimates and judgments about matters that are uncertain and are likely to have a material impact on our financial condition and results of operations, as well as the specific manner in which we apply those principles. While our significant accounting policies are more fully described in Note 3 to our consolidated financial statements appearing elsewhere in this Annual Report, we believe the following are the critical accounting policies used in the preparation of our financial statements that require significant estimates and judgments. Leases We are a lessee in several noncancelable operating leases, primarily for office space, office equipment and vehicles. We currently have no finance leases. We account for leases in accordance with ASC Topic 842, “Leases”. We determine if an arrangement is a lease at inception. Right-of-use (“ROU”) assets and operating lease liabilities are recognized based on the present value of lease payments over the lease term as of the commencement date. Operating lease ROU assets are presented as operating lease right of use assets on the consolidated balance sheets. The current portion of operating lease liabilities is included in other current liabilities and the long-term portion is presented separately as operating lease liabilities on the consolidated balance sheets. Lease expense is recognized on a straight-line basis for operating leases. Variable lease payments associated with our leases are recognized when the event, activity, or circumstance in the lease agreement on which those payments are assessed occurs. Variable lease payments are presented as operating expense on the consolidated statements of operations in the same line item as expense arising from fixed lease payments. Our lease terms may include options to extend the lease. The lease extensions are included in the measurement of the right of use asset and lease liability when it is reasonably certain that it will exercise that option. Because most of our leases do not provide an implicit rate of return, an incremental borrowing rate is used based on the information available at the commencement date in determining the present value of lease payments on an individual lease basis. Our incremental borrowing rate for a lease is the rate of interest it would have to pay on a collateralized basis to borrow an amount equal to the lease payments under similar terms. We have lease agreements with lease and non-lease components. We applied the modified retrospective transition method and elected the transition option to use the effective date of January 1, 2019 as the date of initial application (“Transition Date”). Consequently, the disclosures required under Topic 842 are not provided for dates and periods before January 1, 2019. Revenues We derive virtually all our revenues from a license and supply agreement with Allergan. Under the agreement, we grant Allergan an exclusive license to develop, commercialize, and otherwise exploit products that contain RTGel and agrees to supply Allergan with pre-clinical and clinical quantities of the RTGel product, also referred to as the RTGel vials. The license agreement contains up-front license fees, future supply fees, development, regulatory, and sales-based milestone payments, and sales-based royalty payments. We determined that Allergan is our customer and the license and supply agreements are in scope of accounting standards codification, or ASC, 606, which we adopted as of January 1, 2018. We adopted ASC 606 under the modified retrospective method, which did not have a material impact on the Consolidated Statements of Operations. Previously, we analyzed revenues under ASC 605, which states that revenue is recognized only when all of the following conditions have been met: (i) there is persuasive evidence of an arrangement; (ii) delivery has occurred: (iii) the fee is fixed or determinable: and (iv) collectability of the fee is reasonably assured. The adoption of ASC 606 did not have a material impact on the timing and manner of recognized revenues. Under ASC 606, in determining the appropriate amount of revenue to be recognized as it fulfills its obligations under the agreements with Allergan, we performed the following steps: 1) Identification of the contract; 2) Determination of whether the promised goods or services are performance obligations including whether they are distinct in the context of the contract; 3) Measurement of the transaction price, including the constraint on variable consideration; 4) Allocation of the transaction price to the performance obligations; 5) Recognition of revenue when or as the Company satisfies each performance obligation. The license agreement contains two performance obligations: (a) the license component and (b) Allergan’s right to require supply services of RTGel vials from us. The license component has standalone value (and therefore is accounted for separately from the supply services) since Allergan can use the license for its intended purposes without the Company’s supply services. In an arrangement with multiple goods and services, a good or service that is promised to a customer shall be considered a separate performance obligation if all the following criteria are met: 1) The customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct); and 2) The entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract). Allocating the Consideration in the Arrangement Since the license to our intellectual property was determined to be functional and distinct from the other performance obligations identified in the arrangement, we recognized revenues from non-refundable, up-front fees allocated to the license when the license was transferred to Allergan and Allergan was able to use and benefit from the license. Development and Regulatory Milestone Payments At the inception of an arrangement that includes development milestone payments, we evaluate whether the development milestones are considered probable of being reached and estimates the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant revenue reversal would not occur, the associated development milestone value is included in the transaction price. Development milestone payments that are not within our control or the licensee, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. The milestones are allocated entirely to the license performance obligation, as (1) the terms of milestone and royalty payments relate specifically to the license and (2) allocating milestones and royalties to the license performance obligation is consistent with the overall allocation objective, because management’s estimate of the supply fee approximates the standalone selling price for RTGel vials and management’s estimate of milestones and royalties approximates the standalone selling price of the license. During the year ended December 31, 2017, we recognized revenue of $7.5 million related to a development milestone payment resulting from Allergan’s submission of an IND application for our RTGel in combination with Allergan’s BOTOX for the treatment of overactive bladder to the U.S. FDA. Royalties Based on Allergan’s Revenue We are also entitled to royalties based on Allergan’s revenue from its product, however, these amounts would only be recognized when the conditions are met. Supply of RTGel We recognize revenue related to the supply of RTGel at a point in time, upon delivery to Allergan. During the years ended December 31, 2018 and 2017, we recognized $1.1 million and $0.7 million of revenue related to RTGel vials supplied to Allergan, respectively. Shipping and handling costs associated with supply of RTGel vials are accounted for as a fulfillment cost and are in included in cost of revenues. Research and Development Research and development costs are expensed as incurred and consist primarily of the cost of salaries, share-based compensation expenses, payroll taxes and other employee benefits, subcontractors and materials used for research and development activities, including nonclinical studies, clinical trials, API, other manufacturing costs and professional services. The costs of services performed by others in connection with the research and development activities of an entity, including research and development conducted by others on behalf of the entity, shall be included in research and development costs. The costs of intangibles that are purchased from others for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are recognized as research and development expense at the time the costs are incurred. License fees and development milestone payments related to in-licensed products and technology are expensed as incurred if it is determined at that point that they have no established alternative future use. We recorded $10.0 million in research and development expenses for the year ended December 31, 2019, comprised of a milestone related to our license agreement with Agenus Inc. Share-Based Compensation We account for employees’ and directors’ share-based payment awards classified as equity awards using the grant-date fair value method. The fair value of share-based payment transactions is recognized as an expense over the requisite service period. We account for forfeitures as they occur according to the FASB’s Accounting Standards Update, or ASU, 2016-09, Improvements to Employee Share-Based Payment Accounting. We elected to recognize compensation costs for awards conditioned only on continued service that have a graded vesting schedule using the straight-line method and to value the awards based on the single-option award approach. Performance based awards are expensed over the requisite service period when the achievement of performance criteria is probable. As of December 31, 2018, we adopted ASU 2018-07, Compensation-Stock Compensation, which establishes that the measurement of equity-classified nonemployee awards will be fixed at the grant date. The adoption of ASU 2018-07 did not have an impact on the consolidated statements of operations. Off-Balance Sheet Arrangements During the periods presented, we did not have, nor do we currently have, any off-balance sheet arrangements as defined under SEC rules.

<s>[INST] Overview We are a biopharmaceutical company dedicated to building and commercializing novel solutions that treat specialty cancers and urologic diseases. We have developed RTGel™ reversethermal hydrogel, a proprietary sustained release, hydrogelbased platform technology that has the potential to improve therapeutic profiles of existing drugs. Our technology is designed to enable longer exposure of the urinary tract tissue to medications, making local therapy a potentially more effective treatment option. Our lead investigational candidates, UGN101 (mitomycin gel) for instillation, and UGN102 (mitomycin gel) for intravesical instillation, are designed to ablate tumors by nonsurgical means and to treat several forms of nonmuscle invasive urothelial cancer, including lowgrade upper tract urothelial carcinoma, or LG UTUC, and lowgrade nonmuscle invasive bladder cancer, or LG NMIBC, respectively. We estimate that the annual treatable population of LG UTUC in the United States is approximately 6,000 to 7,000; the annual treatable population of LG Intermediate Risk NMIBC is approximately 80,000. We believe that RTGelbased drug formulations, which provide for the sustained release of an active drug, may improve the efficacy of treatment of various types of urothelial cancer with an acceptable safety profile that permits the natural flow of fluids from the kidney via the urinary tract to the bladder. Our formulations are designed to achieve this by increasing the dwell time in the kidney and bladder to maximize tissue exposure of the active drug. Consequently, we believe that RTGelbased drug formulations may enable us to overcome the anatomical and physiological challenges that have historically contributed to the lack of drug development for the treatment of urothelial cancer and other urological pathologies. In December 2019, the FDA accepted for filing and granted priority review for our New Drug Application, or NDA, for UGN101 (mitomycin gel) for instillation as a potential treatment for patients with LG UTUC. If approved, UGN101 would be the first nonsurgical treatment option for LG UTUC. We are on track for the potential launch of UGN101 by midyear 2020. The FDA previously granted Orphan Drug, Fast Track, and Breakthrough Therapy Designations to UGN101 for the treatment of LG UTUC. The NDA is supported by the positive results from the pivotal Phase 3 OLYMPUS clinical trial. Results from a final analysis of the primary endpoint showed that UGN101 demonstrated a complete response rate of 59% in patients with LG UTUC. In addition, the durability of response was estimated to be 89% at six months and 84% at 12 months by Kaplan Meier analysis. Median time to recurrence was estimated to be 13 months. The most commonly reported treatment emergent adverse events were ureteric stenosis (43.7%), urinary tract infection (32.4%), haematuria (31.0%), flank pain (29.6%) nausea (23.9%), dysuria (21.1%), renal impairment (19.7%) and vomiting (19.7%). The majority of these adverse events were mild to moderate, with 8.5% of patients having events of ureteric stenosis reported as severe. In addition, we are evaluating the safety and efficacy of UGN102 (mitomycin gel) for intravesical instillation, our novel sustainedrelease high dose formulation of mitomycin, for the treatment of LG NMIBC. In September 2019, we reported the interim data of our Phase 2b OPTIMA II trial of investigational UGN102 (mitomycin gel) for intravesical instillation for patients with LG Intermediate Risk NMIBC, defined as those with one or two of the following criteria: multifocal disease, large tumors and rapid rates of recurrence. The singlearm, open label study trial recently completed enrollment of 63 [/INST] Positive. </s>

Evergy, Inc.

2019-02-22

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS EVERGY, INC. EXECUTIVE SUMMARY Evergy, Inc. is a public utility holding company incorporated in 2017 and headquartered in Kansas City, Missouri. Evergy operates primarily through the following wholly-owned direct subsidiaries: • Westar Energy is an integrated, regulated electric utility that provides electricity to customers in the state of Kansas. Westar Energy has one active wholly-owned subsidiary with significant operations, KGE. • KCP&L is an integrated, regulated electric utility that provides electricity to customers in the states of Missouri and Kansas. • GMO is an integrated, regulated electric utility that provides electricity to customers in the state of Missouri. • GPETHC owns 13.5% of Transource with the remaining 86.5% owned by AEP Transmission Holding Company, LLC, a subsidiary of AEP. Transource is focused on the development of competitive electric transmission projects. GPETHC accounts for its investment in Transource under the equity method. Westar Energy also owns a 50% interest in Prairie Wind, which is a joint venture between Westar Energy and affiliates of AEP and Berkshire Hathaway Energy Company. Prairie Wind owns a 108-mile, 345 kV double-circuit transmission line that provides transmission service in the SPP. Westar Energy accounts for its investment in Prairie Wind under the equity method. Westar Energy and KGE conduct business in their respective service territories using the name Westar Energy. KCP&L and GMO conduct business in their respective service territories using the name KCP&L. Collectively, the Evergy Companies have approximately 14,500 MWs of owned generating capacity and renewable purchased power agreements and engage in the generation, transmission, distribution and sale of electricity to approximately 1.6 million customers in the states of Kansas and Missouri. The Evergy Companies assess financial performance and allocate resources on a consolidated basis (i.e., operate in one segment). Great Plains Energy and Westar Energy Merger Evergy was incorporated in 2017 as Monarch Energy, a wholly-owned subsidiary of Great Plains Energy. Prior to the closing of the merger transactions, Monarch Energy changed its name to Evergy and did not conduct any business activities other than those required for its formation and matters contemplated by the Amended Merger Agreement. On June 4, 2018, in accordance with the Amended Merger Agreement, Great Plains Energy merged into Evergy, with Evergy surviving the merger and King Energy merged into Westar Energy, with Westar Energy surviving the merger. These merger transactions resulted in Evergy becoming the parent entity of Westar Energy and the direct subsidiaries of Great Plains Energy, including KCP&L and GMO. As a result of the closing of the merger transactions, each outstanding share of Great Plains Energy common stock was converted into 0.5981 shares of Evergy common stock, resulting in the issuance of 128.9 million shares. Additionally, each outstanding share of Westar Energy common stock was converted into 1 share of Evergy common stock. Westar Energy was determined to be the accounting acquirer and thus, the predecessor of Evergy. Therefore, Evergy's accompanying consolidated financial statements reflect the results of operations of Westar Energy for 2017 and 2016 and the financial position of Westar Energy as of December 31, 2017. Evergy had separate operations for the period beginning with the quarter ended June 30, 2018, and references to amounts for periods after the closing of the merger relate to Evergy. The results of Great Plains Energy's direct subsidiaries have been included in Evergy's results of operations from the date of the closing of the merger and thereafter. KCP&L has elected not to apply "push-down accounting" related to the merger, whereby the adjustments of assets and liabilities to fair value and the resulting goodwill would be recorded on the financial statements of the acquired subsidiary. These adjustments for KCP&L, as well as those related to the acquired assets and liabilities of Great Plains Energy and its other direct subsidiaries, are only reflected on Evergy's consolidated financial statements. See Note 2 to the consolidated financial statements for more information regarding the merger. Common Stock Repurchase Program In July 2018, the Evergy Board authorized the repurchase of up to 60 million shares of Evergy's common stock. Although this repurchase authorization has no expiration date, Evergy expects to repurchase approximately 60 million shares by mid-2020. Evergy plans to utilize various methods to effectuate the share repurchase program, including but not limited to, a series of transactions that may include ASRs, open market transactions or other means, subject to market conditions and applicable legal requirements. The repurchase program may be suspended, discontinued or resumed at any time. For 2018, Evergy had total repurchases of common stock of approximately $1,042 million and had repurchased 16.4 million shares under the repurchase program. These repurchase totals include shares repurchased under ASR agreements, one of which had not reached final settlement as of December 31, 2018, and are discussed further below. In August 2018, Evergy entered into two ASR agreements with financial institutions to purchase $450.0 million of Evergy common stock. The ASR agreements reached final settlement in the fourth quarter of 2018 and resulted in the delivery of 7.9 million shares to Evergy based on the average daily volume weighted-average price of Evergy common stock during the term of the ASR agreements, less a negotiated discount. In November 2018, Evergy entered into an ASR agreement with a financial institution to purchase $475.0 million of Evergy common stock. In December 2018, the financial institution delivered to Evergy 6.4 million shares of common stock, representing a partial settlement of the contract, based on then-current market prices and Evergy paid a total of $475.0 million. The final number of shares of Evergy common stock that Evergy may receive or be required to remit upon settlement of the ASR agreement will be based on the average daily volume weighted-average price of Evergy common stock during the term of the ASR agreement, less a negotiated discount. Final settlement of the ASR agreement will occur by March 2019, but may occur earlier at the option of the financial institution. Evergy expects that the final settlement of the ASR agreement will result in the delivery of additional shares of common stock to Evergy at no additional cost. See Note 17 to the consolidated financial statements for more information regarding Evergy's common stock repurchase program. Missouri Legislation On June 1, 2018, Missouri Senate Bill (S.B.) 564 was signed into law by the Governor of Missouri. Most notably, S.B. 564 includes a PISA provision that can be elected by Missouri electric utilities to defer to a regulatory asset and recover 85% of depreciation expense and associated return on investment for qualifying electric plant rate base additions. Qualifying electric plant includes all rate base additions with the exception of new coal, nuclear or natural gas generating units or rate base additions that increase revenues by allowing service to new customer premises. The deferred depreciation and return recorded in the associated regulatory asset, except for any prudence disallowances, is required to be included in determining the utility's rate base during subsequent general rate proceedings subject to a 3% compound annual growth rate limitation on future electric rates compared with the utility's rates in effect prior to electing PISA. Utilities that elect the PISA provision can make qualifying deferrals of depreciation and return through December 2023, with a potential extension through December 2028 subject to MPSC approval. Except under certain circumstances, utilities that elect the PISA provision must keep base rates constant for three years following the utilities' last general rate case. KCP&L and GMO have elected the PISA provision of S.B. 564 effective as of January 1, 2019. Regulatory Proceedings See Note 5 to the consolidated financial statements for information regarding regulatory proceedings. Plant Retirements In 2017, Westar Energy announced plans to retire Unit 7 at Tecumseh Energy Center, Units 3 and 4 at Murray Gill Energy Center and Units 1 and 2 at Gordon Evans Energy Center, subject to the completion of the merger in 2018. In 2017, KCP&L and GMO also announced plans to retire KCP&L's Montrose Station and GMO's Sibley Station. In the fourth quarter of 2018, Westar Energy, KCP&L and GMO retired these stations consistent with their previously announced plans. Strategy Evergy expects to continue operating its vertically integrated utilities within the currently existing regulatory frameworks. Evergy's objectives are to deliver value to shareholders through earnings and dividend growth; serve customers and communities with reliable service, clean energy and fewer and lower rate increases; and maintain a rewarding and challenging work environment for employees. Significant elements of Evergy's strategy to achieve these objectives include: • the realization of a total of approximately $550 million of potential net savings from 2018 through 2022 resulting from synergies that are expected to be created as a result of the merger; • the repurchase of approximately 60 million outstanding shares of Evergy common stock by mid-2020; • anticipated rate base investment of approximately $6 billion from 2018 through 2022; • the continued growth of Evergy's renewable energy portfolio as the Evergy Companies retire older and less efficient fossil fuel plants; and • implementation of the rate orders received by the KCC and MPSC in 2018. See "Cautionary Statements Regarding Certain Forward-Looking Information" and Part I, Item 1A, Risk Factors, for additional information. Earnings Overview The following table summarizes Evergy's net income and diluted earnings per common share (EPS). Net income and diluted EPS increased in 2018 compared to 2017, primarily due to the inclusion of KCP&L's and GMO's earnings beginning in June 2018, higher Westar Energy retail sales driven by favorable weather and lower income tax expense, partially offset by merger-related costs and reductions of revenue for customer bill credits incurred following the close of the merger. In addition, a higher number of diluted weighted average common shares outstanding due to the issuance of common shares to Great Plains Energy shareholders as a result of the merger diluted earnings per share $1.26 for 2018. For additional information regarding the change in net income, refer to the Evergy Results of Operations section within this MD&A. Impact of Recently Issued Accounting Standards See Note 1 to the consolidated financial statements for information regarding the impact of recently issued accounting standards. Wolf Creek Refueling Outage Wolf Creek's most recent refueling outage began in March 2018 and the unit returned to service in May 2018. Wolf Creek's next refueling outage is planned to begin in the third quarter of 2019. ENVIRONMENTAL MATTERS See Note 14 to the consolidated financial statements for information regarding environmental matters. RELATED PARTY TRANSACTIONS See Note 16 to the consolidated financial statements for information regarding related party transactions. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures. Management considers an accounting estimate to be critical if it requires assumptions to be made that were uncertain at the time the estimate was made and changes in the estimate or different estimates that could have been used could have a material impact on Evergy's results of operations and financial position. Management has identified the following accounting policies as critical to the understanding of Evergy's results of operations and financial position. Management has discussed the development and selection of these critical accounting policies with the Audit Committee of the Evergy Board. Pensions Evergy incurs significant costs in providing non-contributory defined pension benefits. The costs are measured using actuarial valuations that are dependent upon numerous factors derived from actual plan experience and assumptions of future plan experience. Pension costs are impacted by actual employee demographics (including age, life expectancies, compensation levels and employment periods), earnings on plan assets, the level of contributions made to the plan, and plan amendments. In addition, pension costs are also affected by changes in key actuarial assumptions, including anticipated rates of return on plan assets and the discount rates used in determining the projected benefit obligation and pension costs. The assumed rate of return on plan assets was developed based on the weighted-average of long-term returns forecast for the expected portfolio mix of investments held by the plan. The assumed discount rate was selected based on the prevailing market rate of fixed income debt instruments with maturities matching the expected timing of the benefit obligation. These assumptions, updated annually at the measurement date, are based on management's best estimates and judgment; however, material changes may occur if these assumptions differ from actual events. See Note 9 to the consolidated financial statements for information regarding the assumptions used to determine benefit obligations and net costs. The following table reflects the sensitivities associated with a 0.5% increase or a 0.5% decrease in key actuarial assumptions for Evergy's qualified pension plans. Each sensitivity reflects the impact of the change based on a change in that assumption only. Pension expense for Westar Energy, KCP&L and GMO is recorded in accordance with rate orders from the KCC and MPSC. The orders allow the difference between pension costs under GAAP and pension costs for ratemaking to be recorded as a regulatory asset or liability with future ratemaking recovery or refunds, as appropriate. In 2018, Evergy's pension expense was $90.1 million under GAAP and $98.4 million for ratemaking. The impact on 2019 pension expense in the table above reflects the impact on GAAP pension costs. Under the Evergy Companies' rate agreements, any increase or decrease in GAAP pension expense would be deferred in a regulatory asset or liability for future ratemaking treatment. See Note 9 to the consolidated financial statements for additional information regarding the accounting for pensions. Market conditions and interest rates significantly affect the future assets and liabilities of the plan. It is difficult to predict future pension costs, changes in pension liability and cash funding requirements due to the inherent uncertainty of market conditions. Revenue Recognition Evergy recognizes revenue on the sale of electricity to customers over time as the service is provided in the amount it has the right to invoice. Revenues recorded include electric services provided but not yet billed by Evergy. Unbilled revenues are recorded for kWh usage in the period following the customers' billing cycle to the end of the month. This estimate is based on net system kWh usage less actual billed kWhs. Evergy's estimated unbilled kWhs are allocated and priced by regulatory jurisdiction across the rate classes based on actual billing rates. Evergy's unbilled revenue estimate is affected by factors including fluctuations in energy demand, weather, line losses and changes in the composition of customer classes. See Note 4 for the balance of unbilled receivables for Evergy as of December 31, 2018 and 2017. Regulatory Assets and Liabilities Evergy has recorded assets and liabilities on its consolidated balance sheets resulting from the effects of the ratemaking process, which would not otherwise be recorded under GAAP. Regulatory assets represent incurred costs that are probable of recovery from future revenues. Regulatory liabilities represent future reductions in revenues or refunds to customers. Management regularly assesses whether regulatory assets and liabilities are probable of future recovery or refund by considering factors such as decisions by the MPSC, KCC or FERC in Evergy's rate case filings; decisions in other regulatory proceedings, including decisions related to other companies that establish precedent on matters applicable to Evergy; and changes in laws and regulations. If recovery or refund of regulatory assets or liabilities is not approved by regulators or is no longer deemed probable, these regulatory assets or liabilities are recognized in the current period results of operations. Evergy's continued ability to meet the criteria for recording regulatory assets and liabilities may be affected in the future by restructuring and deregulation in the electric industry or changes in accounting rules. In the event that the criteria no longer applied to all or a portion of Evergy's operations, the related regulatory assets and liabilities would be written off unless an appropriate regulatory recovery mechanism were provided. Additionally, these factors could result in an impairment on utility plant assets. See Note 5 to the consolidated financial statements for additional information. Impairments of Assets and Goodwill Long-lived assets are required to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable as prescribed under GAAP. Accounting rules require goodwill to be tested for impairment annually and when an event occurs indicating the possibility that an impairment exists. The goodwill impairment test consists of comparing the fair value of a reporting unit to its carrying amount, including goodwill, to identify potential impairment. In the event that the carrying amount exceeds the fair value of the reporting unit, an impairment loss is recognized for the difference between the carrying amount of the reporting unit and its fair value. Evergy's consolidated operations are considered one reporting unit for assessment of impairment, as management assesses financial performance and allocates resources on a consolidated basis. Evergy's first impairment test for the $2,338.9 million of goodwill from the Great Plains Energy and Westar Energy merger will be conducted on May 1, 2019. Evergy anticipates that the determination of fair value for the reporting unit will consist of two valuation techniques: an income approach consisting of a discounted cash flow analysis and a market approach consisting of a determination of reporting unit invested capital using market multiples derived from the historical revenue, earnings before interest, income taxes, depreciation and amortization, net utility asset values and market prices of stock of peer companies. The results of the two techniques will be evaluated and weighted to determine a point within the range that management considers representative of fair value for the reporting unit, which involves a significant amount of management judgment. The discounted cash flow analysis is most significantly impacted by two assumptions: estimated future cash flows and the discount rate applied to those cash flows. Management will determine the appropriate discount rate to be based on the reporting unit's weighted average cost of capital (WACC). The WACC takes into account both the return on equity authorized by the KCC and MPSC and after-tax cost of debt. Estimated future cash flows are based on Evergy's internal business plan, which assumes the occurrence of certain events in the future, such as the outcome of future rate filings, future approved rates of return on equity, anticipated earnings/returns related to future capital investments, continued recovery of cost of service and the renewal of certain contracts. Management also makes assumptions regarding the run rate of operations, maintenance and general and administrative costs based on the expected outcome of the aforementioned events. Should the actual outcome of some or all of these assumptions differ significantly from the current assumptions, revisions to current cash flow assumptions could cause the fair value of the Evergy reporting unit under the income approach to be significantly different in future periods and could result in a future impairment charge to goodwill. The market approach analysis is most significantly impacted by management's selection of relevant peer companies as well as the determination of an appropriate control premium to be added to the calculated invested capital of the reporting unit, as control premiums associated with a controlling interest are not reflected in the quoted market price of a single share of stock. Management will determine an appropriate control premium by using an average of control premiums for recent acquisitions in the industry. Changes in results of peer companies, selection of different peer companies and future acquisitions with significantly different control premiums could result in a significantly different fair value of the Evergy reporting unit. Income Taxes Income taxes are accounted for using the asset/liability approach. Deferred tax assets and liabilities are determined based on the temporary differences between the financial reporting and tax bases of assets and liabilities, applying enacted statutory tax rates in effect for the year in which the differences are expected to reverse. Deferred investment tax credits are amortized ratably over the life of the related property. Deferred tax assets are also recorded for net operating losses, capital losses and tax credit carryforwards. Evergy is required to estimate the amount of taxes payable or refundable for the current year and the deferred tax liabilities and assets for future tax consequences of events reflected in Evergy's consolidated financial statements or tax returns. Actual results could differ from these estimates for a variety of reasons including changes in income tax laws, enacted tax rates and results of audits by taxing authorities. This process also requires management to make assessments regarding the timing and probability of the ultimate tax impact from which actual results may differ. Evergy records valuation allowances on deferred tax assets if it is determined that it is more likely than not that the asset will not be realized. See Note 19 to the consolidated financial statements for additional information. Asset Retirement Obligations Evergy has recognized legal obligations associated with the disposal of long-lived assets that result from the acquisition, construction, development or normal operation of such assets. Concurrent with the recognition of the liability, the estimated cost of the ARO incurred at the time the related long-lived assets were either acquired, placed in service or when regulations establishing the obligation became effective. The recording of AROs for regulated operations has no income statement impact due to the deferral of the adjustments through the establishment of a regulatory asset or an offset to a regulatory liability. Evergy initially recorded AROs at fair value for the estimated cost to decommission Wolf Creek (94% share), retire wind generating facilities, dispose of asbestos insulating material at its power plants, remediate ash disposal ponds and close ash landfills, among other items. ARO refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement may be conditional on a future event that may or may not be within the control of the entity. In determining Evergy's AROs, assumptions are made regarding probable future disposal costs and the timing of their occurrence. A change in these assumptions could have a significant impact on Evergy's AROs reflected on its consolidated balance sheets. As of December 31, 2018 and 2017, Evergy had recorded AROs of $687.1 million and $405.1 million, respectively. See Note 6 to the consolidated financial statements for more information regarding Evergy's AROs. EVERGY RESULTS OF OPERATIONS Evergy's results of operations and financial position are affected by a variety of factors including rate regulation, fuel costs, weather, customer behavior and demand, the economy and competitive forces. Substantially all of Evergy's revenues are subject to state or federal regulation. This regulation has a significant impact on the price the Evergy Companies charge for electric service. Evergy's results of operations and financial position are affected by its ability to align overall spending, both operating and capital, within the frameworks established by its regulators. Wholesale revenues are impacted by, among other factors, demand, cost and availability of fuel and purchased power, price volatility, available generation capacity, transmission availability and weather. The Evergy Companies primarily use coal and uranium for the generation of electricity for their customers and also purchase power on the open market. The prices for these commodities can fluctuate significantly due to a variety of factors including supply, demand, weather and the broader economic environment. Westar Energy, KCP&L and GMO have fuel recovery mechanisms in their Kansas and Missouri jurisdictions, as applicable, that allow them to defer and subsequently recover or refund, through customer rates, substantially all of the variance in net energy costs from the amount set in base rates without a general rate case proceeding. Weather significantly affects the amount of electricity that Evergy's customers use as electricity sales are seasonal. As summer peaking utilities, the third quarter typically accounts for the greatest electricity sales by the Evergy Companies. Hot summer temperatures and cold winter temperatures prompt more demand, especially among residential and commercial customers, and to a lesser extent, industrial customers. Mild weather reduces customer demand. Energy efficiency investments by customers and the Evergy Companies also can affect the demand for electric service. Through the Missouri Energy Efficiency Investment Act (MEEIA), KCP&L and GMO offer energy efficiency and demand side management programs to their Missouri retail customers and recover program costs, throughput disincentive, and as applicable, certain performance incentives in retail rates through a rider mechanism. The following table summarizes Evergy's comparative results of operations. Evergy Utility Gross Margin and MWh Sales Utility gross margin is a financial measure that is not calculated in accordance with GAAP. Utility gross margin, as used by the Evergy Companies, is defined as operating revenues less fuel and purchased power costs and amounts billed by the SPP for network transmission costs. Expenses for fuel and purchased power costs, offset by wholesale sales margin, are subject to recovery through cost adjustment mechanisms. As a result, changes in fuel and purchased power costs are offset in operating revenues with minimal impact on net income. In addition, SPP network transmission costs fluctuate primarily due to investments by SPP members for upgrades to the transmission grid within the SPP RTO. As with fuel and purchased power costs, changes in SPP network transmission costs are mostly reflected in the prices charged to customers with minimal impact on net income. See Note 3 to the consolidated financial statements for additional information regarding the manner in which Evergy reflects SPP revenues and expenses. Management believes that utility gross margin provides a meaningful basis for evaluating the Evergy Companies' operations across periods compared with operating revenues because utility gross margin excludes the revenue effect of fluctuations in these expenses. Utility gross margin is used internally to measure performance against budget and in reports for management and the Evergy Board. The Evergy Companies' definition of utility gross margin may differ from similar terms used by other companies. The following tables summarize Evergy's utility gross margin and MWhs sold. Evergy's utility gross margin increased $1,155.7 million in 2018 compared to 2017 driven by: • an $1,181.5 million increase due to the inclusion of KCP&L's and GMO's utility gross margin beginning in June 2018; and • a $75.0 million increase primarily due to higher Westar Energy retail sales driven by warmer spring and summer weather and colder winter weather. For 2018 compared to 2017, cooling degree days increased 31% and heating degree days increased 23%; partially offset by • a $69.8 million provision for rate refund recorded at Westar Energy for the change in the corporate income tax rate caused by the passage of the TCJA. See Note 19 to the consolidated financial statements for additional information; and • a $31.0 million reduction in revenue recorded at Westar Energy for one-time and annual bill credits as a result of conditions in the KCC merger order. See Note 2 to the consolidated financial statements for additional information. Evergy's utility gross margin decreased $38.2 million in 2017 compared to 2016 primarily due to lower Westar Energy retail sales driven by milder weather. For 2017 compared to 2016, cooling degree days decreased 13%. Other Operating Expenses (including operating and maintenance expense and taxes other than income tax) Evergy's other operating expenses increased $653.8 million in 2018 compared to 2017 primarily driven by: • a $453.0 million increase in operating and maintenance expense due to the inclusion of KCP&L's and GMO's operating and maintenance expenses beginning in June 2018, excluding the deferral of merger transition costs discussed below; • $69.5 million of merger-related costs incurred following the close of the merger in June 2018, consisting of: ◦ $24.7 million of unconditional charitable contributions and community support recorded by Evergy in accordance with conditions in the KCC and MPSC merger orders; ◦ $44.2 million of Westar Energy change in control payments, Westar Energy voluntary severance and the recording of unrecognized equity compensations costs and the incremental fair value associated with the vesting of outstanding Westar Energy equity compensation awards in accordance with the Amended Merger Agreement; and ◦ $48.4 million of merger consulting fees and fees for other outside services incurred, primarily consisting of merger success fees; partially offset by ◦ a $47.8 million decrease in operating and maintenance expense due to the deferral of merger transition costs to a regulatory asset in June 2018 for future recovery by Westar Energy, KCP&L and GMO in accordance with the KCC and MPSC merger orders; • a $95.3 million increase in taxes other than income taxes due to the inclusion of KCP&L and GMO amounts beginning in June 2018; • $12.3 million of obsolete inventory write-offs for Westar Energy's Unit 7 at Tecumseh Energy Center, Units 3 and 4 at Murray Gill Energy Center and Units 1 and 2 at Gordon Evans Energy Center, which were retired in the fourth quarter of 2018; and • a $5.5 million increase due to Westar Energy's 47% share of voluntary severance expenses incurred related to the Wolf Creek voluntary exit program. Evergy's other operating expenses decreased $47.8 million in 2017 compared to 2016 primarily driven by: • a $24.2 million decrease in Westar Energy's property tax expense due to a decrease in amortization of the regulatory asset comprised of actual costs incurred for property taxes in the prior year in excess of amounts collected in prices in the prior year, which is mostly offset in retail revenues; • an $8.6 million decrease in Westar Energy's transmission and distribution expense due to higher grid resiliency costs in 2016 and receiving credit for assisting other utilities with mutual aid during an active hurricane season, which offsets operating and maintenance expense; • a $7.1 million decrease in Westar Energy's employee at-risk compensation that is payable only upon meeting pre-established operating and financial objectives; • a $5.8 million decrease in Westar Energy's nuclear operating and maintenance costs primarily due to receiving a legal settlement related to Wolf Creek in 2017; and • a $4.9 million decrease in Westar Energy's operating and maintenance expense at coal fired plants primarily due to a planned outage at Jeffrey Energy Center in 2016; partially offset by • an $8.8 million increase in Westar Energy's operating and maintenance expense due to the start of operations at the Western Plains Wind Farm in March 2017. Depreciation and Amortization Evergy's depreciation and amortization increased $247.1 million in 2018 compared to 2017 primarily driven by a $227.9 million increase due to the inclusion of KCP&L's and GMO's depreciation expense beginning in June 2018. Evergy's depreciation and amortization increased $33.2 million in 2017 compared to 2016 primarily driven by the start of operations at Westar Energy's Western Plains Wind Farm in March 2017. Other Income (Expense), Net Evergy's other expense, net increased $27.6 million in 2018 compared to 2017 primarily driven by: • a $25.7 million increase due to the inclusion of KCP&L and GMO amounts beginning in June 2018; and • a $4.6 million decrease in Westar Energy's investment earnings primarily due to a decrease in interest and dividend income. Evergy's other expense, net increased $25.3 million in 2017 compared to 2016 primarily driven by: • a $26.3 million decrease in Westar Energy's other income primarily consisting of: ◦ a $19.5 million decrease due to recording higher corporate-owned life insurance (COLI) benefits in 2016; and ◦ a $9.6 million decrease in equity allowance for funds used during construction (AFUDC); partially offset by ◦ a $3.5 million increase related to the deconsolidation of the trust holding Westar Energy's 8% interest in Jeffrey Energy Center. Interest Expense Evergy's interest expense increased $108.6 million in 2018 compared to 2017 primarily driven by a $102.8 million increase due to the inclusion of KCP&L's and GMO's interest expense beginning in June 2018 and Evergy's assumption of Great Plains Energy's $350.0 million of 4.85% unsecured Senior Notes and $287.5 million of 5.292% unsecured Senior Notes upon the consummation of the merger. Evergy's interest expense increased $9.3 million in 2017 compared to 2016 primarily driven by an increase in Westar Energy's interest expense on long-term debt of $4.9 million as a result of the issuance of first mortgage bonds (FMBs) in excess of retirements and a $4.4 million decrease in debt AFUDC. Income Tax Expense Evergy's income tax expense decreased $92.2 million in 2018 compared to 2017 primarily driven by: • a $53.4 million decrease related to the revaluation of Westar Energy's deferred income tax assets and liabilities based on the Evergy composite tax rate as a result of the merger; • a $58.4 million decrease due to lower Westar Energy pre-tax income; and • a $44.3 million decrease in Westar Energy's income tax expense as a result of the decrease in the federal statutory income tax rate in 2018; partially offset by • a $63.2 million increase as a result of the inclusion of income tax expense related to Evergy, Inc. and the subsidiaries of Great Plains Energy beginning in June 2018. Evergy's income tax expense decreased $33.3 million in 2017 compared to 2016 primarily driven by: • a $24.0 million decrease due to production tax credits, primarily due to the start of operations at Westar Energy's Western Plains Wind Farm in March 2017; and • a $22.9 million decrease due to lower Westar Energy pre-tax income; partially offset by • a $12.2 million increase related to the revaluation of Westar Energy's deferred income taxes not included in rate base as a result of the enactment of the TCJA in 2017. EVERGY SIGNIFICANT BALANCE SHEET CHANGES (December 31, 2018 compared to December 31, 2017) The following table summarizes Evergy's significant balance sheet changes. Change Due to Merger as reflected in the table above represents the preliminary purchase price allocation to Great Plains Energy's assets and liabilities as of June 4, 2018. See Note 2 to the consolidated financial statements for additional information regarding changes in Evergy's balance sheet due to the merger. The following are significant balance sheet changes in addition to those due to the Great Plains Energy and Westar Energy merger: • Evergy's cash and cash equivalents decreased $997.3 million primarily due to the repurchase of common stock for a total cost of approximately $1,042 million in connection with Evergy's share repurchase program. See Note 17 to the consolidated financial statements for additional information on Evergy's share repurchase program. • Evergy's receivables, net decreased $252.6 million primarily due to Westar Energy's entry into a receivable sale facility in December 2018 for an initial amount $185.0 million. This sale of the undivided percentage ownership interest in accounts receivable resulted in the reduction of receivables, net and an increase in accounts receivables pledged as collateral and collateralized note payable of $185.0 million. See Note 4 to the consolidated financial statements for additional information regarding Westar Energy's receivable sale facility. • Evergy's receivables pledged as collateral and collateralized note payable increased $185.0 million due to Westar Energy's entry into a receivable sale facility in December 2018. • Evergy's fuel inventories and supplies decreased $54.1 million primarily due to $31.0 million of obsolete inventory write-offs at Westar Energy's Unit 7 at Tecumseh Energy Center, Units 3 and 4 at Murray Gill Energy Center, Units 1 and 2 at Gordon Evans Energy Center, KCP&L's Montrose Station and GMO's Sibley Station, which were all retired in the fourth quarter of 2018. • Evergy's income taxes receivable increased $67.5 million primarily due to refundable alternative minimum tax (AMT) credits that Evergy expects to receive in 2019. • Evergy's prepaid expenses and other assets decreased $142.8 million primarily due to the $140.6 million settlement of deal contingent interest rate swaps entered into by Great Plains Energy that settled following the consummation of the merger in June 2018. • Evergy's regulatory assets increased by $243.4 million primarily due to the reclassification of retired generating plant of $159.9 million related to GMO's Sibley No. 3 Unit from property, plant and equipment, net to a regulatory asset upon the retirement of the unit in 2018. • Evergy's current maturities of long-term debt increased by $290.1 million primarily due to the reclassification of KGE's $300.0 million of 6.70% Series First Mortgage Bonds from long-term to current. • Evergy's notes payable and commercial paper decreased $98.1 million primarily due to the repayment of commercial paper with funds from operations at KCP&L and GMO. • Evergy's accounts payable increased $55.9 million primarily due to the timing of cash payments. • Evergy's accrued dividends decreased $113.2 million due to Evergy's assumption and subsequent payment of Great Plains Energy's $59.4 million of accrued common stock dividends following the consummation of the merger and the timing of payment between Evergy's common stock dividend declared in November 2018, which was paid in December 2018, and its common stock dividend declared in November 2017, which was paid in January 2018 and was reflected as accrued dividends of $53.8 million as of December 31, 2017. • Evergy's current regulatory liabilities increased $80.9 million primarily due to $71.2 million of refund obligations recorded by KCP&L and GMO consisting of $63.7 million related to the TCJA and $7.5 million related to one-time customer merger bill credits. • Evergy's current asset retirement obligations decreased $21.3 million primarily due to lower expected cash flows in the next twelve months as of December 31, 2018, compared to December 31, 2017, related to closure costs for ponds containing coal combustion residuals (CCRs) at La Cygne Station and Iatan Station. • Evergy's long-term debt decreased by $409.9 million primarily due to the reclassification of KGE's $300.0 million of 6.70% Series First Mortgage Bonds from long-term to current and the redemption of $104.0 million of GMO's Series A and B Senior Notes in 2018. • Evergy's long-term debt of variable interest entities, net decreased $30.3 million primarily due to the VIE that holds the La Cygne Unit 2 leasehold interest having made principal payments totaling $28.5 million. • Evergy's deferred income taxes increased $113.9 million primarily due to the reclassification of refundable AMT credits that Evergy expects to receive in 2019 to income taxes receivable. • Evergy's asset retirement obligations decreased $108.8 million primarily due to a $127.0 million decrease in Evergy's and Westar Energy's AROs for a revision in estimate primarily related to Westar Energy's ARO to decommission its 47% ownership share of Wolf Creek. See Note 6 to the consolidated financial statements for additional information. LIQUIDITY AND CAPITAL RESOURCES Evergy relies primarily upon cash from operations, short-term borrowings, debt issuances and its existing cash and cash equivalents to fund its capital requirements. Evergy's capital requirements primarily consist of capital expenditures, payment of contractual obligations and other commitments, the payment of dividends to shareholders and the repurchase of common shares. Capital Sources Cash Flows from Operations Evergy's cash flows from operations are driven by the regulated sale of electricity. These cash flows are relatively stable but the timing and level of these cash flows can vary based on weather and economic conditions, future regulatory proceedings, the timing of cash payments made for costs recoverable under regulatory mechanisms and the time such costs are recovered, and unanticipated expenses such as unplanned plant outages and/or storms. Short-Term Borrowings As of December 31, 2018, Evergy had $1.7 billion of available borrowing capacity from its master credit facility and receivable sale facilities. Westar Energy's, KCP&L's and GMO's borrowing capacity under the master credit facility also support their issuance of commercial paper. The available borrowing capacity consisted of $449.0 million from Evergy, Inc.'s master credit facility, $570.0 million from Westar Energy's credit facilities, $420.4 million from KCP&L's credit facilities and $297.9 million from GMO's credit facilities. See Notes 4 and 11 to the consolidated financial statements for more information regarding the receivable sale facilities and master credit facility, respectively. Along with cash flows from operations, Evergy generally uses these liquid resources to meet its day-to-day cash flow requirements. Long-Term Debt and Equity Issuances From time to time, Evergy issues long-term debt and/or equity to repay short-term debt, refinance maturing long-term debt and finance growth. As of December 31, 2018 and 2017, Evergy’s capital structure, excluding short-term debt, was as follows: After the completion of its common stock repurchase program, Evergy anticipates targeting a common equity to total capitalization ratio of approximately 47%-50%. Following the utilization of its excess cash and cash equivalents discussed further below, Evergy anticipates issuing debt in 2019 in support of its common stock repurchase program. See "Liquidity and Capital Resources - Capital Requirements - Common Stock Repurchase Program" for additional information. Under stipulations with the MPSC and KCC, Evergy, Westar Energy and KCP&L are required to maintain common equity at not less than 35%, 40% and 40%, respectively, of total capitalization. The master credit facility and certain debt instruments of the Evergy Companies also contain restrictions that require the maintenance of certain capitalization and leverage ratios. As of December 31, 2018, the Evergy Companies were in compliance with these covenants. Significant Debt Issuances See Note 12 to the consolidated financial statements for information regarding significant debt issuances. Credit Ratings The ratings of the Evergy Companies' debt securities by the credit rating agencies impact their liquidity, including the cost of borrowings under their master credit facility and in the capital markets. The Evergy Companies view maintenance of strong credit ratings as vital to their access to and cost of debt financing and, to that end, maintain an active and ongoing dialogue with the agencies with respect to results of operations, financial position and future prospects. While a decrease in these credit ratings would not cause any acceleration of the Evergy Companies' debt, it could increase interest charges under the master credit facility. A decrease in credit ratings could also have, among other things, an adverse impact, which could be material, on the Evergy Companies' access to capital, the cost of funds, the ability to recover actual interest costs in state regulatory proceedings, the type and amounts of collateral required under supply agreements and Evergy's ability to provide credit support for its subsidiaries. As of February 21, 2019, the major credit rating agencies rated the Evergy Companies' securities as detailed in the following table. (a)A securities rating is not a recommendation to buy, sell or hold securities and may be subject to revision or withdrawal at any time by the assigning rating agency. Shelf Registration Statements and Regulatory Authorizations Evergy In November 2018, Evergy filed an automatic shelf registration statement providing for the sale of unlimited amounts of securities with the SEC, which expires in November 2021. Westar Energy In November 2018, Westar Energy filed an automatic shelf registration statement providing for the sale of unlimited amounts of unsecured debt securities and first mortgage bonds with the SEC, which expires in November 2021. KCP&L In November 2018, KCP&L filed an automatic shelf registration statement providing for the sale of unlimited amounts of unsecured notes and mortgage bonds with the SEC, which expires in November 2021. The following table summarizes the regulatory short-term and long-term debt financing authorizations for Westar Energy, KGE, KCP&L and GMO and the remaining amount available under these authorizations as of December 31, 2018. In addition to the above regulatory authorizations, the Westar Energy, KGE and KCP&L mortgages each contain provisions restricting the amount of FMBs that can be issued by each entity. Westar Energy, KGE and KCP&L must comply with these restrictions prior to the issuance of additional FMBs, general mortgage bonds or other secured indebtedness. Under the Westar Energy mortgage, the issuance of bonds is subject to limitations based on the amount of bondable property additions. In addition, so long as any bonds issued prior to January 1, 1997, remain outstanding, the mortgage prohibits additional FMBs from being issued, except in connection with certain refundings, unless Westar Energy’s unconsolidated net earnings available for interest, depreciation and property retirement (which as defined, does not include earnings or losses attributable to the ownership of securities of subsidiaries), for a period of 12 consecutive months within 15 months preceding the issuance, are not less than the greater of twice the annual interest charges on or 10% of the principal amount of all FMBs outstanding after giving effect to the proposed issuance. As of December 31, 2018, $344.5 million principal amount of additional FMBs could be issued under the most restrictive provisions in the mortgage, except in connection with certain refundings. Under the KGE mortgage, the amount of FMBs authorized is limited to a maximum of $3.5 billion and the issuance of bonds is subject to limitations based on the amount of bondable property additions. In addition, the mortgage prohibits additional FMBs from being issued, except in connection with certain refundings, unless KGE’s net earnings before income taxes and before provision for retirement and depreciation of property for a period of 12 consecutive months within 15 months preceding the issuance are not less than either two and one-half times the annual interest charges on or 10% of the principal amount of all KGE FMBs outstanding after giving effect to the proposed issuance. As of December 31, 2018, KGE had sufficient capacity under the most restrictive provisions in the mortgage to meet its near term financing and refinancing needs. Under the KCP&L mortgage, additional KCP&L mortgage bonds may be issued on the basis of property additions or retired bonds. As of December 31, 2018, KCP&L had sufficient capacity under the most restrictive provisions in the mortgage to meet its near term financing and refinancing needs. Cash and Cash Equivalents At December 31, 2018, Evergy had approximately $160.3 million of cash and cash equivalents on hand. Under the Amended Merger Agreement, Great Plains Energy was required to have not less than $1.25 billion in cash and cash equivalents on its balance sheet at the closing of the merger with Westar Energy. In 2018, Evergy primarily utilized this excess cash to repurchase approximately $1,042 million of common stock. Evergy anticipates that its remaining excess cash will also be returned to shareholders through the repurchase of common stock. Capital Requirements Capital Expenditures Evergy requires significant capital investments and expects to need cash primarily for utility construction programs designed to improve and expand facilities related to providing electric service, which include, but are not limited to, expenditures to develop new transmission lines and improvements to power plants, transmission and distribution lines and equipment. Evergy's capital expenditures were $1,069.7 million, $764.6 million and $1,087.0 million in 2018, 2017 and 2016, respectively. Capital expenditures projected for the next five years, excluding AFUDC and including costs of removal, are detailed in the following table. This capital expenditure plan is subject to continual review and change. Contractual Obligations and Other Commitments In the course of its business activities, the Evergy Companies enter into a variety of contracts and commercial commitments. Some of these result in direct obligations reflected on Evergy's consolidated balance sheets while others are commitments, some firm and some based on uncertainties, not reflected in Evergy's underlying consolidated financial statements. The information in the following table is provided to summarize Evergy's cash obligations and commercial commitments. (a) Evergy expects to make contributions to the pension and other post-retirement plans beyond 2023 but the amounts are not yet determined. Long-term debt includes current maturities. Long-term debt principal excludes $57.2 million of unamortized net discounts and debt issuance costs and a $144.8 million fair value adjustment recorded in connection with purchase accounting for the Great Plains Energy and Westar Energy merger. Variable rate interest obligations are based on rates as of December 31, 2018. Operating lease commitments include leases for office buildings, computer equipment, operating facilities, vehicles and rail cars to serve jointly-owned generating units where Westar Energy or KCP&L is the managing partner and is reimbursed by other joint-owners for its proportionate share of the cost. Capital lease commitments include obligations for both principal and interest. Evergy expects to contribute $118.3 million to the pension and other post-retirement plans in 2019, of which the majority is expected to be paid by Westar Energy and KCP&L. Additional contributions to the plans are expected beyond 2023 in amounts at least sufficient to meet the greater of Employee Retirement Income Security Act of 1974, as amended (ERISA) or regulatory funding requirements; however, these amounts have not yet been determined. Amounts for years after 2019 are estimates based on information available in determining the amount for 2019. Actual amounts for years after 2019 could be significantly different than the estimated amounts in the table above. Fuel commitments consist of commitments for nuclear fuel, coal and coal transportation costs. Power commitments consist of certain commitments for renewable energy under power purchase agreements. Other represents individual commitments entered into in the ordinary course of business. Evergy has other insignificant long-term liabilities recorded on its consolidated balance sheet at December 31, 2018, which do not have a definitive cash payout date and are not included in the table above. Common Stock Dividends The amount and timing of dividends payable on Evergy's common stock are within the sole discretion of the Evergy Board. The amount and timing of dividends declared by the Evergy Board will be dependent on considerations such as Evergy's earnings, financial position, cash flows, capitalization ratios, regulation, reinvestment opportunities and debt covenants. Evergy targets a long-term dividend payout ratio of 60% to 70% of earnings. See Note 1 to the consolidated financial statements for information on the common stock dividend declared by the Evergy Board in February 2019. The Evergy Companies also have certain restrictions stemming from statutory requirements, corporate organizational documents, covenants and other conditions that could affect dividend levels. See Note 17 to the consolidated financial statements for further discussion of restrictions on dividend payments. Common Stock Repurchase Program In July 2018, the Evergy Board authorized the repurchase of up to 60 million shares of Evergy's common stock. Although this repurchase authorization has no expiration date, Evergy expects to repurchase approximately 60 million shares by mid-2020. For 2018, Evergy had total repurchases of common stock of approximately $1,042 million and had repurchased 16.4 million shares under the repurchase program. These repurchase totals include shares repurchased under ASR agreements, one of which had not reached final settlement as of December 31, 2018, and are discussed further below. In August 2018, Evergy entered into two ASR agreements with financial institutions to purchase $450.0 million of Evergy common stock. The ASR agreements reached final settlement in the fourth quarter of 2018 and resulted in the delivery of 7.9 million shares to Evergy and Evergy paid a total of $450.0 million. In November 2018, Evergy entered into an ASR agreement with a financial institution to purchase $475.0 million of Evergy common stock. In December 2018, the financial institution delivered to Evergy 6.4 million shares of common stock, representing a partial settlement of the contract, based on then-current market prices and Evergy paid a total of $475.0 million. The ASR agreement is expected to reach final settlement by March 2019 or earlier. See Note 17 to the consolidated financial statements for more information regarding Evergy's common stock repurchase program. Impact of TCJA The TCJA will result in lower operating cash flows for the Evergy Companies due to lower income tax expense recoveries in customer rates and the settlement of related deferred income tax regulatory liabilities, which are significant. These decreases in operating cash flows are expected to exceed the increase in operating cash flows for the Evergy Companies resulting from the lower corporate federal income tax rate primarily due to the utilization of the Evergy Companies' net operating losses and tax credits. These net regulatory liabilities will be refunded in future rates by amortizing amounts related to plant assets primarily over the remaining useful life of the assets and amortizing the amounts related to the other items over various periods as determined in the Evergy Companies' 2018 rate cases. Off-Balance Sheet Arrangements In the ordinary course of business, Evergy and certain of its subsidiaries enter into various agreements providing financial or performance assurance to third parties on behalf of certain subsidiaries. Such agreements include, for example, guarantees and letters of credit. These agreements are entered into primarily to support or enhance the creditworthiness otherwise attributed to a subsidiary on a stand-alone basis, thereby facilitating the extension of sufficient credit to accomplish the subsidiary's intended business purposes. In connection with the closing of the merger, Evergy assumed the guarantees previously provided to GMO by Great Plains Energy. The majority of these agreements guarantee Evergy's own future performance, so a liability for the fair value of the obligation is not recorded. At December 31, 2018, Evergy has provided $111.3 million of credit support for GMO as follows: • Evergy direct guarantees to GMO counterparties totaling $17.0 million, which expire in 2020, and • Evergy's guarantee of GMO long-term debt totaling $94.3 million, which includes debt with maturity dates ranging from 2019 to 2023. Evergy has also guaranteed GMO's short-term debt, including its commercial paper program. At December 31, 2018, GMO had $150.0 million of commercial paper outstanding. None of the guaranteed obligations are subject to default or prepayment if GMO's credit ratings were downgraded. The Evergy Companies also have off-balance sheet arrangements in the form of operating leases and letters of credit entered into in the ordinary course of business. Cash Flows The following table presents Evergy's cash flows from operating, investing and financing activities. Cash Flows from Operating Activities Evergy's $585.1 million increase in cash flows from operating activities in 2018 compared to 2017 was primarily driven by an $800.8 million increase due to the inclusion of KCP&L's and GMO's cash flows from operating activities beginning in June 2018; partially offset by an increase of $50.3 million in amounts paid by Westar Energy related to income taxes; $35.6 million of merger success fees paid by Evergy and Westar Energy upon the completion of the merger; an increase of $27.0 million in purchased power costs paid by Westar Energy; an increase of $15.3 million in Wolf Creek refueling outage costs paid by Westar Energy related to the outage that concluded in May 2018 and an $11.6 million increase in Westar Energy pension and post-retirement contributions. The $108.9 million increase in cash flows from operating activities in 2017 compared to 2016 was primarily driven by a $43.9 million increase in Westar Energy wholesale power sales and transmission services; a $26.3 million decrease in amounts paid for Westar Energy coal and natural gas; a $26.0 million increase due to Westar Energy receiving a $13.0 million refund for income taxes in 2017 and Westar Energy paying $13.0 million in income taxes in 2016 and a $13.6 million increase from Westar Energy retail customers; partially offset by a $16.4 million increase in amounts paid for Westar Energy purchased power and transmission services and a $12.0 million increase in Westar Energy interest payments. Cash Flows from (used in) Investing Activities Evergy's cash flows from investing activities increased $978.2 million in 2018 compared to 2017 primarily due to the inclusion of $1,154.2 million of cash acquired from Great Plains Energy as of the merger date. Evergy's cash flows used in investing activities decreased $213.3 million in 2017 compared to 2016 primarily driven by a $322.3 million decrease in additions to Westar Energy's property, plant and equipment primarily related to the construction of Western Plains Wind Farm in 2016; partially offset by receiving $110.5 million less proceeds from Westar Energy COLI investments than in 2016. Cash Flows from (used in) Financing Activities Evergy's cash flows used in financing activities increased $1,406.8 million in 2018 compared to 2017 primarily due to the repurchase of common stock of $1,042.3 million as a result of Evergy's share repurchase program in 2018; an increase in cash dividends paid of $251.9 million due to an increase in outstanding shares of common stock following the close of the merger and a $0.06 and $0.075 per share increase in the quarterly dividends paid in September 2018 and December 2018, respectively; an increase in retirements of long-term debt of $270.8 million; partially offset by an increase in collateralized short-term debt, net of $185.0 million due to Westar Energy's receivable sale facility that was entered into in December 2018. Evergy's cash flows from financing activities decreased $321.8 million in 2017 compared to 2016 primarily due to Westar Energy issuing $207.5 million less in commercial paper; Westar Energy issuing $162.0 million less in long-term debt of VIEs; Westar Energy issuing $100.1 million less in long-term debt; Westar Energy's redemption of $75.0 million more in long-term debt and paying $18.8 million more in dividends; partially offset by Westar Energy redeeming $163.5 million less in long-term debt of VIEs and repaying $88.3 million less for borrowings against the cash surrender value of COLI. WESTAR ENERGY, INC. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS The below results of operations and related discussion for Westar Energy is presented in a reduced disclosure format in accordance with General Instruction (I)(2)(a) to Form 10-K. The following table summarizes Westar Energy's comparative results of operations. Westar Energy Utility Gross Margin and MWh Sales The following table summarizes Westar Energy's utility gross margin and MWhs sold. (a) Utility gross margin is a non-GAAP financial measure. See explanation of utility gross margin under Evergy's Results of Operations. Westar Energy's utility gross margin decreased $25.8 million in 2018 compared to 2017 driven by: • a $69.8 million provision for rate refund for the change in the corporate income tax rate caused by the passage of the TCJA. See Note 19 to the consolidated financial statements for additional information; and • a $31.0 million reduction in revenue for one-time and annual bill credits as a result of conditions in the KCC merger order. See Note 2 to the consolidated financial statements for additional information; partially offset by • a $75.0 million increase primarily due to higher retail sales driven by warmer spring and summer weather and colder winter weather. For 2018 compared to 2017, cooling degree days increased 29% and heating degree days increased 22%. Westar Energy Other Operating Expenses (including operating and maintenance expense and taxes other than income tax) Westar Energy's other operating expenses increased $83.3 million in 2018 compared to 2017 primarily driven by: • $51.9 million of merger-related costs incurred following the close of the merger in June 2018, consisting of: ◦ $44.2 million of change in control payments, voluntary severance and the recording of unrecognized equity compensation costs and the incremental fair value associated with the vesting of outstanding Westar Energy equity compensation awards in accordance with the Amended Merger Agreement; and ◦ $21.5 million of merger consulting fees and fees for other outside services incurred, primarily consisting of merger success fees; partially offset by ◦ a $13.8 million decrease in operating and maintenance expense due to the net reallocation of incurred merger transition costs between Westar Energy, Evergy, KCP&L and GMO and the subsequent deferral of these transition costs to a regulatory asset in June 2018 for future recovery by Westar Energy in accordance with the KCC merger order; • $12.3 million of obsolete inventory write-offs for Unit 7 at Tecumseh Energy Center, Units 3 and 4 at Murray Gill Energy Center and Units 1 and 2 at Gordon Evans Energy Center, which were retired in 2018; and • a $5.5 million increase due to Westar Energy's 47% share of voluntary severance expenses incurred related to the Wolf Creek voluntary exit program. Westar Energy Depreciation and Amortization Westar Energy's depreciation and amortization expense increased $19.2 million in 2018 compared to 2017 primarily driven by capital additions. Westar Energy Other Income (Expense), Net Westar Energy's other expense, net increased $6.7 million in 2018 compared to 2017 primarily driven by: • a $4.6 million decrease in investment earnings primarily due to a decrease in interest and dividend income; and • a $3.5 million increase in pension non-service costs. Westar Energy Income Tax Expense Westar Energy's income tax expense decreased $155.5 million in 2018 compared to 2017 driven by: • a $53.4 million decrease related to the revaluation of deferred income tax assets and liabilities based on the Evergy composite tax rate as a result of the merger; • a $58.4 million decrease due to lower pre-tax income; and • a $44.3 million decrease as a result of the decrease in the federal statutory income tax rate in 2018. KANSAS CITY POWER & LIGHT COMPANY MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS The below results of operations and related discussion for KCP&L is presented in a reduced disclosure format in accordance with General Instruction (I)(2)(a) to Form 10-K. The following table summarizes KCP&L's comparative results of operations. KCP&L Utility Gross Margin and MWh Sales The following table summarizes KCP&L's utility gross margin and MWhs sold. (a) Utility gross margin is a non-GAAP financial measure. See explanation of utility gross margin under Evergy's Results of Operations. KCP&L's utility gross margin decreased $107.5 million in 2018 compared to 2017 driven by: • a $72.4 million refund obligation for the change in the corporate income tax rate caused by the passage of the TCJA. See Note 19 to the consolidated financial statements for additional information; • $72.9 million of sales taxes and franchise fees collected from KCP&L Missouri customers included in revenue in 2017, which as part of KCP&L's adoption of Accounting Standards Codification (ASC) 606, are now excluded from revenue in 2018; and • a $25.0 million reduction in revenue for one-time and annual bill credits as a result of conditions in the MPSC and KCC merger orders. See Note 2 to the consolidated financial statements for additional information; partially offset by • a $62.8 million increase primarily due to higher retail sales driven by warmer spring and summer weather and colder winter weather. For 2018 compared to 2017, cooling degree days increased 33% and heating degree days increased 23%. KCP&L Other Operating Expenses (including operating and maintenance expense and taxes other than income tax) KCP&L's other operating expenses decreased $45.9 million in 2018 compared to 2017 primarily driven by: • $72.2 million decrease in taxes other than income tax due to sales taxes and franchise fees collected from KCP&L Missouri customers in 2017, which, as part of KCP&L's adoption of ASC 606, Revenue from Contracts with Customers, are now excluded from taxes other than income tax in 2018; and • a $23.2 million decrease in operating and maintenance expense due to the net reallocation of incurred merger transition costs between KCP&L, Evergy, Westar Energy and GMO and the subsequent deferral of these transition costs to a regulatory asset in June 2018 for future recovery by KCP&L in accordance with the KCC and MPSC merger orders; partially offset by • an $11.6 million increase due to voluntary severance expenses incurred related to KCP&L's 47% share of the Wolf Creek voluntary exit program as well as other KCP&L voluntary exit programs; • $7.3 million of obsolete inventory write-offs for Montrose Station, which was retired in the fourth quarter of 2018; • a $6.8 million increase in transmission and distribution operating and maintenance expense; and • a $6.9 million increase in injuries and damages expense primarily due to an increase in estimated worker's compensation losses. KCP&L Depreciation and Amortization KCP&L's depreciation and amortization increased $15.0 million in 2018 compared to 2017 primarily driven by capital additions. KCP&L Other Income (Expense), Net KCP&L's other expense, net decreased $13.7 million in 2018 compared to 2017 driven by a $16.8 million decrease in pension non-service costs due to KCP&L's adoption of ASU 2017-07, Compensation-Retirement Benefits, which requires the non-service cost components to be reported separately from service costs and outside of a subtotal of income from operations. For retrospective application of the 2017 non-service cost components, KCP&L utilized the practical expedient that allows for the use of the amounts disclosed in a company's pension and other post-retirement benefit plan footnote as the estimation basis for retrospective presentation. The 2017 amounts disclosed in KCP&L's pension and other post-retirement benefit plan footnote are presented prior to the effects of capitalization and sharing with joint owners of power plants. See Note 1 and Note 9 to the consolidated financial statements for additional information. KCP&L Income Tax Expense KCP&L's income tax expense decreased $40.9 million in 2018 compared to 2017 primarily driven by: • a $32.2 million decrease in income tax expense as a result of the decrease in the federal statutory income tax rate in 2018; • a $22.5 million decrease due to lower pre-tax income; • a $15.5 million decrease related to the revaluation of deferred income tax assets and liabilities as a result of the enactment of Missouri state income tax reform in June 2018; and • an $8.3 million decrease in income tax expense due to an increase in flow-through items primarily consisting of amortization of regulatory liabilities for excess deferred income taxes generated as a result of the enactment of the TCJA in December 2017; partially offset by • a $51.0 million increase related to the revaluation of deferred income tax assets and liabilities based on the Evergy composite tax rate as a result of the merger.

<s>[INST] EXECUTIVE SUMMARY Evergy, Inc. is a public utility holding company incorporated in 2017 and headquartered in Kansas City, Missouri. Evergy operates primarily through the following whollyowned direct subsidiaries: Westar Energy is an integrated, regulated electric utility that provides electricity to customers in the state of Kansas. Westar Energy has one active whollyowned subsidiary with significant operations, KGE. KCP&L is an integrated, regulated electric utility that provides electricity to customers in the states of Missouri and Kansas. GMO is an integrated, regulated electric utility that provides electricity to customers in the state of Missouri. GPETHC owns 13.5% of Transource with the remaining 86.5% owned by AEP Transmission Holding Company, LLC, a subsidiary of AEP. Transource is focused on the development of competitive electric transmission projects. GPETHC accounts for its investment in Transource under the equity method. Westar Energy also owns a 50% interest in Prairie Wind, which is a joint venture between Westar Energy and affiliates of AEP and Berkshire Hathaway Energy Company. Prairie Wind owns a 108mile, 345 kV doublecircuit transmission line that provides transmission service in the SPP. Westar Energy accounts for its investment in Prairie Wind under the equity method. Westar Energy and KGE conduct business in their respective service territories using the name Westar Energy. KCP&L and GMO conduct business in their respective service territories using the name KCP&L. Collectively, the Evergy Companies have approximately 14,500 MWs of owned generating capacity and renewable purchased power agreements and engage in the generation, transmission, distribution and sale of electricity to approximately 1.6 million customers in the states of Kansas and Missouri. The Evergy Companies assess financial performance and allocate resources on a consolidated basis (i.e., operate in one segment). Great Plains Energy and Westar Energy Merger Evergy was incorporated in 2017 as Monarch Energy, a whollyowned subsidiary of Great Plains Energy. Prior to the closing of the merger transactions, Monarch Energy changed its name to Evergy and did not conduct any business activities other than those required for its formation and matters contemplated by the Amended Merger Agreement. On June 4, 2018, in accordance with the Amended Merger Agreement, Great Plains Energy merged into Evergy, with Evergy surviving the merger and King Energy merged into Westar Energy, with Westar Energy surviving the merger. These merger transactions resulted in Evergy becoming the parent entity of Westar Energy and the direct subsidiaries of Great Plains Energy, including KCP&L and GMO. As a result of the closing of the merger transactions, each outstanding share of Great Plains Energy common stock was converted into 0.5981 shares of Evergy common stock, resulting in the issuance of 128.9 million shares. Additionally, each outstanding share of Westar Energy common stock was converted into 1 share of Evergy common stock. Westar Energy was determined to be the accounting acquirer and thus, the predecessor of Evergy. Therefore, Evergy's accompanying consolidated financial statements reflect the results of operations of Westar Energy for 2017 and 2016 and the financial position of Westar Energy as of December 31, 2017. Evergy had separate operations for the period beginning with the quarter ended June 30, 2018, and references to amounts for periods after the closing of the merger relate to Evergy. The results of Great Plains Energy's direct subsidiaries have been included in Evergy's results of operations from the date of the closing of the merger and thereafter. KCP&L has elected not to apply "pushdown accounting" related to the merger, whereby the adjustments of assets and liabilities to fair value and the resulting goodwill would be recorded on the financial statements of the acquired subsidiary. These adjustments for KCP&L, as well as those related to the acquired assets and liabilities of Great Plains Energy and its other direct subsidiaries, are only reflected on Evergy's consolidated financial statements. See Note 2 to the consolidated financial statements for more information regarding the merger. Common Stock Repurchase [/INST] Negative. </s>

Evergy, Inc.

2020-03-02

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following combined Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) should be read in conjunction with the consolidated financial statements and accompanying notes in this combined annual report on Form 10-K. None of the registrants make any representation as to information related solely to Evergy, Evergy Kansas Central or Evergy Metro other than itself. The following MD&A generally discusses 2019 and 2018 items and year-to-year comparisons between 2019 and 2018. Discussions of 2017 items and year-to-year comparisons between 2018 and 2017 can be found in MD&A in Part II, Item 7, of the Evergy Companies' combined annual report on Form 10-K for the fiscal year ended December 31, 2018. EVERGY, INC. EXECUTIVE SUMMARY Evergy is a public utility holding company incorporated in 2017 and headquartered in Kansas City, Missouri. Evergy operates primarily through the following wholly-owned direct subsidiaries listed below. In September 2019, these wholly-owned direct subsidiaries were rebranded and renamed under the Evergy brand name. • Evergy Kansas Central, formerly known as Westar Energy, Inc., is an integrated, regulated electric utility that provides electricity to customers in the state of Kansas. Evergy Kansas Central has one active wholly-owned subsidiary with significant operations, Evergy Kansas South, formerly known as Kansas Gas and Electric Company. • Evergy Metro, formerly known as Kansas City Power & Light Company, is an integrated, regulated electric utility that provides electricity to customers in the states of Missouri and Kansas. • Evergy Missouri West, formerly known as KCP&L Greater Missouri Operations Company, is an integrated, regulated electric utility that provides electricity to customers in the state of Missouri. • Evergy Transmission Company, formerly known as GPE Transmission Holding Company, LLC, owns 13.5% of Transource with the remaining 86.5% owned by AEP Transmission Holding Company, LLC, a subsidiary of AEP. Transource is focused on the development of competitive electric transmission projects. Evergy Transmission Company accounts for its investment in Transource under the equity method. Evergy Kansas Central also owns a 50% interest in Prairie Wind, which is a joint venture between Evergy Kansas Central and subsidiaries of AEP and Berkshire Hathaway Energy Company. Prairie Wind owns a 108-mile, 345 kV double-circuit transmission line that provides transmission service in the SPP. Evergy Kansas Central accounts for its investment in Prairie Wind under the equity method. Since the rebranding in September 2019, Evergy Kansas Central, Evergy Kansas South, Evergy Metro and Evergy Missouri West have been conducting business in their respective service territories using the name Evergy. Collectively, the Evergy Companies have approximately 14,700 MWs of owned generating capacity and renewable purchased power agreements and engage in the generation, transmission, distribution and sale of electricity to approximately 1.6 million customers in the states of Kansas and Missouri. The Evergy Companies assess financial performance and allocate resources on a consolidated basis (i.e., operate in one segment). Strategy Evergy expects to continue operating its integrated utilities within the currently existing regulatory frameworks. Evergy's objectives are to deliver value to shareholders through earnings and dividend growth; serve customers and communities with cost-effective, reliable and clean energy; and maintain a rewarding and challenging work environment for employees. Significant elements of Evergy's strategy to achieve these objectives include: • the realization of a total of approximately $595 million of potential net savings over the first five years of operation of the combined company, which formed in June 2018, resulting from synergies that are expected to be created as a result of the merger; • anticipated rate base investment of approximately $7.6 billion from 2020 through 2024; and • the reduction of carbon emissions by 80% by 2050 from 2005 levels through the continued growth of Evergy's renewable energy portfolio and the retirement of older and less efficient fossil fuel plants. See "Transforming Evergy's Generation Fleet" in Part I, Item 1, Business, for additional information. In March 2020, the Evergy Board announced the creation of a Strategic Review & Operations Committee that will explore ways to enhance long-term shareholder value (taking into account applicable legal and regulatory requirements and any other relevant considerations), including through a potential strategic combination or an enhanced long-term standalone operating plan and strategy. The committee is expected to complete its review and make a recommendation to Evergy's Board in the first half of 2020. See "Cautionary Statements Regarding Certain Forward-Looking Information" and Part I, Item 1A, Risk Factors, for additional information. Common Stock Repurchase Program In July 2018, the Evergy Board authorized the repurchase of up to 60 million shares of Evergy's common stock. Evergy has utilized various methods to effectuate the share repurchase program since its authorization, including the repurchase of shares through ASR agreements and open market transactions. For 2019, Evergy had total repurchases of common stock of $1,628.7 million and had repurchased 28.8 million shares under the repurchase program. Since the start of the repurchase program in August 2018, Evergy has made total repurchases of common stock of $2,671.0 million and has repurchased 45.2 million shares under the repurchase program. Evergy does not anticipate making additional repurchases of common stock under its share repurchase program while the Strategic Review & Operations Committee of the Evergy Board conducts its review of ways to enhance long-term shareholder value, which is expected to conclude in the first half of 2020. See Note 18 to the consolidated financial statements for more information regarding Evergy's common stock repurchase program. Great Plains Energy and Evergy Kansas Central Merger Evergy was incorporated in 2017 as Monarch Energy, a wholly-owned subsidiary of Great Plains Energy. Prior to the closing of the merger transactions, Monarch Energy changed its name to Evergy and did not conduct any business activities other than those required for its formation and matters contemplated by the Amended Merger Agreement. On June 4, 2018, in accordance with the Amended Merger Agreement, Great Plains Energy merged into Evergy, with Evergy surviving the merger and King Energy merged into Evergy Kansas Central, with Evergy Kansas Central surviving the merger. These merger transactions resulted in Evergy becoming the parent entity of Evergy Kansas Central and the direct subsidiaries of Great Plains Energy, including Evergy Metro and Evergy Missouri West. As a result of the closing of the merger transactions, each outstanding share of Great Plains Energy common stock was converted into 0.5981 shares of Evergy common stock, resulting in the issuance of 128.9 million shares. Additionally, each outstanding share of Evergy Kansas Central common stock was converted into 1 share of Evergy common stock. Evergy Kansas Central was determined to be the accounting acquirer in the merger and thus, the predecessor of Evergy. Evergy had separate operations for the period beginning with the quarter ended June 30, 2018, and references to amounts for periods after the closing of the merger relate to Evergy. The results of Great Plains Energy's direct subsidiaries have been included in Evergy's results of operations from June 4, 2018, the date of the closing of the merger, and thereafter. See Note 2 to the consolidated financial statements for more information regarding the merger. Regulatory Proceedings See Note 5 to the consolidated financial statements for information regarding regulatory proceedings. Earnings Overview The following table summarizes Evergy's net income and diluted earnings per share (EPS). Net income attributable to Evergy, Inc. increased in 2019 compared to 2018, primarily due to the inclusion of Evergy Metro's and Evergy Missouri West's earnings in the first five months of 2019, merger-related costs and reductions of revenue for customer bill credits incurred in June 2018 following the consummation of the merger, lower operating and maintenance expenses at fossil-fuel generating units and lower administrative and general expenses, partially offset by lower retail sales driven by unfavorable weather and higher depreciation expense. Diluted EPS increased in 2019 compared to 2018, primarily due to the increase in net income attributable to Evergy, Inc. discussed above, partially offset by a higher number of diluted weighted average common shares outstanding in 2019, which diluted EPS by $0.34 for 2019. For additional information regarding the change in net income, refer to the Evergy Results of Operations section within this MD&A. Adjusted Earnings (non-GAAP) and Adjusted EPS (non-GAAP) Evergy's adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) for 2019 were $694.0 million or $2.89 per share, respectively. For 2018, Evergy's adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) were $680.9 million or $2.54 per share, respectively. In addition to net income attributable to Evergy, Inc., diluted EPS, pro forma net income attributable to Evergy, Inc. and pro forma diluted EPS as prepared in accordance with GAAP, Evergy's management uses adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) to evaluate earnings and EPS without the costs and/or benefits resulting from rebranding, voluntary severance and significant items related to the Great Plains Energy and Evergy Kansas Central merger. Adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) are intended to enhance an investor's overall understanding of results. Adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) are used internally to measure performance against budget and in reports for management and the Evergy Board. Adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP) are financial measures that are not calculated in accordance with GAAP and may not be comparable to other companies' presentations or more useful than the GAAP information provided elsewhere in this report. The following table provides a reconciliation between net income attributable to Evergy, Inc., diluted EPS, pro forma net income attributable to Evergy, Inc. and pro forma diluted EPS as determined in accordance with GAAP and adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP). (a) Reflects pro forma adjustments made in accordance with Article 11 of Regulation S-X and ASC 805 - Business Combinations. See Note 2 to the consolidated financial statements in the Evergy Companies' combined 2018 annual report on Form 10-K for further information regarding these adjustments. (b) Reflects external costs incurred to rebrand the legacy Westar Energy and KCP&L utility brands to Evergy and are included in operating and maintenance expense on the consolidated statements of comprehensive income. (c) Reflects severance costs incurred associated with certain voluntary severance programs at the Evergy Companies and are included in operating and maintenance expense on the consolidated statements of comprehensive income. (d) Reflects the revaluation of Evergy Kansas Central's deferred income tax assets and liabilities based on the Evergy composite tax rate as a result of the merger in June 2018 and are included in income tax expense on the consolidated statements of comprehensive income. (e) Reflects the portion of the $47.8 million deferral of merger transition costs to a regulatory asset in June 2018 that related to costs incurred prior to 2018. The remaining merger transition costs included within the $47.8 million deferral were both incurred and deferred in 2018 and did not impact earnings. This item is included in operating and maintenance expense on the consolidated statements of comprehensive income. (f) Reflects obsolete inventory write-offs for Evergy Kansas Central's Unit 7 at Tecumseh Energy Center, Units 3 and 4 at Murray Gill Energy Center, Units 1 and 2 at Gordon Evans Energy Center, Evergy Metro's Montrose Station and Evergy Missouri West's Sibley Station and are included in operating and maintenance expense on the consolidated statements of comprehensive income. (g) Reflects an income tax effect calculated at a 26.1% statutory rate, with the exception of certain non-deductible items. Wolf Creek Refueling Outage Wolf Creek's most recent refueling outage began in September 2019 and the unit returned to service in November 2019. Wolf Creek's next refueling outage is planned to begin in the first quarter of 2021. ENVIRONMENTAL MATTERS See Note 15 to the consolidated financial statements for information regarding environmental matters. RELATED PARTY TRANSACTIONS See Note 17 to the consolidated financial statements for information regarding related party transactions. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures. Management considers an accounting estimate to be critical if it requires assumptions to be made that were uncertain at the time the estimate was made and changes in the estimate or different estimates that could have been used could have a material impact on Evergy's results of operations and financial position. Management has identified the following accounting policies as critical to the understanding of Evergy's results of operations and financial position. Management has discussed the development and selection of these critical accounting policies with the Audit Committee of the Evergy Board. Pensions Evergy incurs significant costs in providing non-contributory defined pension benefits. The costs are measured using actuarial valuations that are dependent upon numerous factors derived from actual plan experience and assumptions of future plan experience. Pension costs are impacted by actual employee demographics (including age, life expectancies, compensation levels and employment periods), earnings on plan assets, the level of contributions made to the plan, and plan amendments. In addition, pension costs are also affected by changes in key actuarial assumptions, including anticipated rates of return on plan assets and the discount rates used in determining the projected benefit obligation and pension costs. The assumed rate of return on plan assets was developed based on the weighted-average of long-term returns forecast for the expected portfolio mix of investments held by the plan. The assumed discount rate was selected based on the prevailing market rate of fixed income debt instruments with maturities matching the expected timing of the benefit obligation. These assumptions, updated annually at the measurement date, are based on management's best estimates and judgment; however, material changes may occur if these assumptions differ from actual events. See Note 10 to the consolidated financial statements for information regarding the assumptions used to determine benefit obligations and net costs. The following table reflects the sensitivities associated with a 0.5% increase or a 0.5% decrease in key actuarial assumptions for Evergy's qualified pension plans. Each sensitivity reflects the impact of the change based on a change in that assumption only. Pension expense for Evergy Kansas Central, Evergy Metro and Evergy Missouri West is recorded in accordance with rate orders from the KCC and MPSC. The orders allow the difference between pension costs under GAAP and pension costs for ratemaking to be recorded as a regulatory asset or liability with future ratemaking recovery or refunds, as appropriate. In 2019, Evergy's pension expense was $131.3 million under GAAP and $168.7 million for ratemaking. The impact on 2020 pension expense in the table above reflects the impact on GAAP pension costs. Under the Evergy Companies' rate agreements, any increase or decrease in GAAP pension expense is deferred to a regulatory asset or liability for future ratemaking treatment. See Note 10 to the consolidated financial statements for additional information regarding the accounting for pensions. Market conditions and interest rates significantly affect the future assets and liabilities of the plan. It is difficult to predict future pension costs, changes in pension liability and cash funding requirements due to the inherent uncertainty of market conditions. Revenue Recognition Evergy recognizes revenue on the sale of electricity to customers over time as the service is provided in the amount it has the right to invoice. Revenues recorded include electric services provided but not yet billed by Evergy. Unbilled revenues are recorded for kWh usage in the period following the customers' billing cycle to the end of the month. This estimate is based on net system kWh usage less actual billed kWhs. Evergy's estimated unbilled kWhs are allocated and priced by regulatory jurisdiction across the rate classes based on actual billing rates. Evergy's unbilled revenue estimate is affected by factors including fluctuations in energy demand, weather, line losses and changes in the composition of customer classes. See Note 4 for the balance of unbilled receivables for Evergy as of December 31, 2019 and 2018. Regulatory Assets and Liabilities Evergy has recorded assets and liabilities on its consolidated balance sheets resulting from the effects of the ratemaking process, which would not otherwise be recorded under GAAP. Regulatory assets represent incurred costs that are probable of recovery from future revenues. Regulatory liabilities represent future reductions in revenues or refunds to customers. Management regularly assesses whether regulatory assets and liabilities are probable of future recovery or refund by considering factors such as decisions by the MPSC, KCC or FERC in Evergy's rate case filings; decisions in other regulatory proceedings, including decisions related to other companies that establish precedent on matters applicable to Evergy; and changes in laws and regulations. If recovery or refund of regulatory assets or liabilities is not approved by regulators or is no longer deemed probable, these regulatory assets or liabilities are recognized in the current period results of operations. Evergy's continued ability to meet the criteria for recording regulatory assets and liabilities may be affected in the future by restructuring and deregulation in the electric industry or changes in accounting rules. In the event that the criteria no longer applied to all or a portion of Evergy's operations, the related regulatory assets and liabilities would be written off unless an appropriate regulatory recovery mechanism were provided. Additionally, these factors could result in an impairment on utility plant assets. See Note 5 to the consolidated financial statements for additional information. Impairments of Assets and Goodwill Long-lived assets are required to be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable as prescribed under GAAP. Accounting rules require goodwill to be tested for impairment annually and when an event occurs indicating the possibility that an impairment exists. The goodwill impairment test consists of comparing the fair value of a reporting unit to its carrying amount, including goodwill, to identify potential impairment. In the event that the carrying amount exceeds the fair value of the reporting unit, an impairment loss is recognized for the difference between the carrying amount of the reporting unit and its fair value. Evergy's consolidated operations are considered one reporting unit for assessment of impairment, as management assesses financial performance and allocates resources on a consolidated basis. The annual impairment test for the $2,336.6 million of goodwill from the Great Plains Energy and Evergy Kansas Central merger was conducted on May 1, 2019. The fair value of the reporting unit substantially exceeded the carrying amount, including goodwill. As a result, there was no impairment of goodwill. The determination of fair value for the reporting unit consisted of two valuation techniques: an income approach consisting of a discounted cash flow analysis and a market approach consisting of a determination of reporting unit invested capital using a market multiple derived from the historical earnings before interest, income taxes, depreciation and amortization and market prices of the stock of peer companies. The results of the two techniques were evaluated and weighted to determine a point within the range that management considered representative of fair value for the reporting unit, which involves a significant amount of management judgment. The discounted cash flow analysis is most significantly impacted by two assumptions: estimated future cash flows and the discount rate applied to those cash flows. Management determines the appropriate discount rate to be based on the reporting unit's weighted average cost of capital (WACC). The WACC takes into account both the return on equity authorized by the KCC and MPSC and after-tax cost of debt. Estimated future cash flows are based on Evergy's internal business plan, which assumes the occurrence of certain events in the future, such as the outcome of future rate filings, future approved rates of return on equity, anticipated returns of and earnings on future capital investments, continued recovery of cost of service and the renewal of certain contracts. Management also makes assumptions regarding the run rate of operations, maintenance and general and administrative costs based on the expected outcome of the aforementioned events. Should the actual outcome of some or all of these assumptions differ significantly from the current assumptions, revisions to current cash flow assumptions could cause the fair value of the Evergy reporting unit under the income approach to be significantly different in future periods and could result in a future impairment charge to goodwill. The market approach analysis is most significantly impacted by management's selection of relevant peer companies as well as the determination of an appropriate control premium to be added to the calculated invested capital of the reporting unit, as control premiums associated with a controlling interest are not reflected in the quoted market price of a single share of stock. Management determines an appropriate control premium by using an average of control premiums for recent acquisitions in the industry. Changes in results of peer companies, selection of different peer companies and future acquisitions with significantly different control premiums could result in a significantly different fair value of the Evergy reporting unit. Income Taxes Income taxes are accounted for using the asset/liability approach. Deferred tax assets and liabilities are determined based on the temporary differences between the financial reporting and tax bases of assets and liabilities, applying enacted statutory tax rates in effect for the year in which the differences are expected to reverse. Deferred investment tax credits are amortized ratably over the life of the related property. Deferred tax assets are also recorded for net operating losses, capital losses and tax credit carryforwards. Evergy is required to estimate the amount of taxes payable or refundable for the current year and the deferred tax liabilities and assets for future tax consequences of events reflected in Evergy's consolidated financial statements or tax returns. Actual results could differ from these estimates for a variety of reasons including changes in income tax laws, enacted tax rates and results of audits by taxing authorities. This process also requires management to make assessments regarding the timing and probability of the ultimate tax impact from which actual results may differ. Evergy records valuation allowances on deferred tax assets if it is determined that it is more likely than not that the asset will not be realized. See Note 20 to the consolidated financial statements for additional information. Asset Retirement Obligations Evergy has recognized legal obligations associated with the disposal of long-lived assets that result from the acquisition, construction, development or normal operation of such assets. Concurrent with the recognition of the liability, the estimated cost of the ARO incurred at the time the related long-lived assets were either acquired, placed in service or when regulations establishing the obligation became effective is also recorded to property, plant and equipment, net on the consolidated balance sheets. The recording of AROs for regulated operations has no income statement impact due to the deferral of the adjustments through the establishment of a regulatory asset or an offset to a regulatory liability. Evergy initially recorded AROs at fair value for the estimated cost to decommission Wolf Creek (94% indirect share), retire wind generating facilities, dispose of asbestos insulating material at its power plants, remediate ash disposal ponds and close ash landfills, among other items. ARO refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement may be conditional on a future event that may or may not be within the control of the entity. In determining Evergy's AROs, assumptions are made regarding probable future disposal costs and the timing of their occurrence. A change in these assumptions could have a significant impact on Evergy's AROs reflected on its consolidated balance sheets. As of December 31, 2019 and 2018, Evergy had recorded AROs of $674.1 million and $687.1 million, respectively. See Note 7 to the consolidated financial statements for more information regarding Evergy's AROs. EVERGY RESULTS OF OPERATIONS Evergy's results of operations and financial position are affected by a variety of factors including rate regulation, fuel costs, weather, customer behavior and demand, the economy and competitive forces. Substantially all of Evergy's revenues are subject to state or federal regulation. This regulation has a significant impact on the price the Evergy Companies charge for electric service. Evergy's results of operations and financial position are affected by its ability to align overall spending, both operating and capital, within the frameworks established by its regulators. Wholesale revenues are impacted by, among other factors, demand, cost and availability of fuel and purchased power, price volatility, available generation capacity, transmission availability and weather. The Evergy Companies primarily use coal and uranium for the generation of electricity for their customers and also purchase power through purchase power agreements or on the open market. The prices for fuel used in generation or the market price of purchased power can fluctuate significantly due to a variety of factors including supply, demand, weather and the broader economic environment. Evergy Kansas Central, Evergy Metro and Evergy Missouri West have fuel recovery mechanisms in their Kansas and Missouri jurisdictions, as applicable, that allow them to defer and subsequently recover or refund, through customer rates, substantially all of the variance in net energy costs from the amount set in base rates without a general rate case proceeding. Weather significantly affects the amount of electricity that Evergy's customers use as electricity sales are seasonal. As summer peaking utilities, the third quarter typically accounts for the greatest electricity sales by the Evergy Companies. Hot summer temperatures and cold winter temperatures prompt more demand, especially among residential and commercial customers, and to a lesser extent, industrial customers. Mild weather reduces customer demand. Energy efficiency investments by customers and the Evergy Companies also can affect the demand for electric service. Through the Missouri Energy Efficiency Investment Act (MEEIA), Evergy Metro and Evergy Missouri West offer energy efficiency and demand side management programs to their Missouri retail customers and recover program costs, throughput disincentive, and as applicable, certain earnings opportunities in retail rates through a rider mechanism. The Evergy Companies' taxes other than income taxes, of which property taxes are a significant component, can fluctuate significantly due to a variety of factors, including changes in taxable values and property tax rates. Evergy Kansas Central and Evergy Metro's Kansas jurisdiction have property tax surcharges that allow them to defer and subsequently recover or refund, through customer rates, substantially all of the variance in property tax costs from the amounts set in base rates without a general rate case proceeding. The following table summarizes Evergy's comparative results of operations. Evergy Utility Gross Margin and MWh Sales Utility gross margin is a financial measure that is not calculated in accordance with GAAP. Utility gross margin, as used by the Evergy Companies, is defined as operating revenues less fuel and purchased power costs and amounts billed by the SPP for network transmission costs. Expenses for fuel and purchased power costs, offset by wholesale sales margin, are subject to recovery through cost adjustment mechanisms. As a result, changes in fuel and purchased power costs are offset in operating revenues with minimal impact on net income. In addition, SPP network transmission costs fluctuate primarily due to investments by SPP members for upgrades to the transmission grid within the SPP RTO. As with fuel and purchased power costs, changes in SPP network transmission costs are mostly reflected in the prices charged to customers with minimal impact on net income. See Note 3 to the consolidated financial statements for additional information regarding the manner in which Evergy reflects SPP revenues and expenses. Management believes that utility gross margin provides a meaningful basis for evaluating the Evergy Companies' operations across periods compared with operating revenues because utility gross margin excludes the revenue effect of fluctuations in these expenses. Utility gross margin is used internally to measure performance against budget and in reports for management and the Evergy Board. The Evergy Companies' definition of utility gross margin may differ from similar terms used by other companies. The following tables summarize Evergy's utility gross margin and MWhs sold. (a) Utility gross margin is a non-GAAP financial measure. See explanation of utility gross margin above. Evergy's utility gross margin increased $694.2 million in 2019 compared to 2018 driven by: • a $674.4 million increase due to the inclusion of Evergy Metro's and Evergy Missouri West's utility gross margin in the first five months of 2019; • a $59.7 million increase in revenue due to one-time bill credits recorded by Evergy Kansas Central, Evergy Metro and Evergy Missouri West in June 2018 as a result of conditions in the KCC and MPSC merger orders; and • a $41.6 million increase from new Evergy Kansas Central, Evergy Metro and Evergy Missouri West retail rates effective in 2018, net of a $124.2 million provision for rate refund recorded in 2018 for the change in the corporate income tax rate caused by the TCJA; partially offset by • a $53.0 million decrease primarily due to lower Evergy Kansas Central, Evergy Metro and Evergy Missouri West retail sales driven by cooler summer weather. For 2019 compared to 2018, cooling degree days decreased 16%; • a $12.9 million decrease related to Evergy Kansas Central's transmission delivery charge (TDC) rider; • a $10.2 million decrease in revenue related to the granting of an Accounting Authority Order (AAO) by the MPSC in October 2019 requiring Evergy Missouri West to record a regulatory liability for the estimated amount of revenues it has collected from customers for certain costs related to Sibley Station since its retirement in November 2018; and • a $5.4 million decrease for recovery of programs costs for energy efficiency programs under MEEIA, which have a direct offset in operating and maintenance expense. Operating and Maintenance Evergy's operating and maintenance expense increased $102.7 million in 2019 compared to 2018 primarily driven by: • a $279.9 million increase in operating and maintenance expense due to the inclusion of Evergy Metro's and Evergy Missouri West's operating and maintenance expenses in the first five months of 2019; • $12.1 million of rebranding costs incurred in 2019 to rebrand the legacy Westar Energy and KCP&L utility brands to Evergy; and • $11.8 million of Evergy Kansas Central, Evergy Metro and Evergy Missouri West voluntary severance expenses incurred in 2019; partially offset by • $75.8 million of merger-related costs incurred in 2018, consisting of: ◦ $51.0 million of merger consulting fees and fees for other outside services incurred, primarily consisting of merger success fees; ◦ $47.9 million of Evergy Kansas Central and Evergy Metro voluntary severance and change in control payments as well as the recording of unrecognized equity compensation costs and the incremental fair value associated with the vesting of outstanding Evergy Kansas Central equity compensation awards in accordance with the Amended Merger Agreement; and ◦ $24.7 million of unconditional charitable contributions and community support recorded by Evergy in accordance with conditions in the KCC and MPSC merger orders; partially offset by ◦ a $47.8 million decrease in operating and maintenance expense due to the deferral of merger transition costs to a regulatory asset in June 2018 for future recovery by Evergy Kansas Central, Evergy Metro and Evergy Missouri West in accordance with the KCC and MPSC merger orders; • a $62.1 million decrease in plant operating and maintenance expense at fossil-fuel generating units primarily due to: ◦ a $15.0 million decrease due to the retirement of Evergy Kansas Central's Unit 7 at Tecumseh Energy Center, Units 3 and 4 at Murray Gill Energy Center, Units 1 and 2 at Gordan Evans Energy Center and Evergy Metro's Montrose Station and Evergy Missouri West's Sibley Station in the fourth quarter of 2018; ◦ $31.0 million of Evergy Kansas Central, Evergy Metro and Evergy Missouri West obsolete inventory write-offs at retiring fossil-fuel units in 2018; ◦ $5.2 million of voluntary severance expenses incurred in the third quarter of 2018 by Evergy Kansas Central, Evergy Metro and Evergy Missouri West related to their Local 1523 and Local 412 union voluntary exit programs; and ◦ a $3.7 million decrease due to an extended maintenance outage at Evergy Metro's Iatan No. 2 in 2018; partially offset by ◦ an $8.4 million increase due to the write-off of a regulatory asset for costs incurred during the Jeffrey Energy Center (JEC) lease extension, see Note 5 to the consolidated financial statements; • a $35.6 million decrease in various administrative and general operating and maintenance expenses primarily driven by a $15.3 million decrease in labor and employee benefits expense primarily due to lower employee headcount and Evergy Kansas Central pension and post-retirement costs in 2019 and $10.6 million of voluntary severance expenses incurred in the third quarter of 2018 by Evergy Kansas Central and Evergy Metro related to a Wolf Creek voluntary exit program; • a $9.5 million decrease in plant operating and maintenance expense at nuclear generating units related to Wolf Creek; • a $9.3 million decrease in transmission and distribution operating and maintenance expense primarily due to a higher level of Evergy Kansas Central vegetation management activity in 2018; and • a $5.4 million decrease in program costs for energy efficiency programs under MEEIA, which have a direct offset in revenue. Depreciation and Amortization Evergy's depreciation and amortization increased $242.9 million in 2019 compared to 2018 driven by: • a $173.4 million increase due to the inclusion of Evergy Metro's and Evergy Missouri West's depreciation expense in the first five months of 2019; • a $43.0 million increase primarily due to a change in depreciation rates as a result of Evergy Kansas Central's and Evergy Metro's rate cases effective in 2018; and • a $26.5 million increase primarily due to capital additions at Evergy Kansas Central and Evergy Metro. Taxes Other Than Income Tax Evergy's taxes other than income tax increased $96.4 million in 2019 compared to 2018 primarily driven by: • a $75.7 million increase due to the inclusion of Evergy Metro and Evergy Missouri West amounts in the first five months of 2019; and • a $22.9 million increase primarily due to increased Evergy Kansas Central property taxes. Other Expense, Net Evergy's other expense, net decreased $15.4 million in 2019 compared to 2018 primarily driven by: • a $12.4 million decrease due to recording higher Evergy Kansas Central corporate-owned life insurance (COLI) benefits in 2019; • a $6.3 million decrease due to lower Evergy Kansas Central and Evergy Metro pension non-service costs in 2019; and • a $4.2 million decrease due to higher net unrealized gains in Evergy Kansas Central's rabbi trust in 2019; partially offset by • a $9.5 million increase due to the inclusion of Evergy Metro and Evergy Missouri West amounts in the first five months of 2019. Interest Expense Evergy's interest expense increased $94.4 million in 2019 compared to 2018 primarily driven by: • a $77.2 million increase due to the inclusion of Evergy Metro's and Evergy Missouri West's interest expense and Evergy's interest expense associated with the assumption of legacy Great Plains Energy debt in the first five months of 2019; • a $14.5 million increase due to Evergy's issuance of $1.6 billion of senior notes in September 2019; and • a $7.7 million increase primarily due to Evergy's borrowings under its $1.0 billion term loan credit agreement in 2019; partially offset by • a $10.1 million net decrease due to the repayment of Evergy Metro's $400.0 million of 7.15% Mortgage Bonds at maturity in April 2019, which decreased interest expense by $19.8 million, partially offset by a $9.7 million increase due to Evergy Metro's issuance of $400.0 million of 4.125% Mortgage Bonds in March 2019. Income Tax Expense Evergy's income tax expense increased $38.0 million in 2019 compared to 2018 primarily driven by: • a $52.6 million increase related to the revaluation of Evergy Kansas Central's deferred income tax assets and liabilities based on the Evergy composite tax rate as a result of the merger in 2018; and • an $18.9 million increase due to higher Evergy Kansas Central pre-tax income; partially offset by • a $39.0 million decrease due to flow-through items primarily driven by higher amortization of excess deferred income taxes. EVERGY SIGNIFICANT BALANCE SHEET CHANGES (December 31, 2019 compared to December 31, 2018) • Evergy's cash and cash equivalents decreased $137.1 million primarily due to the repurchase of common stock in connection with Evergy's share repurchase program. See Note 18 to the consolidated financial statements for additional information on Evergy's share repurchase program. • Evergy's income tax receivable increased by $17.5 million primarily due to the $37.9 million reclassification of Evergy's 2019 alternative minimum tax (AMT) credits from deferred income taxes, partially offset by the receipt of $18.6 million in 2019 related to Evergy's 2018 AMT tax credit. • Evergy's regulatory assets - current decreased by $72.2 million primarily due to fuel recovery mechanism recoveries exceeding under-collections at Evergy Metro and Evergy Missouri West by $30.7 million and $24.3 million in 2019, respectively. • Evergy's other assets increased by $115.0 million primarily due to $104.5 million of operating lease right-of-use assets, as of December 31, 2019, that were recorded as a result of Topic 842, Leases in 2019. See Note 1 to the consolidated financial statements for additional information on the new lease standard. • Evergy's current maturities of long-term debt decreased by $454.3 million primarily due to the repayment of Evergy Metro's $400.0 million of 7.15% Mortgage Bonds at maturity in April 2019. • Evergy's notes payable and commercial paper decreased $176.7 million primarily due to a $162.5 million decrease at Evergy Kansas Central due to the repayment of commercial paper with funds from operations and a $56.6 million decrease at Evergy Missouri West primarily due to the repayment of commercial paper with the proceeds from its issuance of $100.0 million of 3.74% Senior Notes in March 2019, partially offset by a $20.0 million increase at Evergy, Inc. due to cash borrowings under its master credit facility. • Evergy's accounts payable increased $77.3 million primarily due to the timing of cash payments. • Evergy's regulatory liabilities - current decreased $46.9 million primarily due to a $70.9 million refund to customers of tax reform benefits at Evergy Kansas Central, Evergy Metro and Evergy Missouri West in 2019, partially offset by a $30.2 million increase in Evergy Kansas Central's regulatory liability for its fuel recovery mechanism due to recoveries exceeding under-collections. • Evergy's other liabilities - current increased $48.9 million primarily due to a $23.7 million increase in funds received from customers for the construction of transmission assets at Evergy Kansas Central and $15.6 million of operating lease liabilities, as of December 31, 2019, that were recorded as a result of the adoption of Topic 842, Leases in 2019. See Note 1 to the consolidated financial statements for additional information on the new lease standard. • Evergy's long-term debt increased by $2,110.4 million primarily due to the issuance of Evergy's $1.6 billion of senior notes in September 2019 and Evergy Metro's issuance of $400.0 million of 4.125% Mortgage Bonds in March 2019. • Evergy's other liabilities - long-term increased $104.0 million primarily due to $82.4 million of operating lease liabilities, as of December 31, 2019, that were recorded as a result of the adoption of Topic 842, Leases in 2019. See Note 1 to the consolidated financial statements for additional information on the new lease standard. • Evergy's common stock decreased $1,614.8 million primarily due to the repurchase of common stock for a total cost of approximately $1,628.7 million in 2019 pursuant to Evergy's share repurchase program. See Note 18 to the consolidated financial statements for additional information on Evergy's share repurchase program. LIQUIDITY AND CAPITAL RESOURCES Evergy relies primarily upon cash from operations, short-term borrowings, debt and equity issuances and its existing cash and cash equivalents to fund its capital requirements. Evergy's capital requirements primarily consist of capital expenditures, payment of contractual obligations and other commitments, the payment of dividends to shareholders and the repurchase of common shares. Capital Sources Cash Flows from Operations Evergy's cash flows from operations are driven by the regulated sale of electricity. These cash flows are relatively stable but the timing and level of these cash flows can vary based on weather and economic conditions, future regulatory proceedings, the timing of cash payments made for costs recoverable under regulatory mechanisms and the time such costs are recovered, and unanticipated expenses such as unplanned plant outages and storms. Short-Term Borrowings As of December 31, 2019, Evergy had $1.9 billion of available borrowing capacity from its master credit facility. The available borrowing capacity under the master credit facility consisted of $429.3 million for Evergy, Inc., $736.6 million for Evergy Kansas Central, $400.7 million for Evergy Metro and $354.5 million for Evergy Missouri West. Evergy Kansas Central's, Evergy Metro's and Evergy Missouri West's borrowing capacity under the master credit facility also supports their issuance of commercial paper. See Note 12 to the consolidated financial statements for more information regarding the credit facility. Along with cash flows from operations and receivable sales facilities, Evergy generally uses borrowings under its master credit facility and the issuance of commercial paper to meet its day-to-day cash flow requirements. Evergy also had short-term borrowings under a term loan credit agreement that was repaid in September 2019 and is discussed further below. In March 2019, Evergy entered into a $1.0 billion, 6-month term loan credit agreement with a group of banks to provide short-term financing for its common stock repurchase program. The agreement allowed for two term loans during the 6-month term of the agreement, in an aggregate principal amount not to exceed the credit limit of the agreement. At closing, Evergy borrowed $500.0 million under the agreement, allowing for one additional term loan borrowing in a principal amount up to $500.0 million, which was subsequently utilized in June 2019. In September 2019, Evergy repaid its $1.0 billion of borrowings under the term loan credit agreement with proceeds from its issuance of $1.6 billion of senior notes in September 2019. Long-Term Debt and Equity Issuances From time to time, Evergy issues long-term debt and equity to repay short-term debt, refinance maturing long-term debt and finance growth. As of December 31, 2019 and 2018, Evergy’s capital structure, excluding short-term debt, was as follows: Under stipulations with the MPSC and KCC, Evergy, Evergy Kansas Central and Evergy Metro are required to maintain common equity at not less than 35%, 40% and 40%, respectively, of total capitalization. The master credit facility and certain debt instruments of the Evergy Companies also contain restrictions that require the maintenance of certain capitalization and leverage ratios. As of December 31, 2019, the Evergy Companies were in compliance with these covenants. Significant Debt Issuances See Note 13 to the consolidated financial statements for information regarding significant debt issuances. Credit Ratings The ratings of the Evergy Companies' debt securities by the credit rating agencies impact the Evergy Companies' liquidity, including the cost of borrowings under their master credit facility and in the capital markets. The Evergy Companies view maintenance of strong credit ratings as vital to their access to and cost of debt financing and, to that end, maintain an active and ongoing dialogue with the agencies with respect to results of operations, financial position and future prospects. While a decrease in these credit ratings would not cause any acceleration of the Evergy Companies' debt, it could increase interest charges under the master credit facility. A decrease in credit ratings could also have, among other things, an adverse impact, which could be material, on the Evergy Companies' access to capital, the cost of funds, the ability to recover actual interest costs in state regulatory proceedings, the type and amounts of collateral required under supply agreements and Evergy's ability to provide credit support for its subsidiaries. As of February 20, 2020, the major credit rating agencies rated the Evergy Companies' securities as detailed in the following table. (a)A securities rating is not a recommendation to buy, sell or hold securities and may be subject to revision or withdrawal at any time by the assigning rating agency. Shelf Registration Statements and Regulatory Authorizations Evergy In November 2018, Evergy filed an automatic shelf registration statement providing for the sale of unlimited amounts of securities with the SEC, which expires in November 2021. Evergy Kansas Central In November 2018, Evergy Kansas Central filed an automatic shelf registration statement providing for the sale of unlimited amounts of unsecured debt securities and First Mortgage Bonds (FMBs) with the SEC, which expires in November 2021. Evergy Metro In November 2018, Evergy Metro filed an automatic shelf registration statement providing for the sale of unlimited amounts of unsecured notes and mortgage bonds with the SEC, which expires in November 2021. The following table summarizes the regulatory short-term and long-term debt financing authorizations for Evergy Kansas Central, Evergy Kansas South, Evergy Metro and Evergy Missouri West and the remaining amount available under these authorizations as of December 31, 2019. In addition to the above regulatory authorizations, the Evergy Kansas Central, Evergy Kansas South and Evergy Metro mortgages each contain provisions restricting the amount of FMBs or mortgage bonds, as applicable, that can be issued by each entity. Evergy Kansas Central, Evergy Kansas South and Evergy Metro must comply with these restrictions prior to the issuance of additional FMBs, general mortgage bonds or other secured indebtedness. Under the Evergy Kansas Central mortgage, the issuance of FMBs is subject to limitations based on the amount of bondable property additions. In addition, so long as any bonds issued prior to January 1, 1997, remain outstanding, the mortgage prohibits additional FMBs from being issued, except in connection with certain refundings, unless Evergy Kansas Central’s unconsolidated net earnings available for interest, depreciation and property retirement (which, as defined, does not include earnings or losses attributable to the ownership of securities of subsidiaries), for a period of 12 consecutive months within 15 months preceding the issuance, are not less than the greater of twice the annual interest charges on or 10% of the principal amount of all FMBs outstanding after giving effect to the proposed issuance. As of December 31, 2019, $305.4 million principal amount of additional FMBs could be issued under the most restrictive provisions in the mortgage, except in connection with certain refundings. Under the Evergy Kansas South mortgage, the amount of FMBs authorized is limited to a maximum of $3.5 billion and the issuance of FMBs is subject to limitations based on the amount of bondable property additions. In addition, the mortgage prohibits additional FMBs from being issued, except in connection with certain refundings, unless Evergy Kansas South's net earnings before income taxes and before provision for retirement and depreciation of property for a period of 12 consecutive months within 15 months preceding the issuance are not less than either two and one-half times the annual interest charges on or 10% of the principal amount of all Evergy Kansas South FMBs outstanding after giving effect to the proposed issuance. As of December 31, 2019, approximately $2,828.6 million principal amount of additional Evergy Kansas South FMBs could be issued under the most restrictive provisions in the mortgage, except in connection with certain refundings. Under the General Mortgage Indenture and Deed of Trust dated as of December 1, 1986, as supplemented (Evergy Metro Mortgage Indenture), additional Evergy Metro mortgage bonds may be issued on the basis of 75% of property additions or retired bonds. As of December 31, 2019, approximately $4,923.3 million principal amount of additional Evergy Metro mortgage bonds could be issued under the most restrictive provisions in the mortgage. Cash and Cash Equivalents At December 31, 2019, Evergy had approximately $23.2 million of cash and cash equivalents on hand. Capital Requirements Capital Expenditures Evergy requires significant capital investments and expects to need cash primarily for utility construction programs designed to improve and expand facilities related to providing electric service, which include, but are not limited to, expenditures to develop new transmission lines and improvements to power plants, transmission and distribution lines and equipment. Evergy's capital expenditures were $1,210.1 million, $1,069.7 million and $764.6 million in 2019, 2018 and 2017, respectively. Capital expenditures projected for the next five years, excluding allowance for fund used during construction (AFUDC) and including costs of removal, are detailed in the following table. This capital expenditure plan is subject to continual review and change. Contractual Obligations and Other Commitments In the course of its business activities, the Evergy Companies enter into a variety of contracts and commercial commitments. Some of these result in direct obligations reflected on Evergy's consolidated balance sheets while others are commitments, some firm and some based on uncertainties, not reflected in Evergy's underlying consolidated financial statements. The information in the following table is provided to summarize Evergy's cash obligations and commercial commitments. (a) Evergy expects to make contributions to the pension and other post-retirement plans beyond 2024 but the amounts are not yet determined. Long-term debt includes current maturities. Long-term debt principal excludes $80.7 million of unamortized net discounts and debt issuance costs and a $125.5 million fair value adjustment recorded in connection with purchase accounting for the Great Plains Energy and Evergy Kansas Central merger. Variable rate interest obligations are based on rates as of December 31, 2019. Operating lease commitments include leases for office buildings, computer equipment, operating facilities, vehicles and rail cars to serve jointly-owned generating units where Evergy Kansas Central or Evergy Metro is the managing partner and is reimbursed by other joint-owners for its proportionate share of the cost. Finance lease commitments include obligations for both principal and interest. Evergy expects to contribute $131.9 million to the pension and other post-retirement plans in 2020, of which the majority is expected to be paid by Evergy Kansas Central and Evergy Metro. Additional contributions to the plans are expected beyond 2024 in amounts at least sufficient to meet the greater of Employee Retirement Income Security Act of 1974, as amended (ERISA) or regulatory funding requirements; however, these amounts have not yet been determined. Amounts for years after 2020 are estimates based on information available in determining the amount for 2020. Actual amounts for years after 2020 could be significantly different than the estimated amounts in the table above. Fuel commitments consist of commitments for nuclear fuel, coal and coal transportation costs. Power commitments consist of certain commitments for renewable energy under power purchase agreements. Other represents individual commitments entered into in the ordinary course of business. Evergy has other insignificant long-term liabilities recorded on its consolidated balance sheet at December 31, 2019, which do not have a definitive cash payout date and are not included in the table above. Common Stock Dividends The amount and timing of dividends payable on Evergy's common stock are within the sole discretion of the Evergy Board. The amount and timing of dividends declared by the Evergy Board will be dependent on considerations such as Evergy's earnings, financial position, cash flows, capitalization ratios, regulation, reinvestment opportunities and debt covenants. Evergy targets a long-term dividend payout ratio of 60% to 70% of earnings. See Note 1 to the consolidated financial statements for information on the common stock dividend declared by the Evergy Board in February 2020. The Evergy Companies also have certain restrictions stemming from statutory requirements, corporate organizational documents, covenants and other conditions that could affect dividend levels. See Note 18 to the consolidated financial statements for further discussion of restrictions on dividend payments. Common Stock Repurchase Program In July 2018, the Evergy Board authorized the repurchase of up to 60 million shares of Evergy's common stock. For 2019, Evergy had total repurchases of common stock of $1,628.7 million and had repurchased 28.8 million shares under the repurchase program. Since the start of the repurchase program in August 2018, Evergy has made total repurchases of common stock of $2,671.0 million and has repurchased 45.2 million shares under the repurchase program. Evergy does not anticipate making additional repurchases of common stock under its share repurchase program while the Strategic Review & Operations Committee of the Evergy Board conducts its review of ways to enhance long-term shareholder value, which is expected to conclude in the first half of 2020. See Note 18 to the consolidated financial statements for more information regarding Evergy's common stock repurchase program. Off-Balance Sheet Arrangements In the ordinary course of business, Evergy and certain of its subsidiaries enter into various agreements providing financial or performance assurance to third parties on behalf of certain subsidiaries. Such agreements include, for example, guarantees and letters of credit. These agreements are entered into primarily to support or enhance the creditworthiness otherwise attributed to a subsidiary on a stand-alone basis, thereby facilitating the extension of sufficient credit to accomplish the subsidiary's intended business purposes. In connection with the closing of the merger, Evergy assumed the guarantees previously provided to Evergy Missouri West by Great Plains Energy. The majority of these agreements guarantee Evergy's own future performance, so a liability for the fair value of the obligation is not recorded. At December 31, 2019, Evergy has provided $110.2 million of credit support for Evergy Missouri West as follows: • Evergy direct guarantees to Evergy Missouri West counterparties totaling $17.0 million, which expire in 2020, and • Evergy's guarantee of Evergy Missouri West long-term debt totaling $93.2 million, which includes debt with maturity dates ranging from 2020 to 2023. Evergy has also guaranteed Evergy Missouri West's short-term debt, including its commercial paper program. At December 31, 2019, Evergy Missouri West had $93.4 million of commercial paper outstanding. None of the guaranteed obligations are subject to default or prepayment if Evergy Missouri West's credit ratings were downgraded. The Evergy Companies also have off-balance sheet arrangements in the form of letters of credit entered into in the ordinary course of business. Cash Flows The following table presents Evergy's cash flows from operating, investing and financing activities. Cash Flows from Operating Activities Evergy's $251.2 million increase in cash flows from operating activities in 2019 compared to 2018 was primarily driven by a $252.3 million increase due to the inclusion of Evergy Metro's and Evergy Missouri West's cash flows from operating activities in the first five months of 2019 and $35.6 million of merger success fees paid by Evergy and Evergy Kansas Central upon the completion of the merger in June 2018. Cash Flows from (used in) Investing Activities Evergy's cash flows used in investing activities increased $1,277.7 million in 2019 compared to 2018 primarily driven by: • $1,154.2 million of cash acquired from Great Plains Energy in June 2018; • a $243.6 million increase in additions to property, plant and equipment due to the inclusion of Evergy Metro and Evergy Missouri West activity in the first five months of 2019; and • $140.6 million in proceeds from the settlement of deal contingent interest rate swaps in June 2018; partially offset by • an increase of $154.9 million in proceeds from COLI investments, primarily from Evergy Kansas Central due to a higher number of policy settlements in 2019. Cash Flows used in Financing Activities Evergy's cash flows used in financing activities decreased $732.6 million in 2019 compared to 2018 primarily driven by: • a $2,081.8 million increase in proceeds from long-term debt, net, as further described in Note 13 to the consolidated financial statements; partially offset by • a $586.4 million increase of repurchased common stock under the common stock repurchase program, as further described in Note 18 to the consolidated financial statements; • a $305.3 million increase in retirement of long-term debt, as further described in Note 13 to the consolidated financial statements; • a $211.0 million decrease in collateralized short-term debt, net borrowings primarily due to the establishment of Evergy Kansas Central’s receivable sale facility in the fourth quarter of 2018; • a $123.6 million increase in the repayment of borrowings from the cash surrender value of COLI, primarily from Evergy Kansas Central due to a higher number of policy settlements in 2019; and • a $69.8 million payment for the settlement of Evergy's interest rate swap that was designated as a cash flow hedge of its issuance of $800.0 million of 2.90% Senior Notes in September 2019. EVERGY KANSAS CENTRAL, INC. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS The below results of operations and related discussion for Evergy Kansas Central is presented in a reduced disclosure format in accordance with General Instruction (I)(2)(a) to Form 10-K. The following table summarizes Evergy Kansas Central's comparative results of operations. Evergy Kansas Central Utility Gross Margin and MWh Sales The following table summarizes Evergy Kansas Central's utility gross margin and MWhs sold. (a)Utility gross margin is a non-GAAP financial measure. See explanation of utility gross margin under Evergy's Results of Operations. Evergy Kansas Central's utility gross margin increased $7.3 million in 2019 compared to 2018 driven by: • a $27.9 million increase from new retail rates effective in September 2018, net of a $69.8 million provision for rate refund recorded in 2018 for the change in the corporate income tax rate caused by the TCJA; and • a $23.1 million increase in revenue due to one-time bill credits recorded in June 2018 as a result of conditions in the KCC merger order; partially offset by • a $30.9 million decrease primarily due to lower retail sales driven by cooler summer weather. For 2019 compared to 2018, cooling degree days decreased 15%; and • a $12.8 million decrease related to Evergy Kansas Central's TDC rider. Evergy Kansas Central Operating and Maintenance Evergy Kansas Central's operating and maintenance expense decreased $110.2 million in 2019 compared to 2018 primarily driven by: • $51.9 million of merger-related costs incurred in 2018, consisting of: ◦ $44.2 million of voluntary severance and change in control payments as well as the recording of unrecognized equity compensation costs and the incremental fair value associated with the vesting of outstanding equity compensation awards in accordance with the Amended Merger Agreement; and ◦ $21.5 million of merger consulting fees and fees for other outside services incurred, primarily consisting of merger success fees; partially offset by ◦ a $13.8 million decrease in operating and maintenance expense due to the net reallocation of incurred merger transition costs between Evergy Kansas Central, Evergy, Evergy Metro and Evergy Missouri West and the subsequent deferral of these transition costs to a regulatory asset in June 2018 for future recovery by Evergy Kansas Central in accordance with the KCC merger order; • a $22.9 million decrease in plant operating and maintenance expense at fossil-fuel generating units primarily due to: ◦ $12.3 million of obsolete inventory write-offs at retiring fossil-fuel units in 2018; ◦ a $7.3 million decrease due to the retirement of Evergy Kansas Central's Unit 7 at Tecumseh Energy Center, Units 3 and 4 at Murray Gill Energy Center and Units 1 and 2 at Gordan Evans Energy Center in the fourth quarter of 2018; and ◦ $0.7 million of voluntary severance expenses incurred in 2018 related to the Local 1523 union voluntary exit program; partially offset by ◦ an $8.4 million increase due to the write-off of a regulatory asset for costs incurred during the JEC lease extension, see Note 5 to the consolidated financial statements; • a $19.2 million decrease in various administrative and general operating and maintenance expenses primarily driven by a $10.0 million decrease in labor and employee benefits expense primarily due to lower employee headcount and pension and post-retirement costs in 2019 and $5.3 million of voluntary severance expenses incurred in the third quarter of 2018 related to a Wolf Creek voluntary exit program; • a $9.6 million decrease in transmission and distribution operating and maintenance expense primarily due to a higher level of vegetation management activity in 2018; and • a $6.3 million decrease in plant operating and maintenance expense at nuclear generating units related to Wolf Creek; partially offset by • $9.3 million of voluntary severance expenses incurred in 2019. Evergy Kansas Central Depreciation and Amortization Evergy Kansas Central's depreciation and amortization expense increased $52.9 million in 2019 compared to 2018 driven by: • a $32.4 million increase primarily due to a change in depreciation rates as a result of Evergy Kansas Central's rate case effective in September 2018; and • a $20.5 million increase primarily due to capital additions. Evergy Kansas Central Taxes Other Than Income Tax Evergy Kansas Central's taxes other than income tax increased $18.6 million in 2019 compared to 2018 primarily driven by an $18.3 million increase in property taxes. Evergy Kansas Central Other Expense, Net Evergy Kansas Central's other expense, net decreased $20.6 million in 2019 compared to 2018 primarily driven by: • a $12.4 million decrease due to recording higher COLI benefits in 2019; • a $4.2 million decrease due to higher net unrealized gains in Evergy Kansas Central's rabbi trust in 2019; and • a $3.4 million decrease due to lower pension non-service costs in 2019. Evergy Kansas Central Income Tax Expense Evergy Kansas Central's income tax expense increased $56.4 million in 2019 compared to 2018 driven by: • a $52.6 million increase related to the revaluation of deferred income tax assets and liabilities based on the Evergy composite tax rate as a result of the merger in June 2018; and • an $18.9 million increase due to higher pre-tax income; partially offset by • a $5.3 million decrease due to flow-through items primarily driven by higher amortization of excess deferred income taxes. EVERGY METRO, INC. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS The below results of operations and related discussion for Evergy Metro is presented in a reduced disclosure format in accordance with General Instruction (I)(2)(a) to Form 10-K. The following table summarizes Evergy Metro's comparative results of operations. Evergy Metro Utility Gross Margin and MWh Sales The following table summarizes Evergy Metro's utility gross margin and MWhs sold. (a) Utility gross margin is a non-GAAP financial measure. See explanation of utility gross margin under Evergy's Results of Operations. Evergy Metro's utility gross margin increased $21.9 million in 2019 compared to 2018 driven by: • a $40.4 million increase from new retail rates effective in December 2018, net of a $72.4 million provision for rate refund recorded for 2018 for the change in the corporate income tax rate caused by the TCJA; and • a $22.4 million increase in revenue due to one-time bill credits recorded in June 2018 as a result of conditions in the KCC and MPSC merger orders; partially offset by • a $30.9 million decrease primarily due to lower retail sales driven by cooler summer weather. For 2019 compared to 2018, cooling degree days decreased 18%; and • a $10.0 million decrease for recovery of programs costs for energy efficiency programs under MEEIA, which have a direct offset in operating and maintenance expense. Evergy Metro Operating and Maintenance Evergy Metro's operating and maintenance expense decreased $42.3 million in 2019 compared to 2018 primarily driven by: • a $26.4 million decrease in plant operating and maintenance expense at fossil-fuel generating units primarily driven by: ◦ a $10.9 million decrease due to the retirement of Montrose Station in 2018, which includes $7.3 million of obsolete inventory write-offs in 2018; ◦ a $3.7 million decrease due to an extended maintenance outage at Iatan No. 2 in 2018; and ◦ $3.2 million of voluntary severance expenses incurred in the third quarter of 2018 related to the Local 412 union voluntary exit program; • a $23.8 million decrease in various administrative and general operating and maintenance expenses, which includes $5.3 million of voluntary severance expenses incurred in the third quarter of 2018 related to a Wolf Creek voluntary exit program and a $3.5 million decrease in injuries and damages expense primarily due to an increase in estimated workers compensation losses recorded in 2018; • a $10.0 million decrease in program costs for energy efficiency programs under MEEIA, which have a direct offset in revenue; • a $6.8 million decrease in plant operating and maintenance expense at nuclear generating units related to Wolf Creek; and • $2.1 million of merger-related costs incurred in 2018; partially offset by • a $23.2 million increase in operating and maintenance expense due to the net reallocation of incurred merger transition costs between Evergy Metro, Evergy, Evergy Kansas Central and Evergy Missouri West and the subsequent deferral of these transition costs to a regulatory asset in June 2018 for future recovery by Evergy Metro in accordance with the KCC and MPSC merger orders; • a $7.1 million increase in transmission and distribution operating and maintenance expense primarily due to costs incurred from storms that occurred in January 2019; and • $6.8 million of voluntary severance expenses incurred in 2019. Evergy Metro Depreciation and Amortization Evergy Metro's depreciation and amortization increased $37.1 million in 2019 compared to 2018 primarily driven by: • a $19.3 million increase primarily due to capital additions; and • a $17.8 million increase due to a change in depreciation rates effective in December 2018 as a result of Evergy Metro's 2018 Kansas rate case. Evergy Metro Taxes Other Than Income Tax Evergy Metro's taxes other than income tax increased $10.4 million in 2019 compared to 2018 primarily driven by a $7.9 million increase in property taxes. Evergy Metro Interest Expense Evergy Metro's interest expense decreased $13.9 million in 2019 compared to 2018 primarily driven by a $12.8 million net decrease due to the repayment of $400.0 million of 7.15% Mortgage Bonds at maturity in April 2019, which decreased interest expense by $25.4 million, partially offset by a $12.6 million increase due to the issuance of $400.0 million of 4.125% Mortgage Bonds in March 2019. Evergy Metro Income Tax Expense Evergy Metro's income tax expense decreased $51.6 million in 2019 compared to 2018 primarily driven by: • a $51.0 million decrease related to the revaluation of deferred income tax assets and liabilities based on the Evergy composite tax rate as a result of the merger in June 2018; and • a $21.4 million decrease due to flow-through items primarily driven by higher amortization of excess deferred income taxes; partially offset by • a $15.5 million increase related to the revaluation of deferred income tax assets and liabilities as a result of the enactment of Missouri state income tax reform in June 2018; and • a $10.8 million increase due to higher pre-tax income.

<s>[INST] The following MD&A generally discusses 2019 and 2018 items and yeartoyear comparisons between 2019 and 2018. Discussions of 2017 items and yeartoyear comparisons between 2018 and 2017 can be found in MD&A in Part II, Item 7, of the Evergy Companies' combined annual report on Form 10K for the fiscal year ended December 31, 2018. EVERGY, INC. EXECUTIVE SUMMARY Evergy is a public utility holding company incorporated in 2017 and headquartered in Kansas City, Missouri. Evergy operates primarily through the following whollyowned direct subsidiaries listed below. In September 2019, these whollyowned direct subsidiaries were rebranded and renamed under the Evergy brand name. Evergy Kansas Central, formerly known as Westar Energy, Inc., is an integrated, regulated electric utility that provides electricity to customers in the state of Kansas. Evergy Kansas Central has one active whollyowned subsidiary with significant operations, Evergy Kansas South, formerly known as Kansas Gas and Electric Company. Evergy Metro, formerly known as Kansas City Power & Light Company, is an integrated, regulated electric utility that provides electricity to customers in the states of Missouri and Kansas. Evergy Missouri West, formerly known as KCP&L Greater Missouri Operations Company, is an integrated, regulated electric utility that provides electricity to customers in the state of Missouri. Evergy Transmission Company, formerly known as GPE Transmission Holding Company, LLC, owns 13.5% of Transource with the remaining 86.5% owned by AEP Transmission Holding Company, LLC, a subsidiary of AEP. Transource is focused on the development of competitive electric transmission projects. Evergy Transmission Company accounts for its investment in Transource under the equity method. Evergy Kansas Central also owns a 50% interest in Prairie Wind, which is a joint venture between Evergy Kansas Central and subsidiaries of AEP and Berkshire Hathaway Energy Company. Prairie Wind owns a 108mile, 345 kV doublecircuit transmission line that provides transmission service in the SPP. Evergy Kansas Central accounts for its investment in Prairie Wind under the equity method. Since the rebranding in September 2019, Evergy Kansas Central, Evergy Kansas South, Evergy Metro and Evergy Missouri West have been conducting business in their respective service territories using the name Evergy. Collectively, the Evergy Companies have approximately 14,700 MWs of owned generating capacity and renewable purchased power agreements and engage in the generation, transmission, distribution and sale of electricity to approximately 1.6 million customers in the states of Kansas and Missouri. The Evergy Companies assess financial performance and allocate resources on a consolidated basis (i.e., operate in one segment). Strategy Evergy expects to continue operating its integrated utilities within the currently existing regulatory frameworks. Evergy's objectives are to deliver value to shareholders through earnings and dividend growth; serve customers and communities with costeffective, reliable and clean energy; and maintain a rewarding and challenging work environment for employees. Significant elements of Evergy's strategy to achieve these objectives include: the realization of a total of approximately $595 million of potential net savings over the first five years of operation of the combined company, which formed in June 2018, resulting from synergies that are expected to be created as a result of the merger; anticipated rate base investment of approximately $7.6 billion from 2020 through 2024; and the reduction of carbon emissions by 80% by 2050 from 2005 levels through the continued growth of Evergy's renewable energy portfolio and the retirement of older and less efficient fossil fuel plants. See "Transforming Evergy's Generation Fleet" in Part I, Item 1, Business, for additional information. In March 2020, the Evergy Board announced the creation of a Strategic Review & Operations Committee that will explore ways to enhance longterm shareholder value (taking into account applicable legal and regulatory requirements and any other relevant considerations), including through a potential strategic combination [/INST] Positive. </s>

Boxwood Merger Corp.

2019-03-26

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Special Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. When used in this Form 10-K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a Delaware corporation formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization, recapitalization or other similar business combination with one or more businesses. Although we may pursue an initial business combination in any business, industry or geographic location, we currently intend to focus on companies that provide technical and industrial services in the United States. We intend to effectuate our initial business combination using cash from the proceeds of our initial public offering and the sale of the private placement securities, our capital stock, debt or a combination of cash, stock and debt. The registration statement for our initial public offering was declared effective on November 15, 2018. On November 20, 2018, we completed our initial public offering of 20,000,000 units sold to the public at the price of $10.00 per unit, generating gross proceeds of $200,000,000. Each unit consists of one share of our common stock, $0.0001 par value and one warrant, each warrant exercisable to purchase one share of our Class A common stock at an exercise price of $11.50, pursuant to our registration statement on Form S-1, as amended (File No. 333-228018). The underwriters were granted a 45-day option to purchase up to 3,000,000 additional units to cover over-allotments, if any, at $10.00 per unit, less underwriting discounts and commissions. The over-allotment option was not exercised prior to its expiration on December 30, 2018. Simultaneously with the consummation of our initial public offering, we completed a private placement of an aggregate of 250,000 units at a price of $10.00 per unit and 3,500,000 warrants at a price of $1.00 per warrant, generating total gross proceeds of $6,000,000. A total of $200,000,000 (including approximately $7,000,000 in deferred underwriting commissions payable to the underwriters) of the net proceeds from our initial public offering and the private placement was deposited in a trust account located in the United States established for the benefit of the Company’s public stockholders with Continental Stock Transfer & Trust Company acting as trustee. If we are unable to complete our initial business combination by November 20, 2020, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a per-share price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest earned on the trust account deposits (which interest shall be net of taxes payable and less up to $100,000 to pay dissolution expenses), divided by the number of then-outstanding public shares, which redemption will completely extinguish our public stockholders’ rights as stockholders (including the right to receive further liquidation distributions, if any), subject to applicable law; and (iii) as promptly as reasonably possible following such redemption, subject to the approval of our remaining stockholders and our board of directors, dissolve and liquidate, subject in each case to our obligations under Delaware law to provide for claims of creditors and the requirements of other applicable law. There will be no redemption rights or liquidating distributions with respect to our warrants, which will expire worthless if we fail to complete our initial business combination by November 20, 2020. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete an initial business combination will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception to December 31, 2018 were organizational activities, those necessary to prepare for our initial public offering, described below, and identifying a target company for an initial business combination. We do not expect to generate any operating revenues until after the completion of our initial business combination. We generate non-operating income in the form of interest income on marketable securities held after our initial public offering. We are incurring expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses in connection with completing an initial business combination. For the year ended December 31, 2018, we had net income of $287,660, which consisted of interest income on marketable securities held in the trust account of $471,972, offset by operating costs of $106,435 and provision for income taxes of $77,877. For the period from June 28, 2017 (inception) through December 31, 2017, we had a net loss of $175, which consisted of operating costs of $175. Liquidity and Capital Resources On November 20, 2018, we consummated our initial public offering of 20,000,000 units at a price of $10.00 per unit, generating gross proceeds of $200,000,000. Simultaneously with the closing of our initial public offering, we consummated the sale of 250,000 private placement units at a price of $10.00 per unit and the sale of 3,500,000 private placement warrants at a price of $1.00 per warrant to the sponsor, generating gross proceeds of $6,000,000. Following our initial public offering and the sale of the private placement securities, a total of $200,000,000 was placed in the trust account and we had $1,347,347 of cash held outside of the trust account, after payment of costs related to our initial public offering, and available for working capital purposes. We incurred $11,698,856 in transaction costs, including $4,000,000 of underwriting fees, $7,000,000 of deferred underwriting fees and $698,856 of other costs. For the year ended December 31, 2018, cash used in operating activities was $43,448. Net income of $287,660 was offset by interest earned on marketable securities held in the trust account of $471,972. Changes in operating assets and liabilities provided $140,864 of cash. At December 31, 2018, we had marketable securities held in the trust account of $200,471,972. We intend to use substantially all of the funds held in the trust account (excluding deferred underwriting commissions and interest to pay taxes) to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our capital stock is used in whole or in part as consideration to effect our initial business combination, the remaining proceeds held in the trust account as well as any other net proceeds not expended will be used as working capital to finance the operations of the target business or businesses. At December 31, 2018, we had cash of $1,275,571 held outside the trust account. We intend to use the funds held outside the trust account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses, review corporate documents and material agreements of prospective target businesses, select the target business to acquire and structure, negotiate and complete an initial business combination. In order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, our sponsor or an affiliate of our sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete an initial business combination, we would repay such loaned amounts. In the event that an initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $250,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant at the option of the lender. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimate of undertaking in-depth due diligence and negotiating an initial business combination is less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial business combination. Moreover, we may need to obtain additional financing either to consummate our initial business combination or because we become obligated to redeem a significant number of our public shares upon consummation of our initial business combination, in which case we may issue additional securities or incur debt in connection with such initial business combination. Subject to compliance with applicable securities laws, we would only complete such financing simultaneously with the completion of our initial business combination. Following our initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. Related Party Transactions We were initially formed by our sponsor in June 2017, at which time our sponsor acquired all 100 shares of our outstanding common stock for an aggregate purchase price of $25,000, or approximately $250.00 per share. Prior to the initial investment in the company of $25,000, the company had no assets, tangible or intangible. The per share price for the founder shares was determined by dividing the amount initially contributed to the company by the number of founder shares issued. In October 2018, our sponsor sold certain of the founder shares to our three independent directors. On November 14, 2018 and November 15, 2018, we effected the Recapitalization and the Forfeiture, respectively, and, as a result, our sponsor and independent directors held 5,750,000 founder shares (up to 750,000 of which were subject to forfeiture depending on the extent to which the underwriters’ option to purchase additional units was exercised, if at all). The number of founder shares issued in the Recapitalization and forfeited in the Forfeiture was determined based on the expectation that the total size of our initial public offering would be a maximum of 23,000,000 units if the underwriters’ option to purchase additional units was exercised in full, and therefore that such founder shares would represent 20% of the issued and outstanding shares of common stock after our initial public offering (not including the shares of Class A common stock underlying the private placement units). On January 4, 2019, our sponsor forfeited 750,000 founder shares to us at no cost, in connection with the expiration of the underwriters’ over-allotment option. Our sponsor, officers and directors or any of their respective affiliates will be reimbursed for any out-of-pocket expenses related to identifying, investigating, negotiating and completing an initial business combination. Our audit committee reviews on a quarterly basis all payments that are made to our sponsor, officers, directors or any of their affiliates, and will determine which expenses and the amount of expenses that will be reimbursed. There is no cap or ceiling on the reimbursement of out-of-pocket expenses incurred by such persons in connection with activities on our behalf, although no such reimbursements will be made from the proceeds of our initial public offering held in the trust account prior to the completion of our initial business combination. Prior to the closing of our initial public offering, our sponsor loaned us an aggregate of $300,000 to cover expenses related to our initial public offering. These loans are non-interest bearing, unsecured and were repaid in full on November 20, 2018. In addition, in order to finance transaction costs in connection with an intended initial business combination, (i) our sponsor has committed an aggregate of $1,000,000, to be provided to us in the event that funds held outside of the trust are insufficient to fund our expenses relating to investigating and selecting a target business and other working capital requirements after our initial public offering and prior to our initial business combination and (ii) our sponsor, one or more affiliates of our sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts out of the proceeds of the trust account released to us. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $250,000 of such loans may be convertible into warrants of the post-business combination entity at a price of $1.00 per warrant at the option of the lender. The warrants would be identical to the private placement warrants issued to our sponsor, including as to exercise price, exercisability and exercise period. The terms of such loans by our sponsor, an affiliate of our sponsor or certain of our officers or directors, if any, have not been determined and no written agreements exist with respect to such loans. We do not expect to seek loans from parties other than our sponsor, an affiliate of our sponsor or certain of our officers or directors, if any, as we do not believe third parties will be willing to loan such funds and provide a waiver against any and all rights to seek access to funds in our trust account. Concurrently with the closing of our initial public offering, our sponsor purchased an aggregate of 250,000 private placement units at a price of $10.00 per unit, or $2,500,000 in the aggregate, and 3,500,000 private placement warrants at a price of $1.00 per warrant, or $3,500,000 in the aggregate. Each private placement warrant entitles the holder to purchase one share of our Class A common stock at $11.50 per share. Our sponsor is permitted to transfer the private placement securities held by it to certain permitted transferees, including its affiliates, our officers and directors and other persons or entities affiliated with or related to our sponsor; provided that the transferees receiving such securities will be subject to the same agreements with respect to such securities as our sponsor. Otherwise, these securities will not, subject to certain limited exceptions, be transferable or salable until 30 days after the completion of our initial business combination. The private placement warrants are non-redeemable so long as they are held by our sponsor or its permitted transferees. The private placement warrants may also be exercised by our sponsor or its permitted transferees for cash or on a cashless basis. The private placement warrants acquired by an affiliate of Macquarie Capital (USA) Inc. are not exercisable more than five years from the effective date of the registration statement and will not be transferable, assignable or salable by any person for a period of 180 days immediately following November 15, 2018, the date of this prospectus, except pursuant to (i) the transfer of any security by operation of law or by reason of our reorganization; (ii) the transfer of any security to any FINRA member firm participating in this offering and the officers or partners thereof, if all securities so transferred remain subject to the lock-up restrictions applicable to the transferee for the remainder of the 180 day time period; (iii) the transfer of any security if the aggregate amount of our securities held by such holder or related person do not exceed 1% of the securities being offered; (iv) the transfer of any security that is beneficially owned on a pro-rata basis by all equity owners of an investment fund, provided that no participating member manages or otherwise directs investments by the fund, and participating members in the aggregate do not own more than 10% of the equity in the fund; or (v) the exercise or conversion of any security, if all securities received remain subject to these lock-up restrictions for the remainder of the 180 day time period.. Otherwise, the private placement units and the private placement warrants have terms and provisions that are identical to those of the units and warrants sold as part of the units in our initial public offering, including as to exercise price, exercisability and exercise period. In addition, we have granted Macquarie Capital (USA) Inc., an affiliate of our sponsor, a right of first refusal for a period of 36 months ending on November 20, 2021 to act as one of potentially several banks which provide to us certain financial advisory, underwriting, capital raising, and other services for which it may receive a portion of the overall fees. We have agreed that Macquarie Capital (USA) Inc. will not be asked to render a fairness opinion with respect to our initial business combination as it may have a conflict of interest by virtue of its affiliation with our sponsor. As a consequence, we may be required to retain another firm to render such an opinion if one is required. Pursuant to the registration rights agreement we have entered into with our initial stockholders and holders of our private placement securities and warrants issued upon conversion of working capital loans, if any, and their respective permitted transferees (and any shares of Class A common stock issuable upon the exercise of the private placement warrants or warrants issued upon conversion of the working capital loans), we may be required to register certain securities for sale under the Securities Act. Our initial stockholders and holders of our private placement securities and warrants issued upon conversion of working capital loans, if any, and their respective permitted transferees are entitled under the registration rights agreement to make up to three demands, excluding short form registration demands (or one demand, in the case of private placement securities to be acquired by an affiliate of Macquarie Capital (USA) Inc.), that we register certain of our securities held by them for sale under the Securities Act and have the securities covered thereby registered for resale pursuant to Rule 415 under the Securities Act. In addition, these holders have the right to include their securities in other registration statements filed by us. However, the registration rights agreement provides that we will not permit any registration statement filed under the Securities Act to become effective until the securities covered thereby are released from their lock-up restrictions, as described herein. In the case of the private placement securities to be acquired by an affiliate of Macquarie Capital (USA) Inc., the demand registration right provided will not be exercisable for longer than five years from the effective date of the registration statement in compliance with FINRA Rule 5110(f)(2)(G)(iv) and the piggyback registration right provided will not be exercisable for longer than seven years from the effective date of the registration statement in compliance with FINRA Rule 5110(f)(2)(G)(v). We will bear the costs and expenses of filing any such registration statements. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policy: Common Stock Subject to Possible Redemption We account for our common stock subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption are classified as a liability instrument and are measured at fair value. Conditionally redeemable common stock (including ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, common stocks are classified as stockholders’ equity. Our common stocks feature certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, the common stock subject to possible redemption are presented at redemption value as temporary equity, outside of the stockholders’ equity section of our balance sheets. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our financial statements. Off-Balance Sheet Arrangements We have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of December 31, 2018. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual Obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. Additionally, we are in the process of evaluating the benefits of relying on the other reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if, as an “emerging growth company”, we choose to rely on such exemptions we may not be required to, among other things: (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act; (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act; (iii) comply with any requirement that may be adopted by the PCAOB regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis); and (iv) disclose certain executive compensation related items such as the correlation between executive compensation and performance and comparisons of the chief executive offer’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we are no longer an “emerging growth company,” whichever is earlier.

<s>[INST] All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forwardlooking statements. When used in this Form 10K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forwardlooking statements. Such forwardlooking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements that involve risks and uncertainties. Overview We are a Delaware corporation formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization, recapitalization or other similar business combination with one or more businesses. Although we may pursue an initial business combination in any business, industry or geographic location, we currently intend to focus on companies that provide technical and industrial services in the United States. We intend to effectuate our initial business combination using cash from the proceeds of our initial public offering and the sale of the private placement securities, our capital stock, debt or a combination of cash, stock and debt. The registration statement for our initial public offering was declared effective on November 15, 2018. On November 20, 2018, we completed our initial public offering of 20,000,000 units sold to the public at the price of $10.00 per unit, generating gross proceeds of $200,000,000. Each unit consists of one share of our common stock, $0.0001 par value and one warrant, each warrant exercisable to purchase one share of our Class A common stock at an exercise price of $11.50, pursuant to our registration statement on Form S1, as amended (File No. 333228018). The underwriters were granted a 45day option to purchase up to 3,000,000 additional units to cover overallotments, if any, at $10.00 per unit, less underwriting discounts and commissions. The overallotment option was not exercised prior to its expiration on December 30, 2018. Simultaneously with the consummation of our initial public offering, we completed a private placement of an aggregate of 250,000 units at a price of $10.00 per unit and 3,500,000 warrants at a price of $1.00 per warrant, generating total gross proceeds of $6,000,000. A total of $200,000,000 (including approximately $7,000,000 in deferred underwriting commissions payable to the underwriters) of the net proceeds from our initial public offering and the private placement was deposited in a trust account located in the United States established for the benefit of the Company’s public stockholders with Continental Stock Transfer & Trust Company acting as trustee. If we are unable to complete our initial business combination by November 20, 2020, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but not more than ten business days thereafter, redeem the public shares, at a pershare price, payable in cash, equal to the aggregate amount then on deposit in the trust account, including interest earned on the trust account deposits (which interest shall be net of taxes payable and less up to $100,000 to pay dissolution expenses), divided by the number of thenoutstanding public shares, which redemption will completely extinguish our public stockholders’ rights as stockholders (including the right to receive further liquid [/INST] Negative. </s>

ATLAS TECHNICAL CONSULTANTS, INC.

2020-03-16

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Special Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. When used in this Form 10-K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the company’s management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We were a Delaware corporation formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization, recapitalization or other similar business combination with one or more businesses. Recent Developments On February 14, 2020, we consummated the business combination. Following the Closing, the combined company is organized in an “Up-C” structure in which the business of Atlas Intermediate and its subsidiaries is held by Holdings and continues to operate through the subsidiaries of Atlas Intermediate, and in which our only direct assets consist of Holdings Units. We are the sole manager of Holdings in accordance with the terms of the Holdings LLC Agreement entered into in connection with the consummation of the business combination. Following the completion of the business combination, the Continuing Members owned an aggregate of 23,974,368 Holdings Units redeemable on a one-for-one basis for shares of Class A common stock. Upon the redemption by any Continuing Member of Holdings Units for shares of Class A common stock, a corresponding number of shares of our Class B common stock held by such Continuing Member will be cancelled. Following the conversion of each outstanding share of our Class F common stock to one share of Class A common stock, the sponsor owned an aggregate 2,225,000 shares of Class A common stock and 3,750,000 private placement warrants. In connection with the Closing, all of our units separated into their component parts of one share of Class A common stock and one warrant to purchase one share of Class A common stock of the company, and the units ceased trading on Nasdaq. Following the Closing, our Class A common stock and warrants will continue to be listed on Nasdaq under the new trading symbols of “ATCX” and “ATCXW,” respectively. Further information regarding the business combination and Atlas Intermediate is set forth in (i) the Definitive Proxy Statement and subsequently supplemented on January 28, 2020 and (ii) our Current Report on Form 8-K filed with the SEC on February 14, 2020. The Form 8-K will be amended to report Atlas Intermediates’ audited financial results and other information for the fiscal year ended December 31, 2019. Results of Operations We neither engaged in any operations nor generated any revenues through December 31, 2019. Our only activities through December 31, 2019 were organizational activities, those necessary to prepare for our initial public offering, described below, identifying a target company for an initial Business Combination and the acquisition of Atlas Intermediate. We generated non-operating income in the form of interest income on marketable securities held after our initial public offering. For the year ended December 31, 2019, we had net loss of $347,357, which consisted of operating costs of $3,712,997 and a provision for income taxes of $688,516, offset by interest income on marketable securities held in the trust account of $4,054,156. For the year ended December 31, 2018, we had net income of $287,660, which consisted of interest income on marketable securities held in the trust account of $471,972, offset by operating costs of $106,435 and a provision for income taxes of $77,877. Liquidity and Capital Resources On November 20, 2018, we consummated our initial public offering of 20,000,000 units at a price of $10.00 per unit, generating gross proceeds of $200,000,000. Each unit consisted of one share of our common stock, $0.0001 par value and one warrant, each warrant exercisable to purchase one share of our Class A common stock at an exercise price of $11.50, pursuant to our registration statement on Form S-1, as amended (File No. 333-228018). The underwriters were granted a 45-day option to purchase up to 3,000,000 additional units to cover over-allotments, if any, at $10.00 per unit, less underwriting discounts and commissions. The over-allotment option was not exercised prior to its expiration on December 30, 2018. Simultaneously with the closing of our initial public offering, we consummated the sale of 250,000 private placement units at a price of $10.00 per unit and the sale of 3,500,000 private placement warrants at a price of $1.00 per warrant to our sponsor, generating gross proceeds of $6,000,000. Following our initial public offering and the sale of the private placement securities, a total of $200,000,000 was placed in the trust account. We incurred $11,698,856 in transaction costs, including $4,000,000 of underwriting fees, $7,000,000 of deferred underwriting fees and $698,856 of other costs. For the year ended December 31, 2019, cash used in operating activities was $1,390,345. Net loss of $347,357 was affected by interest earned on marketable securities held in the Trust Account of $4,054,156. Changes in operating assets and liabilities provided $3,011,168 of cash. For the year ended December 31, 2018, cash used in operating activities was $43,448. Net income of $287,660 was offset by interest earned on marketable securities held in the trust account of $471,972. Changes in operating assets and liabilities provided $140,864 of cash. At December 31, 2019, we had cash of $95,683 held outside the trust account and marketable securities held in the trust account of $204,322,796 (including approximately $4,323,000 of interest income). Through December 31, 2019, we withdrew $203,332 of interest earned on the trust account to pay franchise and income taxes. Critical Accounting Policies and Estimates The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policies: Common stock subject to possible redemption We account for our common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. Our common stock features certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of our consolidated balance sheets. Net loss per common share We apply the two-class method in calculating earnings per share. Shares of common stock subject to possible redemption which are not currently redeemable and are not redeemable at fair value, have been excluded from the calculation of basic net loss per share since such shares, if redeemed, only participate in their pro rata share of the Trust Account earnings. Our net income is adjusted for the portion of income that is attributable to common stock subject to possible redemption, as these shares only participate in the earnings of the Trust Account and not our income or losses. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our financial statements. Off-Balance Sheet Arrangements We had no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of December 31, 2019. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual Obligations We did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay the underwriters a deferred fee of $0.35 per unit, or $7,000,000 in the aggregate as of December 31, 2019. The deferred fee will be paid in cash upon the closing of a business combination from the amounts held in the Trust Account, subject to the terms of the underwriting agreement. At the completion of the business combination, the $7,000,000 deferred fee owed to the underwriters for their services was settled for cash in the amount of $6,000,000. In addition, we granted an affiliate of the Sponsor and an underwriter of the initial public offering, a right of first refusal for a period of 36 months from the date of the commencement of sales of the initial public offering to act as one of potentially several banks which provide to us certain financial advisory, underwriting, capital raising, and other services for which it may receive a portion of the overall fees. At the Closing, we paid Macquarie Capital (USA) Inc. a $4 million fee, comprised of $2 million in cash and 200,000 shares of Class A common stock.

<s>[INST] All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the company’s financial position, business strategy and the plans and objectives of management for future operations, are forwardlooking statements. When used in this Form 10K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the company’s management, identify forwardlooking statements. Such forwardlooking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the company’s management. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements that involve risks and uncertainties. Overview We were a Delaware corporation formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization, recapitalization or other similar business combination with one or more businesses. Recent Developments On February 14, 2020, we consummated the business combination. Following the Closing, the combined company is organized in an “UpC” structure in which the business of Atlas Intermediate and its subsidiaries is held by Holdings and continues to operate through the subsidiaries of Atlas Intermediate, and in which our only direct assets consist of Holdings Units. We are the sole manager of Holdings in accordance with the terms of the Holdings LLC Agreement entered into in connection with the consummation of the business combination. Following the completion of the business combination, the Continuing Members owned an aggregate of 23,974,368 Holdings Units redeemable on a oneforone basis for shares of Class A common stock. Upon the redemption by any Continuing Member of Holdings Units for shares of Class A common stock, a corresponding number of shares of our Class B common stock held by such Continuing Member will be cancelled. Following the conversion of each outstanding share of our Class F common stock to one share of Class A common stock, the sponsor owned an aggregate 2,225,000 shares of Class A common stock and 3,750,000 private placement warrants. In connection with the Closing, all of our units separated into their component parts of one share of Class A common stock and one warrant to purchase one share of Class A common stock of the company, and the units ceased trading on Nasdaq. Following the Closing, our Class A common stock and warrants will continue to be listed on Nasdaq under the new trading symbols of “ATCX” and “ATCXW,” respectively. Further information regarding the business combination and Atlas Intermediate is set forth in (i) the Definitive Proxy Statement and subsequently supplemented on January 28, 2020 and (ii) our Current Report on Form 8K filed with the SEC on February 14, 2020. The Form 8K will be amended to report Atlas Intermediates’ audited financial results and other information for the fiscal year ended December 31, 2019. Results of Operations We neither engaged in any operations nor generated any revenues through December 31, 2019. Our only activities through December 31, 2019 were organizational activities, those necessary to prepare for our initial public offering, described below, identifying a target company for an initial Business Combination and the acquisition of Atlas Intermediate. We generated nonoperating income in the form of interest income on marketable securities held after our initial public offering. For the year ended December 31, 2019, we had net loss of $347,357, which consisted of operating costs of $3,712,997 and a provision for income taxes of $688,516, offset by interest income on marketable securities held in the trust account of $4,054,156. For the year ended December 31, [/INST] Positive. </s>

Meridian Corp

2019-04-01

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Policies and Estimates Our accounting and reporting policies conform to GAAP and conform to general practices within the industry in which we operate. To prepare financial statements in conformity with GAAP, management makes estimates, assumptions and judgments based on available information. These estimates, assumptions and judgments affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgements are based on information available as of the date of the financial statements and, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. In particular, management has identified the provision and allowance for loan and lease losses as the accounting policy that, due to the estimates, assumptions and judgements inherent in that policy, is critical in understanding our financial statements. Management has presented the application of this policy to the audit committee of our board of directors. The JOBS Act permits us an extended transition period for complying with new or revised accounting standards affecting public companies. We have elected to take advantage of this extended transition period, which means that the financial statements included in this Annual Report, as well as any financial statements that we file in the future, will not be subject to all new or revised accounting standards generally applicable to public companies for the transition period for so long as we remain an emerging growth company or until we affirmatively and irrevocably opt out of the extended transition period under the JOBS Act. If we do so, we will prominently disclose this decision in the first periodic report filed with the SEC following our decision, and such decision is irrevocable. The following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgments. Additional information about these policies can be found in footnote 1 of the Corporation’s Consolidated Financial Statements as of and for the years ended December 31, 2018 and 2017. Provision and allowance for loan and lease losses The provision for loan and lease losses reflects the amount required to maintain the allowance for loan and lease losses (“Allowance”) at an appropriate level based upon management’s evaluation of the adequacy of general and specific loss reserves. The Allowance is maintained at a level that management believes is appropriate to provide for incurred loan and lease losses as of the date of the Consolidated Balance Sheet and we have established methodologies for the determination of its adequacy. The methodologies are set forth in a formal policy and take into consideration the need for an overall general allowance as well as specific allowances that are determined on an individual loan basis for impaired loans. We increase our Allowance by charging provisions for losses against our income and decreased by charge-offs, net of recoveries. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. While management uses available information to recognize losses on loans and leases, changes in economic or other conditions may necessitate revision of the estimate in future periods. The Allowance is maintained at a level sufficient to provide for probable losses based upon an ongoing review of the originated loan and lease portfolios by portfolio category, which include consideration of actual loss experience, peer loss experience, changes in the size and risk profile of the portfolio, identification of individual problem loan and lease situations which may affect a borrower’s ability to repay, and evaluation of prevailing economic conditions. Results of operations - Years ended December 31, 2018 and 2017 Overview Our reported net income for the year ended December 31, 2018, was $8.2 million compared to $3.0 million for the same period in 2017. Net income available to common shareholders was $8.2 million or $1.27 per diluted common share for the year ended December 31, 2018 and $1.9 million or $0.49 per diluted common share for the same period in 2017. The $5.1 million increase in net income was attributable to a $3.7 million increase net interest income, a decrease of $401 thousand in net non-interest expense (non-interest expense less non-interest income), a decrease in the provision for loan losses of $584 thousand, and a decrease in income tax expense of $427 thousand. Net interest income Our earnings are derived predominantly from net interest income, which is our interest income less interest expense. Changes in our balance sheet composition, including interest-earning assets, deposits, and borrowings, combined with changes in market interest rates, impact our net interest income. Net interest margin is net interest income divided by average interest-earning assets. We manage our interest-earning assets and funding sources, including non-interest and interest-bearing liabilities, in order to maximize this margin. Net interest income increased by $3.7 million, or 12.9%, to $32.7 million for the year ended December 31, 2018 from $28.9 million for the same period in 2017. Our net interest margin was 3.80% on a tax equivalent yield basis (“TEY”) for the year ended December 31, 2018 as compared to 3.93% for the same period in 2017. The decrease in net interest margin, year-over-year, reflects the pressure from rising cost of funds, which outpaced the favorable trend in yield on earning assets. Average balance sheet, interest and yield/rate analysis. The following table presents average balance sheet information, interest income, interest expense and the corresponding average yield earned, on a tax equivalent basis, and rates paid for the years ended December 31, 2018 and 2017. The average balances are principally daily averages and, for loans, include both performing and nonperforming loans. (1) Yields and net interest income are reflected on a tax-equivalent basis. Rate/Volume Analysis During 2018, net interest income increased $3.7 million or 12.6% on a tax equivalent basis. As shown in the following Rate/Volume Analysis table, this increase was primarily attributable to volume changes. Volume related changes contributed $5.9 million towards interest income which was partially offset by unfavorable changes in rate of $2.3 million. The favorable change in net interest income due to volume changes was driven largely from growth in total loans, which increased $121.9 million on average. This increase contributed $6.5 million to interest income. Total investment securities, cash and cash equivalents increased $4.7 million on average combined, contributing $125 thousand to interest income. On the funding side, interest checking and money market accounts together rose $50.4 million on average during the year, reducing net interest income by $417 thousand. Time deposits increased $61.9 million on average year over year, causing an unfavorable change of $879 thousand to net interest income. Average borrowings decreased $20.1 million and had a favorable impact of $341 thousand on net interest income, while moderately lower levels of subordinated debt contributed $286 thousand favorably to net interest income. The unfavorable change in net interest income due to rate changes was driven largely from the increase in cost of funds, particularly from wholesale funding such as borrowings and time deposits, which rose 88 and 61 basis points, respectively. Cost of funds for core deposits, such as interest checking and money market accounts, rose 63 and 53 basis points, respectively. These unfavorable rate changes reduced net interest income $3.9 million, but were partially offset by favorable rate changes in interest-earning assets which increased net interest income $1.7 million. The favorable change due to rate earned on loans was $1.5 million resulting from a 23 basis point increase on average for the total portfolio. The favorable change due to rate earned on cash and investments was $133 thousand, resulting from a 15 basis point increase in the yields. The following table sets forth, among other things, the extent to which changes in interest rates and changes in the average balances of interest-earning assets and interest-bearing liabilities have affected interest income and expense for the periods noted (tax-exempt yields have been adjusted to a tax equivalent basis using a 22% tax rate). For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to (i) changes in rate (change in rate multiplied by old volume) and (ii) changes in volume (change in volume multiplied by new rate). The net change attributable to the combined impact of rate and volume has been allocated proportionately to the change due to rate and the change due to volume. (1) Yields and net interest income are reflected on a tax-equivalent basis. Provision for loan losses We recorded a provision for loan losses of $1.6 million for the year ended December 31, 2018, down $584 thousand from $2.2 million for the same period in 2017. The decreased provision for 2018 is due to continued strong asset quality and lower levels of net charge-offs which were down $644 thousand, year-over-year. Non-interest income Non-interest income decreased $4.3 million, or 11.8%, to $32.4 million for the year ended December 31, 2018 compared to $36.7 million for the prior year. The decrease was mostly attributable to a $6.6 million decrease in mortgage banking income caused by lower levels of mortgage originations and lower margins. This decline in revenue was partially offset by an increase of $1.1 million in wealth management income, as Meridian Wealth Partners was included in our results for a full year in 2018 after the acquisition of HJ Wealth in the second quarter of 2017. The decline in mortgage banking revenue was also offset somewhat by realized gains on derivatives related to mortgage banking, included in other non- interest income, which increased $1.4 million for the twelve months ended December 31, 2018 to $627 thousand, compared to a loss of $724 thousand for the same period in 2017. Non-interest expense Non-interest expenses decreased $4.7 million, or 8.2%, to $52.9 million for the year ended December 31, 2018 from $57.7 million in 2017. This decrease was mainly attributable to a reduction in salaries and employee benefit expense, as full-time equivalent employees, particularly in the mortgage division were reduced. Also as a result of a decline in mortgage loan originations, variable loan expenses decreased over the prior year. These declines were partially offset by higher costs relative to professional fees, data processing, business development and other expenses related to growth. Income tax expense Income tax expense for the year ended December 31, 2018 was $2.3 million as compared to $2.8 million for the same period in 2017. The effective tax rates for the twelve-month periods ended December 31, 2018 and 2017 were 22.1% and 47.6%, respectively. The decrease in rate from 47.6% to 22.1% between 2017 and 2018 was directly related to the enactment of the Tax Cuts and Jobs Act (“2017 Tax Reform”) on December 22, 2017. The 2017 Tax Reform lowered the top federal corporate rate from 35% to 21%. In accordance with GAAP, this required the re-measurement, in the period including the enactment, of the Corporation’s net deferred tax asset to reflect the rate at which they will be recognized in future periods. The result was a $737 thousand one-time charge to income tax expense in 2017. For more information related to income taxes, refer to footnote 15 in the Notes to Consolidated Financial Statements. Balance Sheet Summary Assets Total assets increased $141.4 million, or 16.5%, to $997.4 million at December 31, 2018 from $856.0 million at December 31, 2017. This growth was concentrated in our loan portfolio, excluding mortgage loans held for sale, which increased by $143.5 million, or 20.7%, year-over-year. Investment securities and cash decreased $1.3 million, or 1.4%, year-over-year. Our overall asset growth was funded largely by an increase in deposits of $125.0 million, or 19.9%, to $752.1 million at December 31, 2018 from $627.1 million at December 31, 2017. An increase in borrowings of $11.9 million, or 11.0% year-over-year also helped to fund the growth in our loan portfolio. Loans Our loan portfolio is the largest category of our interest-earning assets. As of December 31, 2018 and 2017, our total loans amounted to $875.8 million and $729.7 million, respectively. Our loan portfolio is comprised of loans originated to be held in portfolio, as well as residential mortgage loans originated for sale. Meridian engages in the origination of residential mortgages, most typically for 1-4 family dwellings, with the intention of the Corporation to principally sell substantially all of these loans in the secondary market to qualified investors. Our loans held in portfolio are originated by our commercial and consumer loan divisions. We have a strong credit culture that promotes diversity of lending products with a focus on commercial businesses. We have no particular credit concentration. Our commercial loans have been proactively managed in an effort to achieve a balanced portfolio with no unusual exposure to one industry. Loans held for investment increased $143.5 million, or 20.7%, for the year ended December 31, 2018. The following table presents the balance (net of deferred loan origination fees) and associated percentage of each major category in our loan portfolios as of December 31, 2018 and 2017. Commercial loans, commercial construction loans and commercial real estate loans increased a combined $124.0 million, or 21.4%, for the year ended December 31, 2018. The growth in the commercial portfolios continues to reflect the work of our strategically expanded lending team as well as strong local market conditions. Commercial real estate loans. Our commercial real estate loans are secured by real estate that is both owner-occupied and investor owned. Owner-occupied commercial real estate loans generally involve less risk than an investment property and are distinctly reported from non-owner occupied commercial real estate loans for measuring loan concentrations for regulatory purposes. Our owner-occupied commercial real estate loans are originated and managed within our commercial loan department and comprised 39% of our total commercial real estate loan portfolio at December 31, 2018. The remaining commercial real estate loans are managed by our commercial real estate department which offer the following commercial real estate products: · Permanent - Investor Real Estate Loans o Purchase and refinance loan opportunities for a number of product types, including single-family rentals, multi-family residential as well as tenanted income producing properties in a variety of real estate types, including office, retail, industrial, and flex space · Construction Loans o Residential construction loans to finance new construction and renovation of single and 1-4 family homes located within our market area o Commercial construction loans for investment properties, generally with semi-permanent attributes o Construction loans for new, expanded or renovated operations for our owner occupied business clients · Land Development Loans o Meridian considers a limited number of strictly land development oriented loans based upon the risk, merit of the future project and strength of the borrower/guarantor relationship Our commercial real estate loans increased by $62.3 million, or 23.7%, to $325.4 million at December 31, 2018 from $263.1 million at December 31, 2017. Our total commercial real estate loan portfolio represented 37.1% and 36.0% of our total loan portfolio at December 31, 2018 and 2017, respectively. Commercial and industrial loans. We provide a variety of variable and fixed rate commercial business loans and lines of credit. These loans and lines of credit are made to small and medium-sized manufacturers and wholesale, retail and service-related businesses. Additionally, we lend to companies in the technology, healthcare, real estate and financial service industries. Commercial business loans generally include lines of credit and term loans with a maturity of five years or less. The primary source of repayment for commercial business loans is generally operating cash flows of the business and may also include collateralization of inventory, accounts receivable, equipment and/or personal guarantees. Our commercial loans increased by $49.8 million, or 23.8%, to $259.8 million at December 31, 2018 from $210.0 million at December 31, 2017. The total commercial portfolio represented 29.6% and 28.7% of our total loan portfolio at December 31, 2018 and 2017, respectively. Residential loans. Our residential loans held in portfolio are primarily secured by single-family homes located in our market areas. Our loan pipeline is fed via our mortgage loan production offices (“LPOs”) and through relationships with commercial lending and through relationships with sales brokers and agents who actively refer clients to Meridian. The balance of residential loans in portfolio increased $21.0 million, or 64.8%, to $53.4 million at December 31, 2018 from $32.4 million at December 31, 2017. The total residential loan portfolio represented 6.1% and 4.4% of our total loan portfolio at December 31, 2018 and 2017, respectively. Consumer and Personal Loans Our consumer-lending department principally originates home equity based products for our clients and prospects. These loans typically fund completely at closing. Additional products include smaller dollar personal loans and our newly introduced student loan refinance product, designed to provide additional flexibility in repayment terms desired in the marketplace. Our consumer credit products include home equity lines and loans, personal lines and loans, and student loan refinancing. The total consumer loan portfolio represented 0.1% of our total loan portfolio at December 31, 2018 and 2017. Investments Our securities portfolio is used to make various term investments, maintain a source of liquidity and serve as collateral for certain types of deposits and borrowings. We manage our investment portfolio according to written investment policies approved by our board of directors. Investments in our securities portfolio may change over time based on our funding needs and interest rate risk management objectives. Our liquidity levels take into account anticipated future cash flows and other available sources of funds and are maintained at levels that we believe are appropriate to provide the necessary flexibility to meet our anticipated funding requirements. As of December 31, 2018 the fair value of our investment portfolio totaled $63.1 million, with an effective tax equivalent yield of 2.63% and an estimated duration of approximately 3.3 years. The majority of our investment portfolio, or 61.1%, consists of residential mortgage-backed securities, along with 34.2% in municipal securities. The remainder of our securities portfolio is invested in U.S. Treasuries and other securities. We regularly evaluate the composition of our investment portfolio as the interest rate yield curve changes and may sell investment securities from time to time to adjust our exposure to interest rates or to provide liquidity to meet loan demand. Asset Quality Summary As of December 31, 2018, total nonperforming loans and leases increased by $774 thousand to $3.9 million, representing 0.47% of loans and leases held-for-investment, compared to $3.2 million, or 0.45% of loans and leases held-for-investment as of December 31, 2017. The increase to nonperforming loans resulted from an increase of $810 thousand in commercial mortgage loans, an increase of $1.1 million in residential loans, offset partially by a decrease of $849 thousand in commercial loans and a decline of $185 thousand in construction loans from December 31, 2017 to December 31, 2018. As of December 31, 2018, the allowance of $8.1 million represented 0.97% of loans and leases held-for-investment (excluding loans at fair value), compared to 0.98% as of December 31, 2017. The allowance to non-performing loans decreased from 212.5% as of December 31, 2017 to 204.9% as of December 31, 2018. During 2017 one commercial real estate loan was foreclosed on and the property was recorded within other real estate owned (“OREO”) in the balance sheet at the lower of cost or fair value less cost to sell of $437 thousand. During 2018 the real estate property was sold and a net gain of $57 thousand was recorded in other non-interest income upon sale. As of December 31, 2018, the Corporation had $4.3 million of troubled debt restructurings (“TDRs”), of which $3.1 million were in compliance with the modified terms and excluded from non-performing loans and leases. As of December 31, 2017, the Corporation had $2.6 million of TDRs, of which $1.9 million were in compliance with the modified terms, and were excluded from non-performing loans and leases. As of December 31, 2018, the Corporation had a recorded investment of $5.8 million of impaired loans and leases which included $4.3 million of TDRs. Impaired loans and leases are those for which it is probable that the Corporation will not be able to collect all scheduled principal and interest in accordance with the original terms of the loans and leases. Impaired loans and leases as of December 31, 2017 totaled $4.2 million, which included $2.6 million of TDRs. Refer to footnote 7 to the consolidated financial statements for more information regarding the Corporation’s impaired loans and leases. The Corporation continues to be diligent in its credit underwriting process and proactive with its loan review process, including the engagement of the services of an independent outside loan review firm, which helps identify developing credit issues. Proactive steps that are taken include the procurement of additional collateral (preferably outside the current loan structure) whenever possible and frequent contact with the borrower. The Corporation believes that timely identification of credit issues and appropriate actions early in the process serve to mitigate overall risk of loss. Deposits and Equity Deposits increased $125.0 million, or 19.9%, to $752.1 million at December 31, 2018 from $627.1 million at December 31, 2017. This growth year-over-year was across all deposit categories. Non-maturity deposits, consisting of demand deposits, NOW accounts, money market accounts and regular savings accounts increased $64.7 million, or 15.8%. Certificates of deposit increased $60.3 million, or 27.6%. Core funding continues to be a strategic initiative and the deposit growth for the fourth quarter resulted from our expanded business development team as well as the efforts from all sales personnel in our branch markets. The following table summarizes our deposit balances and weighted average rate paid for the periods presented. Total equity increased $8.5 million, or 8.4%, to $109.9 million at December 31, 2018 from $101.4 million at December 31, 2017. This increase was attributable to net income recorded for the year ended December 31, 2018. Liquidity and Capital Resources Management maintains liquidity to meet depositors’ needs for funds, to satisfy or fund loan commitments, and for other operating purposes. Meridian’s foundation for liquidity is a stable and loyal customer deposit base, cash and cash equivalents, a marketable investment portfolio that provides periodic cash flow through regular maturities and amortization, or that can be used as collateral to secure funding. In addition, as part of its liquidity management, Meridian maintains a segment of commercial loan assets that are comprised of SNCs which have a national market and can be sold in a timely manner. Meridian’s primary liquidity, which totaled $136.6 million at December 31, 2018 compared to $145.0 million at December 31, 2017, includes investments, SNCs, federal funds sold, mortgages held-for-sale and cash and cash equivalents, less the amount of securities required to be pledged for certain liabilities. Meridian also anticipates scheduled payments and prepayments on its loan and mortgage-backed securities portfolios. In addition, Meridian maintains borrowing arrangements with various correspondent banks, the FHLB and the Federal Reserve Bank of Philadelphia to meet short-term liquidity needs. Through these relationships, Meridian had available credit of approximately $10.4 million at December 31, 2018. As a member of the FHLB, we are eligible to borrow up to a specific credit limit which is determined by the amount of our residential mortgages, commercial mortgages and other loans that have been pledged as collateral. As of December 31, 2018, Meridian’s maximum borrowing capacity with the FHLB was $437.2 million. At December 31, 2018, Meridian had borrowed $119.3 million and the FHLB had issued letters of credit, on Meridian’s behalf, totaling $45.1 million against its available credit lines. At December 31, 2018, Meridian also had available $39.0 million of unsecured federal funds lines of credit with other financial institutions as well as $99.6 million of available short or long term funding through the Certificate of Deposit Account Registry Service (“CDARS”) program and $50.9 million of available short or long term funding through brokered CD arrangements. Management believes that Meridian has adequate resources to meet its short-term and long-term funding requirements. At December 31, 2018, Meridian had $290.6 million in unfunded loan commitments. Management anticipates these commitments will be funded by means of normal cash flows. Certificates of deposit greater than or equal to $250 thousand scheduled to mature in one year or less from December 31, 2018 totaled $213.8 million. Management believes that the majority of such deposits will be reinvested with Meridian and that certificates that are not renewed will be funded by a reduction in cash and cash equivalents or by pay-downs and maturities of loans and investments. At December 31, 2018, Meridian had a reserve for unfunded loan commitments of $37 thousand. Meridian meets the definition of “well capitalized” for regulatory purposes on December 31, 2018. Our capital category is determined for the purposes of applying the bank regulators’ “prompt corrective action” regulations and for determining levels of deposit insurance assessments and may not constitute an accurate representation of Meridian’s overall financial condition or prospects. Under federal banking laws and regulations, Meridian is required to maintain minimum capital as determined by certain regulatory ratios. Capital adequacy for regulatory purposes, and the capital category assigned to an institution by its regulators, may be determinative of an institution’s overall financial condition. Under the final capital rules that became effective on January 1, 2015, there was a requirement for a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not maintain this required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer has been phased in over a four year period, which began on January 1, 2016, as follows: the maximum buffer was 0.625% of risk-weighted assets for 2016, 1.25% for 2017 and 1.875% for 2018, and effective as of January 1, 2019, the capital conservation buffer is fully phased in at 2.5%. The following table summarizes data and ratios pertaining to our capital structure.

<s>[INST] Our accounting and reporting policies conform to GAAP and conform to general practices within the industry in which we operate. To prepare financial statements in conformity with GAAP, management makes estimates, assumptions and judgments based on available information. These estimates, assumptions and judgments affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgements are based on information available as of the date of the financial statements and, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. In particular, management has identified the provision and allowance for loan and lease losses as the accounting policy that, due to the estimates, assumptions and judgements inherent in that policy, is critical in understanding our financial statements. Management has presented the application of this policy to the audit committee of our board of directors. The JOBS Act permits us an extended transition period for complying with new or revised accounting standards affecting public companies. We have elected to take advantage of this extended transition period, which means that the financial statements included in this Annual Report, as well as any financial statements that we file in the future, will not be subject to all new or revised accounting standards generally applicable to public companies for the transition period for so long as we remain an emerging growth company or until we affirmatively and irrevocably opt out of the extended transition period under the JOBS Act. If we do so, we will prominently disclose this decision in the first periodic report filed with the SEC following our decision, and such decision is irrevocable. The following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgments. Additional information about these policies can be found in footnote 1 of the Corporation’s Consolidated Financial Statements as of and for the years ended December 31, 2018 and 2017. Provision and allowance for loan and lease losses The provision for loan and lease losses reflects the amount required to maintain the allowance for loan and lease losses (“Allowance”) at an appropriate level based upon management’s evaluation of the adequacy of general and specific loss reserves. The Allowance is maintained at a level that management believes is appropriate to provide for incurred loan and lease losses as of the date of the Consolidated Balance Sheet and we have established methodologies for the determination of its adequacy. The methodologies are set forth in a formal policy and take into consideration the need for an overall general allowance as well as specific allowances that are determined on an individual loan basis for impaired loans. We increase our Allowance by charging provisions for losses against our income and decreased by chargeoffs, net of recoveries. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. While management uses available information to recognize losses on loans and leases, changes in economic or other conditions may necessitate revision of the estimate in future periods. The Allowance is maintained at a level sufficient to provide for probable losses based upon an ongoing review of the originated loan and lease portfolios by portfolio category, which include consideration of actual loss experience, peer loss experience, changes in the size and risk profile of the portfolio, identification of individual problem loan and lease situations which may affect a borrower’s ability to repay, and evaluation of prevailing economic conditions. Results of operations Years ended December 31, 2018 and 2017 Overview Our reported net income for the year ended December 31, 2018, was $8.2 million compared to $3.0 million for the same period in 2017. Net income available to common shareholders was $8.2 million or $1.27 per diluted common share for the year ended December 31, 2018 and $1.9 million or $0.49 per diluted common share for the same period in 2017. The $5.1 million increase in net income was attributable to a $3.7 million increase net interest income, a decrease of $401 thousand in net noninterest expense (noninterest expense less noninterest income), a decrease in the provision for loan losses of $584 thousand, and a decrease in income tax expense of $427 thousand. Net interest income Our earnings are derived predominantly from [/INST] Negative. </s>

Meridian Corp

2020-03-30

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Recent Market Conditions Our financial condition and performance, as well as the ability of our borrowers to repay their loans, the value of collateral securing those loans, as well as demand for loans and other products and services that we offer, are all highly dependent on the business environment in the primary markets in which we operate and in the United States as a whole. During the first quarter of 2020, an outbreak of a novel strain of coronavirus (COVID-19), which was originally identified in Wuhan, China, has spread to a number of countries around the world, including the United States. COVID-19 and its associated impacts on trade (including supply chains and export levels), travel, employee productivity and other economic activities have had, are currently having and may for some time continue to have a destabilizing effect on financial markets and economic activity. The extent of the impact of COVID-19 on our operational and financial performance is currently uncertain, cannot be predicted and will depend on certain developments, including, among others, the duration and spread of COVID-19, its impact on our customers, employees and vendors, and governmental, regulatory and private sector responses, which may be precautionary, to the coronavirus. In light of the changing economic outlook as a result of COVID-19, as well as other factors, including the possibility of an oil price war in March 2020, the 10-year Treasury yield has fallen to historic lows, and the equity markets have been significantly impacted. In response, the Federal Reserve reduced the target federal funds rate by 50 basis points on March 3, 2020, and then by an additional 100 basis points on March 15, 2020. The assets and liabilities of the Corporation may be significantly impacted by changes in interest rates. The Corporation is currently reviewing actions that it may take in response to these changes in the event that market turmoil continues for an extended period. Critical Accounting Policies and Estimates Our accounting and reporting policies conform to GAAP and conform to general practices within the industry in which we operate. To prepare financial statements in conformity with GAAP, management makes estimates, assumptions and judgments based on available information. These estimates, assumptions and judgments affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgements are based on information available as of the date of the financial statements and, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. In particular, management has identified the provision and allowance for loan and lease losses as the accounting policy that, due to the estimates, assumptions and judgements inherent in that policy, is critical in understanding our financial statements. Management has presented the application of this policy to the audit committee of our board of directors. The JOBS Act permits us an extended transition period for complying with new or revised accounting standards affecting public companies. We have elected to take advantage of this extended transition period, which means that the financial statements included in this Annual Report, as well as any financial statements that we file in the future, will not be subject to all new or revised accounting standards generally applicable to public companies for the transition period for so long as we remain an emerging growth company or until we affirmatively and irrevocably opt out of the extended transition period under the JOBS Act. If we do so, we will prominently disclose this decision in the first periodic report filed with the SEC following our decision, and such decision is irrevocable. The following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgments. Additional information about these policies can be found in footnote 1 of the Corporation’s Consolidated Financial Statements as of and for the years ended December 31, 2019 and 2018. Provision and allowance for loan and lease losses The provision for loan and lease losses reflects the amount required to maintain the allowance for loan and lease losses (“Allowance”) at an appropriate level based upon management’s evaluation of the adequacy of general and specific loss reserves. The Allowance is maintained at a level that management believes is appropriate to provide for incurred loan and lease losses as of the date of the Consolidated Balance Sheet and we have established methodologies for the determination of its adequacy. The methodologies are set forth in a formal policy and take into consideration the need for an overall general allowance as well as specific allowances that are determined on an individual loan basis for impaired loans. We increase our Allowance by charging provisions for losses against our income and decreased by charge-offs, net of recoveries. The evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. While management uses available information to recognize losses on loans and leases, changes in economic or other conditions may necessitate revision of the estimate in future periods. The Allowance is maintained at a level sufficient to provide for probable losses based upon an ongoing review of the originated loan and lease portfolios by portfolio category, which include consideration of actual loss experience, peer loss experience, changes in the size and risk profile of the portfolio, identification of individual problem loan and lease situations which may affect a borrower’s ability to repay, and evaluation of prevailing economic conditions. Results of operations - Years ended December 31, 2019 and 2018 Overview Our reported net income for the year ended December 31, 2019, was $10.5 million or $1.63 per diluted common share compared to $8.2 million or $1.27 per diluted common share for the same period in 2018. The $2.3 million increase in net income was attributable to a $4.4 million increase net interest income, a decrease in the provision for loan losses of $676 thousand, offset somewhat by an increase of $1.3 million in net non-interest expense (non-interest expense less non-interest income). Net interest income Our earnings are derived predominantly from net interest income, which is our interest income less interest expense. Changes in our balance sheet composition, including interest-earning assets, deposits, and borrowings, combined with changes in market interest rates, impact our net interest income. Net interest margin is net interest income divided by average interest-earning assets. We manage our interest-earning assets and funding sources, including non-interest and interest-bearing liabilities, in order to maximize this margin. Net interest income increased by $3.7 million, or 11.3%, to $36.3 million for the year ended December 31, 2019 from $32.7 million for the same period in 2018. Our net interest margin was 3.65% on a tax equivalent yield basis (“TEY”) for the year ended December 31, 2019 as compared to 3.80% for the same period in 2018. The decrease in net interest margin, year-over-year, reflects the pressure from rising cost of funds, which outpaced the favorable trend in yield on earning assets. Average balance sheet, interest and yield/rate analysis. The following table presents average balance sheet information, interest income, interest expense and the corresponding average yield earned, on a tax equivalent basis, and rates paid for the years ended December 31, 2019 and 2018. The average balances are principally daily averages and, for loans, include both performing and nonperforming loans. (1) Yields and net interest income are reflected on a tax-equivalent basis. Rate/Volume Analysis During 2019, net interest income increased $3.7 million or 11.3% on a tax equivalent basis. As shown in the following Rate/Volume Analysis table, this increase was primarily attributable to volume changes. Volume related changes contributed $5.3 million towards interest income which was partially offset by unfavorable changes in rate of $1.6 million. The favorable change in net interest income due to volume changes was driven largely from growth in total loans, which increased $128.6 million on average. This increase contributed $7.3 million to interest income. Total investment securities, cash and cash equivalents increased $7.6 million on average combined, contributing $186 thousand to interest income. On the funding side, interest checking and money market accounts together rose $50.9 million on average during the year, reducing net interest income by $836 thousand. Time deposits increased $56.1 million on average year over year, causing an unfavorable change of $1.1 million to net interest income. Average borrowings increased $4.8 million and had an unfavorable impact of $83 thousand on net interest income, while moderately higher level of average subordinated debt contributed $95 thousand unfavorably to net interest income. The unfavorable change in net interest income due to rate changes was driven largely from the increase in cost of funds, particularly from wholesale funding such as borrowings and time deposits, which rose 24 and 52 basis points, respectively. Cost of funds for core deposits, such as interest checking and money market accounts, rose 38 and 32 basis points, respectively. These unfavorable rate changes reduced net interest income $3.0 million, but were partially offset by favorable rate changes in interest-earning assets which increased net interest income $1.3 million. The favorable change due to rate earned on loans was $1.2 million resulting from a 16 basis point increase on average for the total portfolio. The favorable change due to rate earned on cash and investments was $151 thousand, resulting from a 23 basis point increase in the yields. The following table sets forth, among other things, the extent to which changes in interest rates and changes in the average balances of interest-earning assets and interest-bearing liabilities have affected interest income and expense for the periods noted (tax-exempt yields have been adjusted to a tax equivalent basis using a 22% tax rate). For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to (i) changes in rate (change in rate multiplied by old volume) and (ii) changes in volume (change in volume multiplied by new rate). The net change attributable to the combined impact of rate and volume has been allocated proportionately to the change due to rate and the change due to volume. (1) Yields and net interest income are reflected on a tax-equivalent basis. Provision for loan losses We recorded a provision for loan losses of $901 thousand for the year ended December 31, 2019, down $676 thousand from $1.6 million for the same period in 2018. The decreased provision for 2019 is due to continued strong asset quality and net recoveries of $559 thousand, compared to net charge-offs of $233 thousand for the same period in 2018. Non-interest income Non-interest income increased $743 thousand, or 2.3%, to $33.1 million for the year ended December 31, 2019 compared to $32.4 million for the prior year. The increase was mainly the result of $1.4 million in SBA income recognized on the sales of SBA loans for the year ended December 31, 2019. There were no SBA loan sales in the prior year. Mortgage revenue for the year ended December 31, 2019 was $26.2 million, relatively unchanged from the same period in 2018. In addition, fair value gains were $489 thousand for the twelve months of 2019, compared to fair value losses of $368 thousand for the twelve months in 2018. For the twelve month period of 2019, wealth management revenue was down $293 thousand to $3.6 million reflecting the market value changes in assets under management largely from the first quarter. Included in other non-interest income is fee income as well as hedging gains and losses. Fee income was $1.6 million for the full year of 2019 compared to $1.6 million for the same period in 2018. Fee income is comprised mainly of FHLB stock dividend income, wire transfer fee income, title fee income, as well as various other less significant income sources. Hedging losses were $816 thousand for the full year of 2019 compared to hedging gains of $627 thousand for the same period in 2018. Non-interest expense Non-interest expenses increased $2.1 million, or 3.9%, to $55.0 million for the year ended December 31, 2019 from $52.9 million in 2018. This increase was mainly attributable to an increase of $452 thousand, or 20.9%, in professional fees for the twelve month periods ended December 31, 2019 compared to the same periods in 2018. The higher professional fees were due largely to legal and accounting fees incurred as part of the Maryland mortgage licensing issue in the first quarter, in addition to legal fees incurred related to the litigation matter discussed below. Other non-interest expenses increased $1.2 million, or 29.6%, to $5.1 million when compared to the prior year period. The settlement of the outstanding litigation matter contributed $790 thousand to other non-interest expense, along with $79 thousand of other expense incurred for the previously disclosed Maryland mortgage licensing issue. Increases in the PA shares tax assessment and FDIC insurance due to the growth of the Bank also contributed to higher other non-interest expenses during the year-to-date period, from the same period in the prior year. Income tax expense Income tax expense for the year ended December 31, 2019 was $3.0 million as compared to $2.3 million for the same period in 2018. The effective tax rates for the twelve-month periods ended December 31, 2019 and 2018 were 22.4% and 22.1%, respectively. For more information related to income taxes, refer to footnote 14 in the Notes to Consolidated Financial Statements. Balance Sheet Summary Assets As of December 31, 2019, total assets were $1.2 billion compared with $997.5 million as of December 31, 2018. Total assets increased $152.5 million, or 15.3%, on a year-over-year basis. This growth was concentrated in our loan portfolio, excluding mortgage loans held for sale, which increased by $126.6 million, or 15.1%, year-over-year. Investment securities and cash decreased $20.9 million, or 24.0%, year-over-year. Our overall asset growth was funded largely by an increase in deposits of $99.0 million, or 13.2%, to $851.2 million at December 31, 2019 from $752.1 million at December 31, 2018. Increases in borrowings of $6.3 million, or 5.2% year-over-year, as well as an increase of $31.7 million or 343.4% in subordinated debt, also helped to fund the growth in our loan portfolio. Loans Our loan portfolio is the largest category of our interest-earning assets. As of December 31, 2019 and 2018, our total loans amounted to $998.4 million and $875.8 million, respectively. Our loan portfolio is comprised of loans originated to be held in portfolio, as well as residential mortgage loans originated for sale. Meridian engages in the origination of residential mortgages, most typically for 1-4 family dwellings, with the intention of the Corporation to principally sell substantially all of these loans in the secondary market to qualified investors. Our loans held in portfolio are originated by our commercial and consumer loan divisions. We have a strong credit culture that promotes diversity of lending products with a focus on commercial businesses. We have no particular credit concentration. Our commercial loans have been proactively managed in an effort to achieve a balanced portfolio with no unusual exposure to one industry. Loans held for investment increased $126.6 million, or 15.1%, for the year ended December 31, 2019. Loans and leases outstanding at December 31, 2019 and 2018 are detailed by category as follows: Commercial loans, commercial construction loans and commercial real estate loans increased a combined $111.6 million, or 16.0%, for the year ended December 31, 2019. The growth in the commercial portfolios continues to reflect the work of our strategically expanded lending team as well as strong local market conditions. Commercial real estate loans. Our commercial real estate loans are secured by real estate that is both owner-occupied and investor owned. Owner-occupied commercial real estate loans generally involve less risk than an investment property and are distinctly reported from non-owner occupied commercial real estate loans for measuring loan concentrations for regulatory purposes. Our owner-occupied commercial real estate loans are originated and managed within our commercial loan department and comprised 37% of our total commercial real estate loan portfolio at December 31, 2019. The remaining commercial real estate loans are managed by our commercial real estate department which offer the following commercial real estate products: · Permanent - Investor Real Estate Loans o Purchase and refinance loan opportunities for a number of product types, including single-family rentals, multi-family residential as well as tenanted income producing properties in a variety of real estate types, including office, retail, industrial, and flex space · Construction Loans o Residential construction loans to finance new construction and renovation of single and 1-4 family homes located within our market area o Commercial construction loans for investment properties, generally with semi-permanent attributes o Construction loans for new, expanded or renovated operations for our owner occupied business clients · Land Development Loans o Meridian considers a limited number of strictly land development oriented loans based upon the risk, merit of the future project and strength of the borrower/guarantor relationship Our commercial real estate loans increased by $37.2 million, or 11.4%, to $362.6 million at December 31, 2019 from $325.4 million at December 31, 2018. Our total commercial real estate loan portfolio represented 36.3% and 37.1% of our total loan portfolio at December 31, 2019 and 2018, respectively. Commercial and Industrial Loans We provide a variety of variable and fixed rate commercial business loans and lines of credit. These loans and lines of credit are made to small and medium-sized manufacturers and wholesale, retail and service-related businesses. Additionally, we lend to companies in the technology, healthcare, real estate and financial service industries. Commercial business loans generally include lines of credit and term loans with a maturity of five years or less. The primary source of repayment for commercial business loans is generally operating cash flows of the business and may also include collateralization of inventory, accounts receivable, equipment and/or personal guarantees. Our commercial loans increased by $19.3 million, or 7.6%, to $273.3 million at December 31, 2019 from $254.0 million at December 31, 2018. The total commercial portfolio represented 27.3% and 29.0% of our total loan portfolio at December 31, 2019 and 2018, respectively. Small Business Loans We provide financing to small businesses in various industries that include guarantees under the Small Business Administrations (SBA’s) loan programs. Our small business loans increased by $15.9 million, or 275.5%, to $21.6 million at December 31, 2019 from $5.8 million at December 31, 2018. The small business loans portfolio represented 2.2% and 0.7% of our total loan portfolio at December 31, 2019 and 2018, respectively. Residential loans Our residential loans held in portfolio are primarily secured by single-family homes located in our market areas. Our loan pipeline is fed via our mortgage loan production offices (“LPOs”) and through relationships with commercial lending and through relationships with sales brokers and agents who actively refer clients to Meridian. The balance of residential loans in portfolio increased $305 thousand, or 0.6%, to $53.7 million at December 31, 2019 from $53.4 million at December 31, 2018. The total residential loan portfolio represented 5.4% and 6.1% of our total loan portfolio at December 31, 2019 and 2018, respectively. Consumer and Personal Loans Our consumer-lending department principally originates home equity based products for our clients and prospects. These loans typically fund completely at closing. Additional products include smaller dollar personal loans and our newly introduced student loan refinance product, designed to provide additional flexibility in repayment terms desired in the marketplace. Our consumer credit products include home equity lines and loans, personal lines and loans, and student loan refinancing. The total consumer loan portfolio represented 0.1% of our total loan portfolio at December 31, 2019 and 2018. Investments Our securities portfolio is used to make various term investments, maintain a source of liquidity and serve as collateral for certain types of deposits and borrowings. We manage our investment portfolio according to written investment policies approved by our board of directors. Investments in our securities portfolio may change over time based on our funding needs and interest rate risk management objectives. Our liquidity levels take into account anticipated future cash flows and other available sources of funds and are maintained at levels that we believe are appropriate to provide the necessary flexibility to meet our anticipated funding requirements. As of December 31, 2019 the fair value of our investment portfolio totaled $68.9 million, with an effective tax equivalent yield of 2.65% and an estimated duration of approximately 3.64 years. The majority of our investment portfolio, or 59.1%, consists of residential mortgage-backed securities, along with 22.2% in municipal securities. The remainder of our securities portfolio is invested in U.S. Treasuries and other securities. We regularly evaluate the composition of our investment portfolio as the interest rate yield curve changes and may sell investment securities from time to time to adjust our exposure to interest rates or to provide liquidity to meet loan demand. Asset Quality Summary As of December 31, 2019, total nonperforming loans and leases decreased by $696 thousand to $3.2 million, representing 0.34% of loans and leases held-for-investment, compared to $3.9 million, or 0.48% of loans and leases held-for-investment as of December 31, 2018. The decrease to nonperforming loans resulted from a decrease of $491 thousand in commercial mortgage loans, and a decrease of $56 thousand in commercial and industrial loans. Nonperforming residential mortgage loans decreased $603 thousand as well but were offset by a $454 thousand increase in nonperforming home equity loans from December 31, 2018 to December 31, 2019. As of December 31, 2019, the allowance of $9.5 million represented 1.00% of loans and leases held-for-investment (excluding loans at fair value), compared to 0.97% as of December 31, 2018. The allowance to non-performing loans increased from 204.85% as of December 31, 2018 to 294.12% as of December 31, 2019. During 2019 one residential mortgage loan was foreclosed on and the property was recorded within other real estate owned (“OREO”) in the balance sheet at the lower of cost or fair value less cost to sell of $120 thousand. As of December 31, 2019, the Corporation had $3.9 million of troubled debt restructurings (“TDRs”), of which $3.6 million were in compliance with the modified terms and excluded from non-performing loans and leases. As of December 31, 2018, the Corporation had $4.3 million of TDRs, of which $3.1 million were in compliance with the modified terms, and were excluded from non-performing loans and leases. As of December 31, 2019, the Corporation had a recorded investment of $7.3 million of impaired loans and leases which included $3.9 million of TDRs. Impaired loans and leases are those for which it is probable that the Corporation will not be able to collect all scheduled principal and interest in accordance with the original terms of the loans and leases. Impaired loans and leases as of December 31, 2018 totaled $5.8 million, which included $4.3 million of TDRs. Refer to footnote 6 in the notes to the Consolidated Financial Statements for more information regarding the Corporation’s impaired loans and leases. The Corporation continues to be diligent in its credit underwriting process and proactive with its loan review process, including the engagement of the services of an independent outside loan review firm, which helps identify developing credit issues. Proactive steps that are taken include the procurement of additional collateral (preferably outside the current loan structure) whenever possible and frequent contact with the borrower. The Corporation believes that timely identification of credit issues and appropriate actions early in the process serve to mitigate overall risk of loss. Deposits and Equity Deposits increased $99.0 million, or 13.2%, to $851.2 million at December 31, 2019 from $752.1 million at December 31, 2018. This growth year-over-year was across all deposit categories except for interest-bearing demand deposits. Non-maturity deposits, consisting of demand deposits, NOW accounts, money market accounts and regular savings accounts increased $65.9 million, or 13.9%. Certificates of deposit increased $33.1 million, or 11.9%. Core funding continues to be a strategic initiative and the deposit growth for the fourth quarter resulted from our expanded business development team as well as the efforts from all sales personnel in our branch markets. The following table summarizes our deposit balances and weighted average rate paid for the periods presented. Total equity increased $11.1 million, or 10.2%, to $120.7 million at December 31, 2019 from $109.6 million at December 31, 2018. This increase was attributable to net income recorded for the year ended December 31, 2019. Liquidity and Capital Resources Management maintains liquidity to meet depositors’ needs for funds, to satisfy or fund loan commitments, and for other operating purposes. Meridian’s foundation for liquidity is a stable and loyal customer deposit base, cash and cash equivalents, a marketable investment portfolio that provides periodic cash flow through regular maturities and amortization, or that can be used as collateral to secure funding. In addition, as part of its liquidity management, Meridian maintains a segment of commercial loan assets that are comprised of SNCs which have a national market and can be sold in a timely manner. Meridian’s primary liquidity, which totaled $161.5 million at December 31, 2019 compared to $136.6 million at December 31, 2018, includes investments, SNCs, federal funds sold, mortgages held-for-sale and cash and cash equivalents, less the amount of securities required to be pledged for certain liabilities. Meridian also anticipates scheduled payments and prepayments on its loan and mortgage-backed securities portfolios. In addition, Meridian maintains borrowing arrangements with various correspondent banks, the FHLB and the Federal Reserve Bank of Philadelphia to meet short-term liquidity needs. Through these relationships, Meridian had available credit of approximately $8.5 million at December 31, 2019. As a member of the FHLB, we are eligible to borrow up to a specific credit limit which is determined by the amount of our residential mortgages, commercial mortgages and other loans that have been pledged as collateral. As of December 31, 2019, Meridian’s maximum borrowing capacity with the FHLB was $507.3 million. At December 31, 2019, Meridian had borrowed $126.8 million and the FHLB had issued letters of credit, on Meridian’s behalf, totaling $102.8 million against its available credit lines. At December 31, 2019, Meridian also had available $39.0 million of unsecured federal funds lines of credit with other financial institutions as well as $161.6 million of available short or long term funding through the Certificate of Deposit Account Registry Service (“CDARS”) program and $45.3 million of available short or long term funding through brokered CD arrangements. Management believes that Meridian has adequate resources to meet its short-term and long-term funding requirements. At December 31, 2019, Meridian had $327.8 million in unfunded loan commitments. Management anticipates these commitments will be funded by means of normal cash flows. Certificates of deposit greater than or equal to $250 thousand scheduled to mature in one year or less from December 31, 2019 totaled $243.3 million. Management believes that the majority of such deposits will be reinvested with Meridian and that certificates that are not renewed will be funded by a reduction in cash and cash equivalents or by pay-downs and maturities of loans and investments. At December 31, 2019, Meridian had a reserve for unfunded loan commitments of $47 thousand. Meridian meets the definition of “well capitalized” for regulatory purposes on December 31, 2019. Our capital category is determined for the purposes of applying the bank regulators’ “prompt corrective action” regulations and for determining levels of deposit insurance assessments and may not constitute an accurate representation of Meridian’s overall financial condition or prospects. Under federal banking laws and regulations, Meridian is required to maintain minimum capital as determined by certain regulatory ratios. Capital adequacy for regulatory purposes, and the capital category assigned to an institution by its regulators, may be determinative of an institution’s overall financial condition. Under the final capital rules that became effective on January 1, 2015, there was a requirement for a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets which is in addition to the other minimum risk-based capital standards in the rule. Institutions that do not maintain this required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer has been phased in over a four year period, which began on January 1, 2016, as follows: the maximum buffer was 0.625% of risk-weighted assets for 2016, 1.25% for 2018 and 1.875% for 2018, and effective as of January 1, 2019, the capital conservation buffer is fully phased in at 2.5%. The following table summarizes data and ratios pertaining to our capital structure. * Does not include capital conservation buffer of 1.250% for 2019 and 1.875% for 2018

<s>[INST] Our financial condition and performance, as well as the ability of our borrowers to repay their loans, the value of collateral securing those loans, as well as demand for loans and other products and services that we offer, are all highly dependent on the business environment in the primary markets in which we operate and in the United States as a whole. During the first quarter of 2020, an outbreak of a novel strain of coronavirus (COVID19), which was originally identified in Wuhan, China, has spread to a number of countries around the world, including the United States. COVID19 and its associated impacts on trade (including supply chains and export levels), travel, employee productivity and other economic activities have had, are currently having and may for some time continue to have a destabilizing effect on financial markets and economic activity. The extent of the impact of COVID19 on our operational and financial performance is currently uncertain, cannot be predicted and will depend on certain developments, including, among others, the duration and spread of COVID19, its impact on our customers, employees and vendors, and governmental, regulatory and private sector responses, which may be precautionary, to the coronavirus. In light of the changing economic outlook as a result of COVID19, as well as other factors, including the possibility of an oil price war in March 2020, the 10year Treasury yield has fallen to historic lows, and the equity markets have been significantly impacted. In response, the Federal Reserve reduced the target federal funds rate by 50 basis points on March 3, 2020, and then by an additional 100 basis points on March 15, 2020. The assets and liabilities of the Corporation may be significantly impacted by changes in interest rates. The Corporation is currently reviewing actions that it may take in response to these changes in the event that market turmoil continues for an extended period. Critical Accounting Policies and Estimates Our accounting and reporting policies conform to GAAP and conform to general practices within the industry in which we operate. To prepare financial statements in conformity with GAAP, management makes estimates, assumptions and judgments based on available information. These estimates, assumptions and judgments affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions and judgements are based on information available as of the date of the financial statements and, as this information changes, actual results could differ from the estimates, assumptions and judgments reflected in the financial statements. In particular, management has identified the provision and allowance for loan and lease losses as the accounting policy that, due to the estimates, assumptions and judgements inherent in that policy, is critical in understanding our financial statements. Management has presented the application of this policy to the audit committee of our board of directors. The JOBS Act permits us an extended transition period for complying with new or revised accounting standards affecting public companies. We have elected to take advantage of this extended transition period, which means that the financial statements included in this Annual Report, as well as any financial statements that we file in the future, will not be subject to all new or revised accounting standards generally applicable to public companies for the transition period for so long as we remain an emerging growth company or until we affirmatively and irrevocably opt out of the extended transition period under the JOBS Act. If we do so, we will prominently disclose this decision in the first periodic report filed with the SEC following our decision, and such decision is irrevocable. The following is a discussion of the critical accounting policies and significant estimates that require us to make complex and subjective judgments. Additional information about these policies can be found in footnote 1 of the Corporation’s Consolidated Financial Statements as of and for the years ended December 31, 2019 and 2018. Provision and allowance for loan and lease losses The provision for loan and lease losses reflects the amount required to maintain the allowance for loan and lease losses (“Allowance”) at an appropriate level based upon management’s evaluation of the adequacy of general and specific loss reserves. The Allowance is maintained at a level that management believes is appropriate to provide for incurred loan and lease losses as of the date of the Consolidated Balance Sheet and we have established methodologies for the determination of its adequacy. The methodologies are set forth in a [/INST] Positive. </s>

DXC Technology Co

2018-05-29

2018-03-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction The purpose of the MD&A is to present information that management believes is relevant to an assessment and understanding of our results of operations and cash flows for the fiscal year ended March 31, 2018 and our financial condition as of March 31, 2018. The MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and notes. The MD&A is organized in the following sections: • Background • Results of Operations • Liquidity and Capital Resources • Off-Balance Sheet Arrangements • Contractual Obligations • Critical Accounting Policies and Estimates Background DXC was formed by the combination of CSC and HPES on April 1, 2017. We are the world's leading independent, end-to-end IT services company, serving nearly 6,000 private and public-sector clients from a diverse array of industries across 70 countries. Our technology independence, global talent and extensive partner network deliver transformative digital offerings and solutions that help clients harness the power of innovation to thrive on change. We generate revenue by offering a wide range of information technology services and solutions primarily in North America, Europe, Asia and Australia. We operate through three segments: GBS, GIS and USPS. We market and sell our services directly to clients through our direct sales force operating out of sales offices around the world. Our clients include commercial businesses of many sizes and in many industries and public sector enterprises. Results of Operations In connection with the HPES Merger, CSC was deemed the accounting acquirer of HPES for accounting purposes under GAAP, therefore, CSC is considered DXC's predecessor and the historical financial statements of CSC prior to April 1, 2017, are reflected herein as DXC's historical financial statements. Accordingly, the financial results of DXC as of and for any periods ending prior to April 1, 2017 do not include the financial results of HPES, and therefore, are not directly comparable. Additionally, CSC used to report its results based on a fiscal year convention that comprises four thirteen-week quarters. However, effective April 1, 2017, DXC's fiscal year was modified to end on March 31 of each year with each quarter ending on the last calendar day. In an effort to provide investors with additional information, the following discussion includes certain comparisons of our results of operations for the fiscal year ended March 31, 2018 to our pro forma results of operations for the fiscal year ended March 31, 2017. Our pro forma results of operations for the fiscal year ended March 31, 2017 are based upon the historical statements of operations of each of CSC and HPES, giving effect to the HPES Merger as if it had been consummated on April 2, 2016. CSC reported its results based on a fiscal year convention that comprised four thirteen-week quarters. HPES reported its results on a fiscal year basis ended October 31. As a consequence of CSC and HPES having different fiscal year-end dates, all references to the unaudited pro forma statement of operations include the results of operations of CSC for the fiscal year ended March 31, 2017 and of HPES for the fiscal year ended January 31, 2017. See "Unaudited Pro Forma Combined Statement of Operations" below for additional information. The following table sets forth certain financial data for fiscal 2018, 2017 and 2016: Fiscal 2018 Highlights During fiscal 2018, we surpassed our first year HPES Merger integration milestones, delivering over $1 billion of year one cost take-out. The additional savings were primarily driven by workforce optimization actions including the acceleration of management reductions and the global deployment of our automation program, Bionix. These ongoing cost actions address both internal labor, as well as third party contractors. We further enhanced our workforce management processes to cost-effectively deliver existing business while staffing the required labor for new business. We also executed on several initiatives to optimize non-labor spend, including ongoing rate negotiations, vendor consolidation, demand management, reductions in maintenance expense and rationalization of facilities. Fiscal 2018 financial highlights include the following: • Fiscal 2018 revenues were $24,556 million. • Fiscal 2018 net income and diluted EPS were $1,782 million and $6.04, respectively, including the cumulative impact of certain items of $550 million, or $1.90 per share, reflecting restructuring costs, transaction, separation and integration-related costs, amortization of acquired intangible assets, pension and other post-retirement benefit ("OPEB") actuarial and settlement gains and a tax adjustment related to U.S. tax reform. • Our cash and cash equivalents were $2,648 million at March 31, 2018. • We generated $3,243 million of cash from operations during fiscal 2018. • The Company returned $311 million to shareholders in the form of common stock dividends and share repurchases during fiscal 2018. Revenues The following discussion includes a comparison of our revenues for fiscal 2018 compared with fiscal 2017 and fiscal 2017 compared with fiscal 2016. The discussion of revenues for fiscal 2018 compared with fiscal 2017 contains an analysis on a GAAP basis and on a pro forma basis giving effect to the HPES Merger. The discussion of revenues for fiscal 2017 compared with fiscal 2016 contains an analysis on a GAAP basis only and does not include revenues of HPES. Fiscal 2018 compared with fiscal 2017 (NM) Calculation is not meaningful. The increase in revenues for fiscal 2018 compared with fiscal 2017 was driven by the HPES Merger. As a global company, over 56% of our fiscal 2018 revenues were earned internationally. As a result, the comparison of revenues denominated in currencies other than the U.S. dollar from period to period is impacted, and we expect will continue to be impacted, by fluctuations in foreign currency exchange rates. Constant currency revenues are a non-GAAP measure calculated by translating current period activity into U.S. dollars using the comparable prior period’s currency conversion rates. This information is consistent with how management views our revenues and evaluates our operating performance and trends. The table below summarizes our constant currency revenues for the fiscal year ended March 31, 2018 compared to pro forma revenues for the fiscal year ended March 31, 2017: (1) Fiscal 2018 revenues are presented at constant currency and include purchase price accounting adjustments of $(24) million, $(98) million and $(8) million for GBS, GIS and USPS, respectively. See Note 2 - "Acquisitions." (2) Our pro forma results of operations are further discussed below in the section “Unaudited Pro Forma Combined Statement of Operations." Our Digital revenue cuts across all three of our reporting segments of GBS, GIS, and USPS, and includes Enterprise, Cloud Applications and Consulting, Cloud, Analytics and Security. Digital revenue grew year-over-year, reflecting our clients’ accelerating shift to Digital. During fiscal 2018, we also formed a new digital business team to jointly develop digital transformations with our clients, leveraging assets from across the company and our partnerships. Global Business Services Our GBS segment revenues were $9.3 billion for fiscal 2018, representing an increase of $5.1 billion over fiscal 2017. The revenue growth is attributed to the HPES Merger. Constant currency revenues were $9.1 billion for fiscal 2018 compared to $9.5 billion for fiscal 2017 on a pro forma basis. The $0.4 billion decrease was primarily driven by $0.9 billion of contracts that concluded or were renewed at a lower rate. These decreases were partially offset by a $0.7 billion increase in revenues from new business as well as the contributions from our recent acquisition of Tribridge. Digital revenues in Enterprise, Cloud Applications and Consulting and Analytics grew year-over-year, offset by declines in traditional Application Services revenues. Enterprise, Cloud Applications and Consulting offerings continue to drive growth through an expanded portfolio of quick start offerings, which allow us to rapidly understand the client environment and develop more impactful large scale transformations. Global Infrastructure Services Our GIS segment revenues were $12.5 billion for fiscal 2018, representing an increase of $9.0 billion over fiscal 2017. The revenue growth is attributed to the HPES Merger. Constant currency revenues were $12.2 billion for fiscal 2018 compared to $13.0 billion for fiscal 2017 on a pro forma basis. The $0.8 billion decrease was primarily driven by $1.3 billion of contracts that concluded or were renewed at a lower rate. These decreases were partially offset by a $0.6 billion increase in revenues from new business. Cloud revenue grew year-over-year as clients continue to migrate workloads from legacy infrastructure environments to hybrid cloud environments. United States Public Sector We began to report the USPS segment, formerly the HPES U.S. public sector business, in fiscal 2018. The USPS segment provides infrastructure and other services similar to our GIS and GBS segments to all levels of government in the U.S. Constant currency revenues were $2.8 billion for fiscal 2018 compared to $2.8 billion for fiscal 2017 on a pro forma basis. The year-over-year comparison of revenues was impacted by an increase in revenues from new business during fiscal 2018 that was offset by the non-recurrence of a contract reset that resulted in a one-time revenue increase in fiscal 2017. During fiscal 2018, GBS, GIS and USPS had contract awards of $10.2 billion, $11.6 billion and $1.9 billion, respectively. Fiscal 2017 compared with fiscal 2016 Our fiscal 2017 revenues increased $501 million as compared with fiscal 2016. The increase was due to growth in our GBS segment and revenues from our recent acquisitions. The increase in fiscal 2017 revenues was partially offset by a decrease in revenues of $317 million caused by contracts that concluded or were renewed at lower rates and a $221 million adverse impact of foreign currency movement due to the strengthening of the U.S. dollar against the British pound. The table below summarizes our constant currency revenues for the fiscal year ended March 31, 2017 compared to the fiscal year ended April 1, 2016: (1) Fiscal 2017 revenues are presented at constant currency. Constant currency revenues is a non-GAAP measure and is further described above in the section “Fiscal 2018 compared with fiscal 2017.” Global Business Services The $654 million, or 18.0%, constant currency increase for fiscal 2017 as compared to fiscal 2016 was driven by growth in next generation business processing services offerings, as well as contributions from our recent acquisitions, primarily within our Digital Applications business and our IS&S business where we continue to prioritize the development of our digital capabilities. Digital Applications, our enterprise, cloud applications and consulting business, increased over 38% in constant currency and IS&S increased over 26% in constant currency when compared to prior fiscal year. The increase was largely due to revenues from our recent acquisitions which we continue to integrate into our existing business and new business revenues increased $249 million. These increases were partially offset by a $274 million decrease in revenues from contracts that concluded and a $131 million decline from contracts renewed at lower rates. Global Infrastructure Services GIS segment constant currency revenues for fiscal 2017 increased $68 million, or 2.0%, as compared to fiscal 2016. The increase was primarily due to an increase of $243 million in revenues from new business and an increase in revenues contributed from our recent acquisitions. In addition, we recognized incremental revenues of $43 million under our GIS segment's portion of the IP matters agreement (see Note 3 - "Divestitures"). These increases were partially offset by decreases in revenues of $335 million from contracts that concluded, $89 million from contracts renewed with scope changes and $23 million due to price-downs. We continued to take actions to mitigate the secular headwinds facing our traditional IT outsourcing business and focus GIS on the next generation digital needs of our clients. During fiscal 2017, GBS and GIS had contract awards of $4.9 billion and $3.7 billion, respectively, as compared to fiscal 2016 contract awards of $4.3 billion and $4.3 billion. Costs and Expenses Our total costs and expenses were as follows: (1) Fiscal 2017 and 2016 costs and expenses are for CSC only and therefore are not directly comparable to fiscal 2018 costs and expenses. During fiscal 2018, we took actions to optimize our workforce, extract greater supply chain efficiencies and rationalize our real estate footprint. We reduced our labor base by approximately 13% through a combination of automation, best shoring and pyramid correction. We also rebalanced our skill mix, including the addition of more than 18,000 new employees and the ongoing retraining of the existing workforce. In real estate, we restructured over four million square feet of space during fiscal 2018. Costs of Services Fiscal 2018 compared with fiscal 2017 Cost of services excluding depreciation and amortization and restructuring costs ("COS") was $17.9 billion for fiscal 2018 as compared to $5.5 billion for fiscal 2017. The increase in COS was driven by the HPES Merger and was partially offset by reduction in costs associated with our labor base and real estate. COS for fiscal 2018 included $192 million of pension and OPEB actuarial and settlement gains associated with our defined benefit pension plans. Fiscal 2017 compared with fiscal 2016 COS as a percentage of revenues remained consistent year over year. The $360 million increase in COS was largely related to our acquisitions and a $31 million gain on the sale of certain intangible assets in our GIS segment during fiscal 2016 not present in the current fiscal year. This increase was offset by management's ongoing cost reduction initiatives and a year-over-year favorable change of $28 million to pension and OPEB actuarial and settlement losses associated with our defined benefit pension plans. The amount of restructuring charges, net of reversals, excluded from COS was $219 million and $7 million for fiscal 2017 and 2016, respectively. Selling, General and Administrative Fiscal 2018 compared with fiscal 2017 Selling, general and administrative expense excluding depreciation and amortization and restructuring costs ("SG&A") was $2.0 billion for fiscal 2018 as compared to $1.3 billion for fiscal 2017. The increase in SG&A was driven by the HPES Merger. Integration, separation and transaction-related costs were $408 million during fiscal 2018, as compared to $305 million during fiscal 2017. Fiscal 2017 compared with fiscal 2016 SG&A as a percentage of revenues increased 2.2% to 16.8% for fiscal 2017 from 14.6% for fiscal 2016. The increase was due to transaction and integration costs of $305 million associated with our recent acquisitions and the HPES Merger, an increase of $16 million in the recognition of pension and OPEB actuarial and pension settlement losses and a non-recurring settlement recovery of $16 million recorded as a reduction of SG&A during fiscal 2016, not present in the current fiscal year. These increases were partially offset by higher revenues. During fiscal 2017 and 2016, we recognized $15 million and $(1) million, respectively, of actuarial and pension settlement losses (gains) in SG&A. The amount of restructuring charges, net of adjustments, excluded from SG&A was $19 million and $16 million for fiscal 2017 and 2016, respectively. Depreciation and Amortization Fiscal 2018 compared with fiscal 2017 Depreciation and amortization expense ("D&A") was $2.0 billion for fiscal 2018 as compared to $0.6 billion for fiscal 2017. The increase in D&A was attributed to acquired property and equipment and intangible assets associated with the HPES Merger. Fiscal 2017 compared with fiscal 2016 D&A as a percentage of revenues decreased less than 1% to 8.5% for fiscal 2017 from 9.3% for fiscal 2016 due to an increase in revenues for the GBS segment and lower D&A within the GIS segment as a result of reduced capital expenditures from contract terminations, as well as a continued focus on capital efficiency. The decrease in the D&A ratio was partially offset by an increase in amortization related to acquisitions, primarily within the GBS segment. Restructuring Costs Restructuring costs represent severance related to workforce optimization programs and expense associated with facilities and data center rationalization. During fiscal 2018, 2017 and 2016 we initiated certain restructuring actions across our segments. The fiscal 2018 restructuring initiatives are intended to reduce our core structure and related operating costs, improve our competitiveness, and facilitate the achievement of acceptable and sustainable profitability following our recent acquisitions and the HPES Merger. Total restructuring costs recorded, net of reversals, during fiscal 2018, 2017 and 2016 were $803 million, $238 million and $23 million, respectively. The net amounts recorded included $13 million, $6 million and $7 million of pension benefit augmentations for fiscal 2018, 2017 and 2016, respectively, owed to certain employees under legal or contractual obligations. These augmentations will be paid as part of normal pension distributions over several years. See Note 19 - "Restructuring Costs" for additional information about our restructuring actions. Interest Expense and Interest Income Fiscal 2018 compared with fiscal 2017 Interest expense for fiscal 2018 was $335 million as compared to $117 million in fiscal 2017. The year-over-year increase in interest expense includes interest expense associated with $5.6 billion of debt acquired in connection with the HPES Merger. Interest income for fiscal 2018 was $89 million as compared to $35 million in fiscal 2017. The year-over-year increase in interest income was due to higher cash balances during fiscal 2018 as compared to the prior fiscal year. Fiscal 2017 compared with fiscal 2016 Interest expense for fiscal 2017 was $117 million as compared to $123 million in fiscal 2016. The year-over-year decrease in interest expense was due to the fourth quarter fiscal 2016 redemption of our 6.50% term notes and lower interest rates on our existing debt. Interest income for fiscal 2017 was $35 million as compared to $38 million in fiscal 2016. The decrease in interest income was due to lower average deposit balances in our money market funds and money market deposit accounts during fiscal 2017 as compared to the prior fiscal year. Debt Extinguishment Costs During fiscal 2016, CSC redeemed all outstanding 6.50% term notes due March 2018 at par plus redemption premiums related to a make-whole provision and accrued interest. Debt extinguishment costs of $95 million for fiscal 2016 consists primarily of redemption premiums. There were no debt extinguishment costs recorded in fiscal 2018 or fiscal 2017. Other Income, Net Fiscal 2018 compared with fiscal 2017 Other income, net consists of movement in foreign currency exchange rates on our foreign currency denominated assets and liabilities and the related economic hedges, equity earnings of unconsolidated affiliates and other miscellaneous gains and losses. The $72 million increase in other income for fiscal 2018 was primarily due to foreign currency gain related to a change in the functional currency of a European holding company. Fiscal 2017 compared with fiscal 2016 The $1 million year-over-year increase in other income was due to a $7 million year-over-year benefit of favorable movements in foreign currency exchange rates used to fair value our foreign currency forward contracts and the related foreign currency denominated assets and liabilities partially offset by a $6 million gain on sale of certain assets during fiscal 2016 not present in fiscal 2017. Taxes Our effective tax rate ("ETR") on income (loss) from continuing operations, before taxes for fiscal 2018, 2017 and 2016 was (6.6)%, (42.5)% and (620.0)%, respectively. A reconciliation of the differences between the U.S. federal statutory rate and the ETR, as well as other information about our income tax provision, is provided in Note 11 - "Income Taxes." In fiscal 2018, the ETR was primarily impacted by the effects of the Act: • The release of a deferred tax liability relating to the outside basis difference of foreign subsidiaries which increased the income tax benefit and decreased the ETR by $554 million and 33.2%, respectively. • The accrual of the one-time transition tax on estimated unremitted foreign earnings which decreased the income tax benefit and increased the ETR by $361 million and 21.6%, respectively. • The remeasurement of deferred tax assets and liabilities as a result of the Act, which increased the income tax benefit and decreased the ETR by $338 million and 20.3%, respectively. In fiscal 2017, the ETR was primarily impacted by: • A change in the valuation allowance that primarily consists of an aggregate income tax detriment for the increase in the valuation allowances on tax attributes primarily in the U.S., Germany and Luxembourg, which decreased the overall income tax benefit and decreased the ETR by $135 million and 78%, respectively. Offset by an aggregate income tax benefit related to the release of valuation allowances on tax attributes primarily in the U.K., Denmark and Japan, which increased the overall income tax benefit and increased the ETR by $75 million and 43.0%, respectively. • An income tax detriment for transaction costs incurred that are not deductible for tax purposes, which resulted in a decrease to the overall tax benefit and decreased the ETR by $21 million and 12.1%, respectively. • An income tax benefit from excess tax benefits realized from employee share-based payment awards, which resulted in an increase in the overall income tax benefit and increased the ETR by $20 million and 11.3%, respectively. In fiscal 2016, the ETR was primarily impacted by: • The adoption of a new accounting standard on excess tax benefits realized from share options vested or exercised. This increased the overall income tax benefit and the ETR by $23 million and 230%, respectively. • An increase in the overall valuation allowance primarily due to the Separation related to state net operating losses and state tax credits. This decreased the overall income tax benefit and ETR by $27 million and 270%, respectively. • The release of a liability for uncertain tax positions following the closure of the U.K. tax audit for fiscal 2010 to 2012. This increased the income tax benefit by $58 million and increased the ETR by 580%. • Adjustments to uncertain tax positions in the U.S. that increased the overall income tax benefit by $24 million and increased the ETR by 240%, respectively. The IRS is examining CSC's federal income tax returns for fiscal 2008 through 2016. With respect to CSC's fiscal 2008 through 2010 federal tax returns, we previously entered into negotiations for a resolution through settlement with the IRS Office of Appeals. The IRS examined several issues for this audit that resulted in various audit adjustments. We have an agreement in principle with the IRS Office of Appeals as to some but not all of these adjustments. We have agreed to extend the statute of limitations associated with this audit through April 30, 2019. In addition, during the first quarter of fiscal 2018, we received a Revenue Agent’s Report with proposed adjustments to CSC's fiscal 2011 through 2013 federal returns. We have filed a protest of certain of these adjustments to the IRS Office of Appeals. The IRS is also examining CSC's fiscal 2014 through 2016 federal income tax returns. We have not received any adjustments for this cycle. For HPES entities the IRS is examining federal income tax returns for fiscal 2008 through 2012. In addition, HPE entities have received a Revenue Agent's Report with respect to calendar years 2005 through 2008, and these adjustments were protested to the IRS Office of Appeals. We continue to believe that our tax positions are more-likely-than-not sustainable and that we will ultimately prevail. In addition, we may settle certain other tax examinations, have lapses in statutes of limitations, or voluntarily settle income tax positions in negotiated settlements for different amounts than we have accrued as uncertain tax positions. We may need to accrue and ultimately pay additional amounts for tax positions that previously met a more-likely-than-not standard if such positions are not upheld. Conversely, we could settle positions by payment with the tax authorities for amounts lower than those that have been accrued or extinguish a position through payment. We believe the outcomes that are reasonably possible within the next twelve months may result in a reduction in liability for uncertain tax positions of $36 million to $70 million, excluding interest, penalties, and tax carry-forwards. Income from Discontinued Operations Income from discontinued operations, net of taxes, primarily reflects the results of operations of CSC's former NPS segment which was divested on November 27, 2015. There were no discontinued operations in fiscal 2018 or fiscal 2017. Earnings (Loss) Per Share Fiscal 2018 compared with fiscal 2017 Diluted EPS for fiscal 2018 was $6.04, an increase of $6.92 per share compared with the prior fiscal year. The increase was due to an increase of $1,874 million in net income attributable to DXC common stockholders, partially offset by an increase in weighted average common shares outstanding for diluted EPS attributable to capital restructuring associated with the HPES Merger. Diluted EPS for fiscal 2018 includes $2.06 per share of restructuring costs, $1.00 per share of transaction, separation and integration-related costs, $1.37 per share of amortization of acquired intangible assets, $(0.60) per share of pension and OPEB actuarial and settlement gains, and $(1.94) per share reflecting the estimated non-recurring benefit of the Act. Fiscal 2017 compared with fiscal 2016 Diluted EPS from continuing operations in fiscal 2017 decreased $1.38 per share to $(0.88) per share primarily due to $403 million of transaction and integration related costs during fiscal 2017 for the HPES Merger and other acquisitions. In addition, restructuring costs increased $215 million as compared to the same period in the prior year. These decreases were partially offset by the non-recurrence of fiscal 2016 debt extinguishment costs of $95 million. Total diluted EPS for fiscal 2017 decreased $2.66 per share due to the reasons mentioned above for EPS from continuing operations and the lack of discontinued operations associated with the Separation of NPS during the current fiscal year. Unaudited Pro Forma Condensed Combined Statement of Operations In an effort to provide investors with additional information, we are disclosing certain unaudited pro forma financial information of DXC for the fiscal year ended March 31, 2017 as supplemental information herein. The following unaudited pro forma condensed combined statement of operations of DXC (the “unaudited pro forma statement of operations”) is for the fiscal year ended March 31, 2017 after giving effect to the HPES Merger. See Note 1 - "Summary of Significant Accounting Policies" and Note 2 - "Acquisitions" for additional information about the HPES Merger. CSC reported its results based on a fiscal year convention that comprised four thirteen-week quarters. Every fifth year included an additional week in the first quarter to prevent the fiscal year moving from an approximate end of March date. HPES reported its results on a fiscal year basis ended October 31. As a consequence of CSC and HPES having different fiscal year-end dates, all references to the unaudited pro forma statement of operations include the results of operations of CSC for the fiscal year ended March 31, 2017 and of HPES for the fiscal year ended January 31, 2017. The historical combined statement of operations of HPES was “carved-out” from the combined statement of operations of HPE and reflects assumptions and allocations made by HPE. The combined statement of operations of HPES included all revenues and costs directly attributable to HPES and an allocation of expenses related to certain HPE corporate functions. The results of operations in the HPES historical combined statement of operations does not necessarily include all expenses that would have been incurred by HPES had it been a separate, stand-alone entity. Actual costs that may have been incurred if HPES had been a stand-alone company would depend on a number of factors, including the chosen organizational structure, functions outsourced or performed by employees and strategic decisions made in areas such as information technology and infrastructure. Consequently, HPES’ historical combined statement of operations does not necessarily reflect what HPES’ results of operations would have been had HPES operated as a stand-alone company during the period presented. The unaudited pro forma statement of operations has been prepared using the acquisition method of accounting with CSC considered the accounting acquirer of HPES. The unaudited pro forma statement of operations combines the historical results of CSC and HPES, reflects preliminary purchase accounting adjustments and aligns accounting policies of CSC and HPES. The historical statements of operations have been adjusted in the unaudited pro forma statement of operations to give effect to pro forma events that were (i) directly attributable to the HPES Merger, (ii) factually supportable, and (iii) which are expected to have a continuing impact on the consolidated results of operations of DXC. The pro forma results do not reflect the costs of integration activities or benefits that may result from realization of first-year synergies. The adjustments included in the unaudited pro forma statement of operations were based upon currently available information and assumptions that management of DXC believes to be reasonable. The unaudited pro forma statement of operations is for informational purposes only and is not intended to represent or to be indicative of the actual results of operations that the combined company would have reported had the HPES Merger been completed on April 2, 2016, and should not be taken as being indicative of DXC’s future consolidated financial results. UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS Non-GAAP Financial Measures We present non-GAAP financial measures of performance which are derived from the statements of operations and unaudited pro forma statement of operations of DXC. These non-GAAP financial measures include earnings before interest and taxes ("EBIT"), adjusted EBIT, non-GAAP income before income taxes, non-GAAP net income and non-GAAP EPS. We present these non-GAAP financial measures to provide investors with meaningful supplemental financial information, in addition to the financial information presented on a GAAP or pro forma basis. These non-GAAP financial measures exclude certain items from GAAP results that DXC management believes are not indicative of core operating performance. DXC management believes these non-GAAP measures provide investors supplemental information about the financial performance of DXC exclusive of the impacts of corporate wide strategic decisions. DXC management believes that adjusting for these items provides investors with additional measures to evaluate the financial performance of our core business operations on a comparable basis from period to period. DXC management believes the non-GAAP measures provided are also considered important measures by financial analysts covering DXC as equity research analysts continue to publish estimates and research notes based on our non-GAAP commentary, including our guidance around non-GAAP EPS. There are limitations to the use of the non-GAAP financial measures presented in this report. One of the limitations is that they do not reflect complete financial results. We compensate for this limitation by providing a reconciliation between our non-GAAP financial measures and the respective most directly comparable financial measure calculated and presented in accordance with GAAP or on a pro forma basis. Additionally, other companies, including companies in our industry, may calculate non-GAAP financial measures differently than we do, limiting the usefulness of those measures for comparative purposes between companies. Non-GAAP financial measures and the respective most directly comparable financial measures calculated and presented in accordance with GAAP or on a pro forma basis include: Reconciliation of Non-GAAP Financial Measures Our non-GAAP adjustments include: • Restructuring - reflects costs, net of reversals, related to workforce optimization and real estate charges. • Transaction, separation and integration-related costs - reflects costs related to integration planning, financing, and advisory fees associated with the HPES Merger and other acquisitions and costs related to the separation of USPS. • Amortization of acquired intangible assets - reflects amortization of intangible assets acquired through business combinations. • Pension and OPEB actuarial and settlement gains and losses - reflects pension and OPEB actuarial and settlement gains and losses. • Certain overhead costs - reflects certain fiscal 2017 HPE costs allocated to HPES that are expected to be largely eliminated on a prospective basis. • Tax adjustment - reflects the estimated non-recurring benefit of the Tax Cuts and Jobs Act of 2017 for fiscal 2018 and the application of an approximate 27.5% pro forma tax rate for fiscal 2017, which is the midpoint of prospective targeted effective tax rate range of 25% to 30% and effectively excludes the impact of discrete tax adjustments for that period. A reconciliation of reported results to non-GAAP results is as follows: * The net periodic pension cost within income from continuing operations includes $371 million of actual return on plan assets, whereas the net periodic pension cost within non-GAAP income from continuing operations includes $(534) million of expected long-term return on pension assets of defined benefit plans subject to interim remeasurement. A reconciliation of pro forma combined results to pro forma non-GAAP results is as follows: Reconciliations of net income (loss) and pro forma net income (loss) to adjusted EBIT and pro forma adjusted EBIT are as follows: Liquidity and Capital Resources Cash and Cash Equivalents and Cash Flows As of March 31, 2018, our cash and cash equivalents ("cash") were $2.6 billion, of which $1.0 billion was held outside of the United States. A substantial portion of funds can be returned to the U.S. from funds advanced previously to finance our foreign acquisition initiatives. As a result of the Tax Cuts and Jobs Act of 2017, and after the mandatory one-time income inclusion (deemed repatriation) of the historically untaxed earnings of our foreign subsidiaries, we expect a significant portion of the cash held by our foreign subsidiaries will no longer be subject to U.S. income tax consequences upon a subsequent repatriation to the United States. However, a portion of this cash may still be subject to foreign and state income tax consequences upon future remittance. Therefore, if additional funds held outside the U.S. are needed for our operations in the United States, we plan to repatriate these funds. Based on a preliminary analysis, we have recorded a provisional estimate for foreign withholding taxes, state taxes, and India dividend distribution tax of $99 million as described in Note 11 - "Income Taxes". We have changed our permanent reinvestment assertion on our foreign subsidiaries and will no longer consider current and accumulated earnings for all non-U.S. subsidiaries permanently reinvested, except for current year and future Indian earnings. Cash and cash equivalents increased $1.4 billion during fiscal 2018 to $2.6 billion, primarily due to growth in our business The following table summarizes our cash flow activity: Operating cash flow Net cash provided by operating activities during fiscal 2018 was $3,243 million as compared to $978 million during fiscal 2017. The increase of $2,265 million was predominately due to an increase in net income of $1,882 million. The increase in cash provided by operating activities during fiscal 2018 was partially offset by additional deferred tax adjustments to operating activities of $842 million and an increase in the gain on pension and other post-employment benefits of $307 million. Net cash provided by operating activities during fiscal 2017 increased $176 million as compared to fiscal 2016. The increase was due to an increase in trade payables of $411 million, a decrease in net account receivables of $457 million, $32 million less restructuring charges compared to fiscal 2016 and a cash outflow of $190 million for SEC settlement paid in fiscal 2016 with no comparative outflow for the current year. In addition, payments received from CSRA under the amended IP matters agreement increased $35 million. The increase in operating cash flows was partially offset by a $189 million increase in payments for transaction and integration-related costs, an increase in the deferred purchase price receivable of $252 million and a $545 million decrease in net income adjusted for non-cash transactions from fiscal 2016. Investing cash flow Net cash used in investing activities during fiscal 2018 decreased $893 million to $33 million. The decrease was predominantly due to net cash provided by acquisitions of $735 million during fiscal 2018, compared with cash paid for acquisitions of $434 million during fiscal 2017. The decrease in net cash used in investing activities was partially offset by an increase in cash payments for outsourcing contract costs of $227 million, software purchases of $71 million and a restricted cash outflow of $67 million primarily related to our Federal Receivables Sales Facility. Net cash used in investing activities during fiscal 2017 decreased $254 million to $926 million. This decrease was driven by a decline of $120 million spent on acquisitions and a decline in capital expenditures of $150 million. Financing cash flow Net cash used by financing activities during fiscal 2018 was $1,890 million, as compared to $93 million during fiscal 2017. The $1,983 million increase in net cash used by financing activities was primarily due to a decrease in credit facility draws, net of repayments of $868 million, additional payments on capitalized lease obligations of $915 million, additional payments on long-term debt obligations of $1,379 million and $132 million in payments for repurchases of common stock. These cash outflows were partially offset by draws on long-term debt of $462 million and cash proceeds from bond issuance of $989 million. Net cash provided by financing activities during fiscal 2017 was $93 million, as compared to cash used of $485 million during fiscal 2016. The decline was due primarily to certain fiscal 2016 cash outflows that did not re-occur during fiscal 2017, including a $350 million repayment of our 2.5% term notes, a $313 million special cash dividend paid as part of the NPS Separation, a $95 million payment for the early extinguishment of debt and payments of $73 million for treasury stock that occurred during fiscal 2016. These declines of cash used in financing activities were partially offset by a $254 million payment of acquired debt from the acquisition of Xchanging and $85 million in net proceeds from the structured sale of our U.K. campus. Capital Resources See Note 20 - "Commitments and Contingencies" for a discussion of the general purpose of guarantees and commitments. The anticipated sources of funds to fulfill such commitments are listed below and under the subheading "Liquidity." The following table summarizes out total debt: The $5.4 billion increase in total debt during fiscal 2018 was attributed primarily to debt assumed in connection with the HPES Merger. The maturity chart below summarizes the future maturities of long-term debt principal for fiscal years subsequent to March 31, 2018 and excludes maturities of borrowings for assets acquired under long-term financing and capitalized lease liabilities. During fiscal 2018, we increased commitments under our revolving credit facility to $3.8 billion from $3.0 billion pre-HPES Merger and completed a senior bond offering in an aggregate principal amount of $650 million due 2021, the proceeds of which were used to retire the outstanding USD term loan due 2021. Additionally, we entered into an unsecured €400 million term loan agreement maturing during May 2018, which was subsequently replaced by long-term debt maturing in fiscal 2020, and we entered into amendments to our existing AUD term loan to increase total borrowings to AUD $275 million. We also issued £250 million of senior notes maturing in 2025. The proceeds from these borrowings were used to make prepayments to term loans maturing in 2022 and fully repay the borrowings under revolving credit facilities. During fiscal 2018, we completed a debt exchange offer whereby $234 million principal amount of the $300 million Senior Notes (the “EDS Notes”) were tendered to DXC in exchange for a like principal amount of DXC notes with identical maturity and interest rate. As of March 31, 2018, DXC held approximately $234 million principal amount of the EDS Notes that were tendered, and which are eliminated upon financial statement consolidation, while the remaining $66 million principal amount of the EDS Notes outstanding were held by public noteholders. Subsequent to the period end, DXC extinguished on May 25, 2018 the $234 million principal amount of EDS Notes that it held in preparation for the USPS Separation and Mergers. The $66 million principal amount of EDS Notes that remain outstanding will remain with the legal entity that is spinning off with the USPS Separation. We were in compliance with all financial covenants associated with our borrowings as of March 31, 2018 and March 31, 2017. For more information on our debt, see Note 12 - "Debt". The following table summarizes our capitalization ratios: (1) Net debt and Net debt-to-total capitalization are non-GAAP measures used by management to assess our ability to service our debts using only our cash and cash equivalents. We present these non-GAAP measures to assist investors in analyzing our capital structure in a more comprehensive way compared to gross debt based ratios alone. The decrease in net debt-to-total capitalization was primarily due to a $4.0 billion increase in net debt and a $11.7 billion increase in equity, which were primarily a result of the HPES Merger. As of March 31, 2018, our credit ratings were as follows: Liquidity We expect our existing cash and cash equivalents, together with cash generated from operations, will be sufficient to meet our normal operating requirements for the next 12 months. We expect to continue to use cash generated by operations as a primary source of liquidity; however, should we require funds greater than that generated from our operations to fund discretionary investment activities, such as business acquisitions, we have the ability to draw on our multi-currency revolving credit facility or raise capital through the issuance of capital market debt instruments such as commercial paper, term loans and bonds. However, there can be no guarantee that we will be able to obtain debt financing, if required, on terms and conditions acceptable to us, if at all, in the future. Our exposure to operational liquidity risk is primarily from long-term contracts which require significant investment of cash during the initial phases of the contracts. The recovery of these investments is over the life of the contract and is dependent upon our performance as well as customer acceptance. The following table summarizes our total liquidity: Share Repurchases During fiscal 2018, our Board of Directors authorized the repurchase of up to $2.0 billion of our common stock. This program became effective on April 3, 2017 and no end date was established. During fiscal 2018, we repurchased 1,537,782 shares of our common stock at an aggregate cost of $137 million. Dividends During fiscal 2018 the Board of Directors of DXC declared aggregate cash dividends to our stockholders of $0.72 per share, or approximately $209 million. Future dividends are subject to customary board review and approval prior to declaration. Off-Balance Sheet Arrangements In the normal course of business, we are a party to arrangements that include guarantees, the receivables securitization facility, receivables sales arrangements and financial instruments with off-balance sheet risk, such as letters of credit and surety bonds. We also use performance letters of credit to support various risk management insurance policies. No liabilities related to these arrangements are reflected in balance sheets. See Note 5 - "Receivables" and Note 20 - "Commitments and Contingencies" for additional information regarding these off-balance sheet arrangements. Contractual Obligations Our contractual obligations as of March 31, 2018 were as follows: (1) Amounts represent scheduled principal payments of long-term debt and mandatory redemption of preferred stock of a consolidated subsidiary. (2) Includes long-term purchase agreements with certain software, hardware, telecommunication and other service providers and exclude agreements that are cancelable without penalty. If we do not meet the specified service minimums, we may have an obligation to pay the service provider a portion of or the entire shortfall. (3) The calculated amount for transition tax is payable over eight years; 8% of net tax liability in each of years 1-5, 15% in year 6, 20% in year 7, and 25% in year 8. This amount has been calculated provisionally under SAB 118 and is subject to change in future periods. See Note 11 - "Income Taxes" for additional information about the transition tax and for the estimated liability related to unrecognized tax benefits, which has been omitted from this table. (4) Amounts represent scheduled interest payments on long-term debt and scheduled dividend payments associated with the mandatorily redeemable preferred stock of a consolidated subsidiary excluding contingent dividends associated with the participation and variable appreciation premium features. (5) See Note 13 - "Pension and Other Benefit Plans" for the estimated liability related to estimated future benefit payments under our Pension and OPEB plans that have been omitted from this table. Critical Accounting Policies and Estimates The preparation of financial statements in accordance with GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities. These estimates may change in the future if underlying assumptions or factors change. Accordingly, actual results could differ materially from our estimates under different assumptions, judgments or conditions. We consider the following policies to be critical because of their complexity and the high degree of judgment involved in implementing them: revenue recognition, income taxes, business combinations, defined benefit plans and valuation of assets. We have discussed the selection of our critical accounting policies and the effect of estimates with the audit committee of our board of directors. Revenue Recognition Most of our revenues are recognized based on objective criteria and do not require significant estimates that may change over time. However, some arrangements are subject to specific accounting guidance that may require significant estimates, including contracts which include multiple-element deliverables. Multiple-element arrangements Many of our contracts require us to provide a range of services or elements to our customers, which may include a combination of services, products or both. As a result, significant judgment may be required to determine the appropriate accounting, including whether the elements specified in a multiple-element arrangement should be treated as separate units of accounting for revenue recognition purposes, and, when considered appropriate, how the total revenues should be allocated among the elements and the timing of revenue recognition for each element. If vendor specific objective evidence is not available, allocation of total contract consideration to each element requires estimating the fair value or selling price of each element based on third party evidence or management's best estimate of selling price for the deliverables when third party evidence ("TPE") is not available. TPE is established by considering our competitors' prices for comparable product and service offerings in the market in which we operate. When we conclude that comparable products or services are sold by competitors to similarly situated customers, we consult available information sources such as published list prices, quoted market prices and industry reports to estimate TPE. We establish a best estimate of selling price consistent with our existing pricing practices involving a cost-plus-reasonable-margin methodology as well as comparison of the margins to those realized on recent contracts for similar products or services in that market. Once the total revenues have been allocated to the various contract elements, revenues for each element are recognized based on the relevant revenue recognition method for the services performed or elements delivered if the revenue recognition criteria have been met. Estimates of total revenues at contract inception often differ materially from actual revenues due to volume differences, changes in technology or other factors which may not be foreseen at inception. Income Taxes We are subject to income taxes in the United States (federal and state) and numerous foreign jurisdictions. Significant judgment is required in determining our provision for income taxes, analyzing our income tax reserves, the determination of the likelihood of recoverability of deferred tax assets and adjustment of valuation allowances accordingly. In addition, our tax returns are routinely audited and settlements of issues raised in these audits sometimes affect our tax provisions. For example, we are currently undergoing IRS audits for CSC's fiscal 2008 through 2016 U.S. Federal tax returns. As a global enterprise, our ETR is affected by many factors, including our global mix of earnings among countries with differing statutory tax rates, the extent to which our non-U.S. earnings are indefinitely reinvested outside the U.S, changes in the valuation allowance for deferred tax assets, changes in tax regulations, acquisitions, dispositions and the tax characteristics of our income. We cannot predict what our ETR will be in the future because there is uncertainty regarding these factors. As a result of the HPES Merger and changes in U.S. cash requirements, a deferred tax liability of $542 million was recorded for U.S. income taxes based on the estimated historical taxable earnings of the HPES foreign subsidiaries. In addition, we recorded an estimated liability of $50 million for India DDT tax based on estimated historical taxable earnings of the HPES India subsidiary. These liabilities were recorded as part of acquisition accounting. As a result of the Tax Cuts and Jobs Act (the "Act"), we have changed our ASC 740-30 assertion with respect to the remaining CSC foreign subsidiaries and no longer consider current and accumulated earnings for all non-U.S. subsidiaries permanently reinvested, except for current year Indian earnings. The deferred tax liability relating to HPES foreign subsidiaries of $554 million has been released and our estimated liability for India DDT was increased by $30 million to $80 million to include estimated historical taxable earnings for CSC Indian subsidiaries. For those subsidiaries from which we were able to make a reasonable estimate of the tax effects of our change in assertion, we have recorded a provisional estimate for withholding taxes, state taxes, and India DDT of $12 million, $7 million and $80 million, respectively. For those subsidiaries which we were not able to make a reasonable estimate, we have not recorded any deferred taxes. We will record the tax effects of any change in our prior assertion with respect to these subsidiaries and disclose any unrecognized deferred tax liability for temporary differences related to our foreign subsidiaries, if practicable, in the period that we are first able to make a reasonable estimate, no later than December 2018. Considerations impacting the recoverability of deferred tax assets include the period of expiration of the tax asset, planned use of the tax asset and historical and projected taxable income as well as tax liabilities for the tax jurisdiction to which the tax asset relates. In determining whether the deferred tax assets are realizable, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, taxable income in prior carryback years, projected future taxable income, tax planning strategies and recent financial operations. We recorded a valuation allowance against deferred tax assets of approximately $1.4 billion as of March 31, 2018 due to uncertainties related to the ability to utilize these assets. However, valuation allowances are subject to change in future reporting periods due to changes in various factors. Changes in tax laws, such as the Act or changes in tax laws resulting from the Organization for Economic Co-operation and Development’s multi-jurisdictional plan of action to address “base erosion and profit shifting” could impact our effective tax rate. The calculation of our tax liabilities involves uncertainties in the application of complex changing tax regulations. As discussed in Note 11 - "Income Taxes", for example, the Act provides provisions that limit interest expense, provide for immediate expensing of qualified assets, further limits executive compensation deductions, generally eliminates Federal tax on foreign dividend distributions, subjects certain payments from U.S. corporations to foreign related parties to additional taxes, places restrictions or eliminates certain exclusions, deductions and credits and generally broadens the tax base. Further guidance for these provisions is forthcoming and the laws are subject to change in future periods. The Finance Act of 2012 (the "2012 Finance Act") was signed into law in India on May 28, 2012. The 2012 Finance Act provides for the taxation of indirect foreign investment in India, including on a retroactive basis. The 2012 Finance Act overrides the Vodafone NL ruling by the Supreme Court of India which held that the Indian Tax Authorities cannot assess capital gains taxes on the sale of shares of non-Indian companies that indirectly own shares in an Indian company. The retroactive nature of these changes in law has been strongly criticized and challenged in the Indian courts; however, there is no assurance that such a challenge will be successful. We have engaged in the purchase of shares of foreign companies that indirectly own shares of an Indian company and internal reorganizations involving Indian companies. The Indian tax authorities may seek to apply the provisions of the 2012 Finance Act to these prior transactions and seek to tax us directly or as a withholding agent or representative assessee of the sellers involved in prior acquisitions. We believe that the 2012 Finance Act does not apply to these prior acquisitions and that we have strong defenses against any claims that might be raised by the Indian tax authorities. The U.K. Finance (No 2) Act 2017 was passed into law on 16 November 2017, enacting measures deferred from the Finance Act 2017-19. The legislation imposes, with effect from 1 April 2017, restrictions on the utilization of prior period losses against current period profits and limitations on interest deductions. We do not expect there to be a material impact on our financial statements as a result of this legislation. Business Combinations We account for the acquisition of a business using the acquisition method of accounting, which requires us to estimate the fair values of the assets acquired and liabilities assumed. This includes acquired intangible assets such as customer-related intangibles, the liabilities assumed and contingent consideration, if any. Liabilities assumed may include litigation and other contingency reserves existing at the time of acquisition and require judgment in ascertaining the related fair values. Independent appraisals may be used to assist in the determination of the fair value of certain assets and liabilities. Such appraisals are based on significant estimates provided by us, such as forecasted revenues or profits utilized in determining the fair value of contract-related acquired intangible assets or liabilities. Significant changes in assumptions and estimates subsequent to completing the allocation of the purchase price to the assets and liabilities acquired, as well as differences in actual and estimated results, could result in material impacts to our financial results. Adjustments to the fair value of contingent consideration are recorded in earnings. Additional information related to the acquisition date fair value of acquired assets and liabilities obtained during the allocation period, not to exceed one year, may result in changes to the recorded values of acquired assets and liabilities, resulting in an offsetting adjustment to the goodwill associated with the business acquired. Defined Benefit Plans The computation of our pension and other post-retirement benefit costs and obligations is dependent on various assumptions. Inherent in the application of the actuarial methods are key assumptions, including discount rates, expected long-term rates of return on plan assets, mortality rates, rates of compensation increases and medical cost trend rates. Our management evaluates these assumptions annually and updates assumptions as necessary. The fair value of assets is determined based on observable inputs for similar assets or on significant unobservable inputs if not available. Two of the most significant assumptions are the expected long-term rate of return on plan assets and the discount rate. Our weighted average rates used were: The assumption for the expected long-term rate of return on plan assets is impacted by the expected asset mix of the plan; judgments regarding the correlation between historical excess returns and future excess returns and expected investment expenses. The discount rate assumption is based on current market rates for high-quality, fixed income debt instruments with maturities similar to the expected duration of the benefit payment period. The following table provides the impact changes in the weighted-average assumptions would have had on our net periodic pension benefits and settlement and contractual termination charges for fiscal 2018: Valuation of Assets We review long-lived ("assets, intangible assets, and goodwill") for impairment in accordance with our accounting policy disclosed in Note 1 - Summary of Significant Accounting Policies. Assessing the fair value of assets involves significant estimates and assumptions including estimation of future cash flows, the timing of such cash flows, and discount rates reflecting the risk inherent in projecting future cash flows. The valuation of long-lived and intangible assets involves management estimates about future values and remaining useful lives of assets, particularly purchased intangible assets. These estimates are subjective and can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and forecasts. Evaluation of goodwill for impairment requires judgment, including the identification of reporting units, assignment of assets, liabilities, and goodwill to reporting units and determination of the fair value of each reporting unit. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions include a significant change in the business climate, established business plans, operating performance indicators or competition which could materially affect the determination of fair value for each reporting unit. We estimate the fair value of our reporting units using a combination of an income approach, utilizing a discounted cash flow analysis, and a market approach, using market multiples. The discount rate used in an income approach is based on our weighted-average cost of capital and may be adjusted for the relevant risks associated with business-specific characteristics and any uncertainty related to a reporting unit's ability to execute on the projected future cash flows.

<s>[INST] The purpose of the MD&A is to present information that management believes is relevant to an assessment and understanding of our results of operations and cash flows for the fiscal year ended March 31, 2018 and our financial condition as of March 31, 2018. The MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and notes. The MD&A is organized in the following sections: Background Results of Operations Liquidity and Capital Resources OffBalance Sheet Arrangements Contractual Obligations Critical Accounting Policies and Estimates Background DXC was formed by the combination of CSC and HPES on April 1, 2017. We are the world's leading independent, endtoend IT services company, serving nearly 6,000 private and publicsector clients from a diverse array of industries across 70 countries. Our technology independence, global talent and extensive partner network deliver transformative digital offerings and solutions that help clients harness the power of innovation to thrive on change. We generate revenue by offering a wide range of information technology services and solutions primarily in North America, Europe, Asia and Australia. We operate through three segments: GBS, GIS and USPS. We market and sell our services directly to clients through our direct sales force operating out of sales offices around the world. Our clients include commercial businesses of many sizes and in many industries and public sector enterprises. Results of Operations In connection with the HPES Merger, CSC was deemed the accounting acquirer of HPES for accounting purposes under GAAP, therefore, CSC is considered DXC's predecessor and the historical financial statements of CSC prior to April 1, 2017, are reflected herein as DXC's historical financial statements. Accordingly, the financial results of DXC as of and for any periods ending prior to April 1, 2017 do not include the financial results of HPES, and therefore, are not directly comparable. Additionally, CSC used to report its results based on a fiscal year convention that comprises four thirteenweek quarters. However, effective April 1, 2017, DXC's fiscal year was modified to end on March 31 of each year with each quarter ending on the last calendar day. In an effort to provide investors with additional information, the following discussion includes certain comparisons of our results of operations for the fiscal year ended March 31, 2018 to our pro forma results of operations for the fiscal year ended March 31, 2017. Our pro forma results of operations for the fiscal year ended March 31, 2017 are based upon the historical statements of operations of each of CSC and HPES, giving effect to the HPES Merger as if it had been consummated on April 2, 2016. CSC reported its results based on a fiscal year convention that comprised four thirteenweek quarters. HPES reported its results on a fiscal year basis ended October 31. As a consequence of CSC and HPES having different fiscal yearend dates, all references to the unaudited pro forma statement of operations include the results of operations of CSC for the fiscal year ended March 31, 2017 and of HPES for the fiscal year ended January 31, 2017. See "Unaudited Pro Forma Combined Statement of Operations" below for additional information. The following table sets forth certain financial data for fiscal 2018, 2017 and 2016: Fiscal 2018 Highlights During fiscal 2018, we surpassed our first year HPES Merger integration milestones, delivering over $1 billion of year one cost takeout. The additional savings were primarily driven by workforce optimization actions including the acceleration of management reductions and the global deployment of our automation program, Bionix. These ongoing cost actions address both internal labor, as well as third party contractors. We further enhanced our workforce management processes to costeffectively deliver existing business while staffing the required labor for new business. We also executed on several initiatives to optimize nonlabor spend, including ongoing rate negotiations, vendor consolidation, demand management, reductions [/INST] Negative. </s>

DXC Technology Co

2019-06-13

2019-03-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction The purpose of the MD&A is to present information that management believes is relevant to an assessment and understanding of our results of operations and cash flows for the fiscal year ended March 31, 2019 and our financial condition as of March 31, 2019. The MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and notes. The MD&A is organized in the following sections: • Background • Results of Operations • Liquidity and Capital Resources • Off-Balance Sheet Arrangements • Contractual Obligations • Critical Accounting Policies and Estimates The following discussion includes a comparison of our results of operations and liquidity and capital resources for fiscal 2019 and fiscal 2018. A discussion of changes in our results of operations from fiscal 2017 to fiscal 2018 may be found in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Exhibit 99.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on August 16, 2018. Background As the world's leading independent, end-to-end IT services company, DXC leads digital transformations for clients by modernizing and integrating their mainstream IT, and by deploying digital solutions at scale to produce better business outcomes. The company’s technology independence, global talent, and extensive partner network enable 6,000 private and public-sector clients in 70 countries to thrive on change. DXC is a recognized leader in corporate responsibility. We generate revenue by offering a wide range of information technology services and solutions primarily in North America, Europe, Asia and Australia. We operate through two segments: GBS and GIS. We market and sell our services directly to clients through our direct sales force operating out of sales offices around the world. Our clients include commercial businesses of many sizes and in many industries and public sector enterprises. Results of Operations The following table sets forth certain financial data for fiscal 2019 and 2018: Fiscal 2019 Highlights Fiscal 2019 financial highlights include the following: • Fiscal 2019 revenues were $20,753 million. • Fiscal 2019 income from continuing operations and diluted EPS from continuing operations were $1,227 million and $4.35, respectively, including the cumulative impact of certain items of $1,125 million, or $3.99 per share, reflecting restructuring costs, transaction, separation and integration-related costs, amortization of acquired intangible assets, pension and other post-retirement benefit ("OPEB") actuarial and settlement losses and a tax adjustment related to U.S. tax reform. • Our cash and cash equivalents were $2,899 million at March 31, 2019. • We generated $1,783 million of cash from operations during fiscal 2019. • We returned $1,549 million to shareholders in the form of common stock dividends and share repurchases during fiscal 2019. Revenues The decrease in revenues for fiscal 2019 compared with fiscal 2018 reflects an ongoing decline in our traditional application maintenance business and legacy infrastructure services. Fiscal 2019 revenues included an unfavorable foreign currency exchange rate impact of 1.6%, primarily driven by the strengthening of the U.S. dollar against the Euro and British Pound. During fiscal 2019 and fiscal 2018, the distribution of our revenues across geographies was as follows: For a discussion of risks associated with our foreign operations, see Part I, Item 1A "Risk Factors" of this Annual Report. As a global company, approximately 63% of our fiscal 2019 revenues were earned internationally. As a result, the comparison of revenues denominated in currencies other than the U.S. dollar from period to period is impacted, and we expect will continue to be impacted, by fluctuations in foreign currency exchange rates. Constant currency revenues are a non-GAAP measure calculated by translating current period activity into U.S. dollars using the comparable prior period’s currency conversion rates. This information is consistent with how management views our revenues and evaluates our operating performance and trends. The table below summarizes our constant currency revenues: Global Business Services Our GBS segment revenues were $8.7 billion for fiscal 2019, representing a decrease of $0.6 billion, or 6.2%, compared to fiscal 2018. The revenue decline included an unfavorable foreign currency exchange rate impact of $0.1 billion, or 1.5%. GBS revenues in constant currency were $8.8 billion for fiscal 2019, representing a decrease of $0.4 billion, or 4.7%. The decrease in GBS revenue in fiscal 2019 reflects a decline in the traditional application maintenance and management business and includes the impact of accelerated cloud adoption. Global Infrastructure Services Our GIS segment revenues were $12.1 billion for fiscal 2019, representing a decrease of $0.4 billion, or 3.3%, compared to fiscal 2018. The revenue decline included an unfavorable foreign currency exchange rate impact of $0.2 billion, or 1.7%.GIS revenues in constant currency were $12.3 billion for fiscal 2019, representing a decrease of $0.2 billion, or 1.6%. The decrease in GIS revenue in fiscal 2019 reflects the ongoing migration out of legacy infrastructure environments, partially offset by growth in our cloud infrastructure and digital workplace offerings. During fiscal 2019, GBS and GIS had contract awards of $9.3 billion and $11.4 billion, respectively, compared with $10.2 billion and $11.6 billion, respectively, during fiscal 2018. Costs and Expenses Our total costs and expenses were as follows: The 1.3% improvement in costs and expenses, as a percentage of revenue for fiscal 2019, reflects continued execution of our synergy initiatives, including workforce optimization, supply chain efficiencies and rationalization of our real estate footprint. Costs of Services Cost of services (excluding depreciation and amortization and restructuring costs) ("COS"), was $14.9 billion for fiscal 2019, as compared to $16.3 billion for fiscal 2018. COS decreased $1.4 billion, and as a percentage of revenue decreased 2.9%, compared to fiscal 2018. This decrease was driven by headcount reduction and procurement efficiencies. Employee labor costs, as a percentage of revenue, decreased in both segments and across our geographic regions, year-over-year. Selling, General and Administrative Selling (general and administrative expense, excluding depreciation and amortization and restructuring costs) ("SG&A"), was $2.0 billion for fiscal 2019, as compared to $1.9 billion for fiscal 2018. SG&A increased $0.1 billion, and as a percentage of revenue increased 0.7%, compared to fiscal 2018. The increase in SG&A reflects an increase in integration, separation, and transaction-related costs and allocated worldwide support costs. Integration, separation and transaction-related costs, included in SG&A, were $401 million during fiscal 2019, as compared to $359 million during fiscal 2018. Depreciation and Amortization Depreciation and amortization expense ("D&A") was $2.0 billion for fiscal 2019, compared to $1.8 billion for fiscal 2018. The increase in D&A was primarily due to an increase in depreciation expense from leased equipment and an increase in amortization expense related to accelerated transition and transformation contract costs as compared to fiscal 2018. Restructuring Costs Restructuring costs represent severance related to workforce optimization programs and expense associated with facilities and data center rationalization. During fiscal 2019 we initiated certain restructuring actions across our segments and geographies. The fiscal 2019 global cost savings initiatives were designed to better align our organizational structure with our strategic initiatives and continue the integration of HPES and other acquisitions. Total restructuring costs recorded, net of reversals, during fiscal 2019 and 2018 were $465 million and $789 million, respectively. The net amounts recorded included $2 million and $13 million of pension benefit augmentations for fiscal 2019 and 2018, respectively, owed to certain employees under legal or contractual obligations. These augmentations will be paid as part of normal pension distributions over several years. See Note 20 - "Restructuring Costs" for additional information about our restructuring actions. Interest Expense and Interest Income Interest expense for fiscal 2019 was $334 million as compared to $320 million in fiscal 2018. Interest income for fiscal 2019 was $128 million, as compared to $89 million in fiscal 2018. The year-over-year increase in interest expense and interest income was primarily due to our cash pool arrangements. The increase in cash pool expense was partially offset by a decrease in interest expense related to our borrowings. Other Income, Net Other income, net includes non-service cost components of net periodic pension income, movement in foreign currency exchange rates on our foreign currency denominated assets and liabilities and the related economic hedges, equity earnings of unconsolidated affiliates, gain on sale of non-operating assets and other miscellaneous gains and losses. The components of other income, net for fiscal 2019 and fiscal 2018 are as follows: The $287 million decrease in other income for fiscal 2019 was due to a year-over-year decrease of $327 million in non-service components of net periodic pension income and a year-over-year unfavorable foreign currency impact of $102 million resulting primarily from a gain recognized as a result of a change in the functional currency of a European holding company during fiscal 2018, which was not present in the current fiscal year. These decreases were partially offset by a $142 million increase in other gains primarily due to sales of non-operating assets during fiscal 2019. Taxes Our effective tax rate ("ETR") on income (loss) from continuing operations, before taxes, for fiscal 2019 and 2018 was 19.0% and (18.6)% respectively. A reconciliation of the differences between the U.S. federal statutory rate and the ETR, as well as other information about our income tax provision, is provided in Note 11 - "Income Taxes." In fiscal 2019, the ETR was primarily impacted by: • Local tax losses on investments in Luxembourg that decreased the foreign tax rate differential and decreased the ETR by $360 million and 23.7%, respectively, with an offsetting increase in the ETR due to an increase in the valuation allowance of the same amount. • A change in the net valuation allowance on certain deferred tax assets, primarily in Luxembourg, Germany, Spain, UK, and Switzerland, which increased income tax expense and increased the ETR by $256 million and 16.9%, respectively. • A decrease in the transition tax liability and a change in tax accounting method for deferred revenue, which decreased income tax expense and decreased the ETR by $66 million and 4.3%, respectively. In fiscal 2018, the ETR was primarily impacted by: • Due to the Company's change in repatriation policy, the reversal of a deferred tax liability relating to the outside basis difference of foreign subsidiaries which increased the income tax benefit and decreased the ETR by $554 million and 42.5%, respectively. • The accrual of the one-time transition tax on estimated unremitted foreign earnings, which decreased the income tax benefit and increased the ETR by $361 million and 27.7%, respectively. • The remeasurement of deferred tax assets and liabilities, which increased the income tax benefit and decreased the ETR by $338 million and 25.9%, respectively. As of March 31, 2018, our net deferred tax assets in certain DXC German entities were primarily the result of net operating loss carryforwards, pension, restructuring, and other miscellaneous accruals. A full valuation allowance was recorded against these net deferred tax assets as of that reporting date. For the period ended December 31, 2018 management determined that the positive evidence, including the duration of the current profitability due to realization of cost synergies relating to the HPES merger, a legal entity restructuring allowing the future utilization of net operating loss carryforwards and the nonrecurring nature of the factors that primarily drove historical losses outweighs the negative evidence of a three-year cumulative loss. Therefore, as of December 31, 2018, management had a change in judgment and concluded that it is now more likely than not that the net deferred tax assets in these DXC German entities will be fully utilized. As a result, we have recorded a valuation allowance release of $113 million. As of March 31, 2019, management had no change in our conclusions regarding the positive and negative evidence and future realizability of these DXC German entities' deferred tax assets. The IRS is examining CSC's federal income tax returns for fiscal 2008 through 2017. With respect to CSC's fiscal 2008 through 2010 federal tax returns, we previously entered into negotiations for a resolution through settlement with the IRS Office of Appeals. The IRS examined several issues for this audit that resulted in various audit adjustments. We have an agreement in principle with the IRS Office of Appeals as to some but not all of these adjustments. We have agreed to extend the statute of limitations associated with this audit through November 30, 2019. In addition, during the first quarter of fiscal 2018, we received a Revenue Agent’s Report with proposed adjustments to CSC's fiscal 2011 through 2013 federal returns. We have filed a protest of certain of these adjustments to the IRS Office of Appeals. The IRS is also examining CSC's fiscal 2014 through 2017 federal income tax returns. We have not received any proposed adjustments for this cycle. We continue to believe that our tax positions are more likely than not sustainable and that we will ultimately prevail. The Company now expects to reach a resolution for all years no earlier than fiscal 2021. In addition, we may settle certain other tax examinations, have lapses in statutes of limitations, or voluntarily settle income tax positions in negotiated settlements for different amounts than we have accrued as uncertain tax positions. We may need to accrue and ultimately pay additional amounts for tax positions that previously met a more likely than not standard if such positions are not upheld. Conversely, we could settle positions by payment with the tax authorities for amounts lower than those that have been accrued or extinguish a position through payment. We believe the outcomes that are reasonably possible within the next twelve months may result in a reduction in liability for uncertain tax positions of $9 million, excluding interest, penalties, and tax carryforwards. Income from Discontinued Operations Income from discontinued operations reflects the net income generated by USPS. As the Separation occurred on May 31, 2018, there are only two months of USPS results included in fiscal 2019. Earnings Per Share Diluted EPS from continuing operations for fiscal 2019 was $4.35, a decrease of $0.88 per share compared with the prior fiscal year. The EPS decrease was due to a decrease of $319 million in income from continuing operations. Diluted EPS for fiscal 2019 includes $1.25 per share of restructuring costs, $1.06 per share of transaction, separation and integration-related costs, $1.42 per share of amortization of acquired intangible assets, $0.41 per share of pension and OPEB actuarial and settlement losses and $(0.16) per share of tax adjustment related to U.S. tax reform. Non-GAAP Financial Measures We present non-GAAP financial measures of performance which are derived from the statements of operations of DXC. These non-GAAP financial measures include earnings before interest and taxes ("EBIT"), adjusted EBIT, non-GAAP income before income taxes, non-GAAP net income and non-GAAP EPS, constant currency revenues and net debt-to-total capitalization. We present these non-GAAP financial measures to provide investors with meaningful supplemental financial information, in addition to the financial information presented on a GAAP basis. Non-GAAP financial measures exclude certain items from GAAP results which DXC management believes are not indicative of core operating performance. DXC management believes these non-GAAP measures allow investors to better understand the financial performance of DXC exclusive of the impacts of corporate-wide strategic decisions. DXC management believes that adjusting for these items provides investors with additional measures to evaluate the financial performance of our core business operations on a comparable basis from period to period. DXC management believes the non-GAAP measures provided are also considered important measures by financial analysts covering DXC, as equity research analysts continue to publish estimates and research notes based on our non-GAAP commentary, including our guidance around non-GAAP EPS targets. There are limitations to the use of the non-GAAP financial measures presented in this report. One of the limitations is that they do not reflect complete financial results. We compensate for this limitation by providing a reconciliation between our non-GAAP financial measures and the respective most directly comparable financial measure calculated and presented in accordance with GAAP. Additionally, other companies, including companies in our industry, may calculate non-GAAP financial measures differently than we do, limiting the usefulness of those measures for comparative purposes between companies. Non-GAAP financial measures and the respective most directly comparable financial measures calculated and presented in accordance with GAAP include: Reconciliation of Non-GAAP Financial Measures Our non-GAAP adjustments include: • Restructuring - reflects costs, net of reversals, related to workforce optimization and real estate charges. • Transaction, separation and integration-related costs - reflects costs related to integration planning, financing and advisory fees associated with the HPES Merger and other acquisitions and costs related to the separation of USPS. • Amortization of acquired intangible assets - reflects amortization of intangible assets acquired through business combinations. • Pension and OPEB actuarial and settlement gains and losses - reflects pension and OPEB actuarial and settlement gains and losses. • Tax adjustment - reflects the estimated non-recurring benefit of the Tax Cuts and Jobs Act of 2017 for fiscal 2019 and the application of an approximate 28% tax rate for fiscal 2018, which is within the targeted effective tax rate range for the prior year. A reconciliation of reported results to non-GAAP results is as follows: * The net periodic pension cost within income from continuing operations includes $700 million of actual return on plan assets, whereas the net periodic pension cost within non-GAAP income from continuing operations includes $570 million of expected long-term return on pension assets of defined benefit plans subject to interim remeasurement. * The net periodic pension cost within income from continuing operations includes $371 million of actual return on plan assets, whereas the net periodic pension cost within non-GAAP income from continuing operations includes $534 million of expected long-term return on pension assets of defined benefit plans subject to interim remeasurement. Reconciliations of net income to adjusted EBIT and pro forma adjusted EBIT are as follows: Liquidity and Capital Resources Cash and Cash Equivalents and Cash Flows As of March 31, 2019, our cash and cash equivalents ("cash") were $2.9 billion, of which $1.4 billion was held outside of the United States. A substantial portion of funds can be returned to the U.S. from funds advanced previously to finance our foreign acquisition initiatives. As a result of the Tax Cuts and Jobs Act of 2017, and after the mandatory one-time income inclusion (deemed repatriation) of the historically untaxed earnings of our foreign subsidiaries and current income inclusions for global intangible low taxed income, we expect a significant portion of the cash held by our foreign subsidiaries will no longer be subject to U.S. federal income tax consequences upon subsequent repatriation to the U.S. However, a portion of this cash may still be subject to foreign income tax consequences upon future remittance. Therefore, if additional funds held outside the U.S. are needed for our operations in the U.S. we plan to repatriate these funds. Cash and cash equivalents increased $0.3 billion during fiscal 2018 to $2.9 billion, primarily due to changes in operating activities. The cash flows of USPS have not been segregated and are included in the statements of cash flows for the fiscal year ended March 31, 2018 and through the separation date of May 31, 2018 in the statements of cash flows for the fiscal year ended March 31, 2019. The following table summarizes our cash flow activity: Operating cash flow Net cash provided by operating activities during fiscal 2019 was $1,783 million as compared to $2,567 million during fiscal 2018. The decrease of $784 million was predominately due to a decrease in net income of $520 million, a change in net accounts receivables of $483 million, and other working capital. This was partially offset by additional deferred tax adjustments of $939 million. Net cash provided by operating activities during fiscal 2018 was $2,567 million as compared to $619 million during fiscal 2017. The increase of $1,948 million was predominately due to an increase in net income of $1,882 million. The increase in cash provided by operating activities during fiscal 2018 was partially offset by additional deferred tax adjustments to operating activities of $842 million and an increase in the gain on pension and other post-employment benefits of $307 million. Investing cash flow Net cash provided by investing activities during fiscal 2019 decreased $650 million to $69 million. The decrease was due to net cash provided by acquisitions of $735 million during fiscal 2018, compared with cash paid for acquisitions of $365 million during fiscal 2019. In addition, there was an increase in cash payments for outsourcing contract costs of $66 million, software purchases of $50 million and purchase of property and equipment of $73 million. The decrease in net cash provided by investing activities was offset by additional proceeds from sale of assets of $299 million and cash collections from deferred purchase price receivables of $399 million. Net cash provided by (used in) investing activities during fiscal 2018 was $719 million as compared to $(565) million for fiscal 2017. The increase was predominantly due to net cash provided by acquisitions of $735 million during fiscal 2018, compared with cash paid for acquisitions of $434 million during fiscal 2017. The increase in net cash provided by (used in) investing activities was partially offset by an increase in cash payments for outsourcing contract costs of $227 million and software purchases of $71 million. Financing cash flow Net cash used in financing activities during fiscal 2019 was $1,663 million, as compared to $1,890 million during fiscal 2018. The $227 million decrease in net cash used in financing activities was primarily due to repayments of $737 million in fiscal 2018, which did not recur in the current year, additional draws on long-term debt of $1,025 million, and borrowings of $1,114 million for the USPS Separation. This was partially offset by additional payments on long-term debt obligations of $1,078 million, repurchases of common stock of $1,212 million, and a decrease in cash proceeds from bond issuance of $236 million. Net cash (used in) provided by financing activities during fiscal 2018 was $(1,890) million, as compared to $93 million during fiscal 2017. The $1,983 million increase in net cash used by financing activities was primarily due to a decrease in credit facility draws, net of repayments of $868 million, additional payments on capitalized lease obligations of $915 million, additional payments on long-term debt obligations of $1,379 million and $132 million in payments for repurchases of common stock. These cash outflows were partially offset by draws on long-term debt of $462 million and cash proceeds from bond issuance of $989 million. Capital Resources See Note 21 - "Commitments and Contingencies" for a discussion of the general purpose of guarantees and commitments. The anticipated sources of funds to fulfill such commitments are listed below and under the subheading "Liquidity." The following table summarizes out total debt: The $0.6 billion decrease in total debt during fiscal 2019 was primarily attributed to the repayment of $899 million principal amount of the USD term loan due 2022. This debt repayment was financed from the cash payment received from Perspecta in connection with the Separation. During fiscal 2019, we completed a senior note offering in an aggregate principal of €650 million due 2026 and entered into term loan credit agreements in aggregate principal amounts of £450 million maturing in fiscal 2022 and AUD 800 million maturing in fiscal 2021. The proceeds of these credit facilities were used to repay debt and for general corporate purposes. Also, we amended our commercial paper program to issue short-term commercial paper notes up to a maximum aggregate amount outstanding at any time of €1 billion or its equivalent in U.S. dollars. Additionally, during fiscal 2019, we entered into a term loan credit agreement consisting of three tranches (the "delayed draw term loan"): (i) $500 million maturing five years following the funding date; (ii) €750 million maturing two years following the funding date; and (iii) €750 million maturing three years following the funding date. The proceeds of this term loan will be used to finance in part the acquisition of Luxoft and for general corporate purposes. The term loan is undrawn as of March 31, 2019. We were in compliance with all financial covenants associated with our borrowings as of March 31, 2019 and March 31, 2018. The maturity chart below summarizes the future maturities of long-term debt principal for fiscal years subsequent to March 31, 2019 and excludes maturities of borrowings for assets acquired under long-term financing and capitalized lease liabilities. For more information on our debt, see Note 12 - "Debt" to the financial statements. The following table summarizes our capitalization ratios: (1) Net debt and Net debt-to-total capitalization are non-GAAP measures used by management to assess our ability to service our debts using only our cash and cash equivalents. We present these non-GAAP measures to assist investors in analyzing our capital structure in a more comprehensive way compared to gross debt based ratios alone. The decrease in net debt-to-total capitalization was due to a $0.9 billion decrease in net debt, attributed to a $0.6 billion decrease in total debt. The decrease in net debt was partially offset by a $2.1 billion decrease in equity resulting primarily from the Separation of USPS and share repurchases. As of March 31, 2019, our credit ratings were as follows: Subsequent to the January 2019 announcement by DXC and Luxoft of a definitive agreement for DXC to acquire Luxoft, Fitch, Moody's and S&P affirmed their ratings and outlook for DXC. See Note 21 - "Commitments and Contingencies" for a discussion of the general purpose of guarantees and commitments. The anticipated sources of funds to fulfill such commitments are listed below. Liquidity We expect our existing cash and cash equivalents, together with cash generated from operations, will be sufficient to meet our normal operating requirements for the next 12 months. We expect to continue using cash generated by operations as a primary source of liquidity; however, should we require funds greater than that generated from our operations to fund discretionary investment activities, such as business acquisitions, we have the ability to draw on our multi-currency revolving credit facility or raise capital through the issuance of capital market debt instruments such as commercial paper, term loans, and bonds. In addition, we currently utilize, and will further utilize, our cross currency cash pool for liquidity needs. However, there is no guarantee that we will be able to obtain debt financing, if required, on terms and conditions acceptable to us, if at all, in the future. Our exposure to operational liquidity risk is primarily from long-term contracts which require significant investment of cash during the initial phases of the contracts. The recovery of these investments is over the life of the contract and is dependent upon our performance as well as customer acceptance. The following table summarizes our total liquidity: Share Repurchases During fiscal 2018, our Board of Directors authorized the repurchase of up to $2.0 billion of our common stock and on November 8, 2018, we announced that our Board of Directors had approved an incremental $2.0 billion share repurchase authorization. An expiration date has not been established for this repurchase plan. During fiscal 2019, we repurchased 19,342,586 shares of our common stock at an aggregate cost of $1,339 million. Dividends During fiscal 2019, our Board of Directors declared aggregate cash dividends to our stockholders of $0.76 per share, or approximately $209 million. Future dividends are subject to customary board review and approval prior to declaration. Off-Balance Sheet Arrangements In the normal course of business, we are a party to arrangements that include guarantees, the receivables securitization facility and certain other financial instruments with off-balance sheet risk, such as letters of credit and surety bonds. We also use performance letters of credit to support various risk management insurance policies. No liabilities related to these arrangements are reflected in balance sheets. See Note 5 - "Receivables" and Note 21 - "Commitments and Contingencies" for additional information regarding these off-balance sheet arrangements. Contractual Obligations Our contractual obligations as of March 31, 2019, were as follows: (1) Amounts represent scheduled principal payments of long-term debt and mandatory redemption of preferred stock of a consolidated subsidiary. (2) Includes long-term purchase agreements with certain software, hardware, telecommunication and other service providers and exclude agreements that are cancelable without penalty. If we do not meet the specified service minimums, we may have an obligation to pay the service provider a portion of or the entire shortfall. (3) The transition tax, which has now been determined to be complete, resulted in recording a total transition tax obligation of $316 million, of which $324 million was recorded as income tax liability and $(8) million recorded as a reduction in our unrecognized tax benefits, which has been omitted from this table. The transition tax is payable over eight years; 8% of net tax liability in each of years 1-5, 15% in year 6, 20% in year 7, and 25% in year 8. We have made our first payment. See Note 11 - "Income Taxes" for additional information about the transition tax. (4) Amounts represent scheduled interest payments on long-term debt and scheduled dividend payments associated with the mandatorily redeemable preferred stock of a consolidated subsidiary excluding contingent dividends associated with the participation and variable appreciation premium features. (5) See Note 13 - "Pension and Other Benefit Plans" for the estimated liability related to estimated future benefit payments under our Pension and OPEB plans that have been omitted from this table. Critical Accounting Policies and Estimates The preparation of financial statements, in accordance with GAAP, requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities. These estimates may change in the future if underlying assumptions or factors change. Accordingly, actual results could differ materially from our estimates under different assumptions, judgments or conditions. We consider the following policies to be critical because of their complexity and the high degree of judgment involved in implementing them: revenue recognition, income taxes, business combinations, defined benefit plans and valuation of assets. We have discussed the selection of our critical accounting policies and the effect of estimates with the audit committee of our board of directors. Revenue Recognition Most of our revenues are recognized based on objective criteria and do not require significant estimates that may change over time. However, some arrangements may require significant estimates, including contracts which include multiple performance obligations. Contracts with Multiple performance obligations Many of our contracts require us to provide a range of services or performance obligations to our customers, which may include a combination of services, products or both. As a result, significant judgment may be required to determine the appropriate accounting, including whether the elements specified in contracts with multiple performance obligations should be treated as separate performance obligations for revenue recognition purposes, and, when considered appropriate, how the total transaction price should be allocated among the performance obligations and the timing of revenue recognition for each. For contracts with multiple performance obligations, we allocate the contract’s transaction price to each performance obligation based on the relative standalone selling price of each distinct good or service in the contract. Other than software sales involving multiple performance obligations, the primary method used to estimate standalone selling price is the expected cost plus a margin approach, under which we forecast our expected costs of satisfying a performance obligation and then add an appropriate margin for that distinct good or service. Certain of our contracts involve the sale of DXC proprietary software, post contract customer support and other software-related services. The standalone selling price generally is determined for each performance obligation using an adjusted market assessment approach based on the price charged where each deliverable is sold separately. In certain limited cases (typically for software licenses) when the historical selling price is highly variable, the residual approach is used. This approach allocates revenue to the performance obligation equal to the difference between the total transaction price and the observable standalone selling prices for the other performance obligations. These methods involve significant judgments and estimates that we assess periodically by considering market and entity-specific factors, such as type of customer, features of the products or services and market conditions. Once the total revenues have been allocated to the various performance obligations, revenues for each are recognized based on the relevant revenue recognition method for each. Estimates of total revenues at contract inception often differ materially from actual revenues due to volume differences, changes in technology or other factors which may not be foreseen at inception. Costs to obtain contracts with customers Accounting for the costs to obtain contracts with customers requires significant judgments and estimates with regards to the determination of sales commission payments that qualify for deferral of costs and the related amortization period. Most of our sales commission plans are quota-based and payments are made by achieving targets related to a large number of new and renewed contracts. Certain sales commissions earned by our sales force are considered incremental and recoverable costs of obtaining a contract with a customer. We defer and amortize these costs on a straight-line basis over an average period of benefit of five years, which is determined and regularly assessed by considering the length of our customer contracts, our technology and other factors. Significant changes in these estimates or impairment may result if material contracts terminate earlier than the expected benefit period, or if there are material changes in the average contract period. Income Taxes We are subject to income taxes in the United States (federal and state) and numerous foreign jurisdictions. Significant judgment is required in determining our provision for income taxes, analyzing our income tax reserves, the determination of the likelihood of recoverability of deferred tax assets and any corresponding adjustment of valuation allowances. In addition, our tax returns are routinely audited and settlements of issues raised in these audits sometimes affect our tax provisions. As a global enterprise, our ETR is affected by many factors, including our global mix of earnings among countries with differing statutory tax rates, the extent to which our non-U.S. earnings are indefinitely reinvested outside the U.S., changes in the valuation allowance for deferred tax assets, changes in tax regulations, acquisitions, dispositions and the tax characteristics of our income. We cannot predict what our ETR will be in the future because there is uncertainty regarding these factors. As a result of the Tax Cuts and Jobs Act (the "Act"), in the fiscal year ending March 31, 2018, we changed our ASC 740-30 assertion with respect to the remaining CSC foreign subsidiaries and no longer consider current and accumulated earnings for all non-U.S. subsidiaries permanently reinvested, except for current year Indian earnings. The $554 million deferred tax liability relating to HPES foreign subsidiaries was released and the $46 million liability for the India dividend distribution tax was reversed in the current period as the Company changed its reinvestment assertion relating to certain India earnings due to a change in cash requirements of the U.S. parent and India. Considerations impacting the recoverability of deferred tax assets include the period of expiration of the tax asset, planned use of the tax asset and historical and projected taxable income as well as tax liabilities for the tax jurisdiction to which the tax asset relates. In determining whether the deferred tax assets are realizable, we consider all available positive and negative evidence, including future reversals of existing taxable temporary differences, taxable income in prior carryback years, projected future taxable income, tax planning strategies and recent financial operations. We recorded a valuation allowance against deferred tax assets of approximately $1.6 billion as of March 31, 2019 due to uncertainties related to the ability to utilize these assets. However, valuation allowances are subject to change in future reporting periods due to changes in various factors. Changes in tax laws, such as the Act or changes in tax laws resulting from the Organization for Economic Co-operation and Development’s multi-jurisdictional plan of action to address “base erosion and profit shifting” could impact our effective tax rate. The calculation of our tax liabilities involves uncertainties in the application of complex changing tax regulations. As discussed in Note 11 - "Income Taxes", for example, the Act provides provisions that limit interest expense, provide for immediate expensing of qualified assets, further limits executive compensation deductions, generally eliminates Federal tax on foreign dividend distributions, subjects certain payments from U.S. corporations to foreign related parties to additional taxes, places restrictions or eliminates certain exclusions, deductions and credits and generally broadens the tax base. Further guidance for these provisions is forthcoming and the laws are subject to change in future periods. Business Combinations We account for the acquisition of a business using the acquisition method of accounting, which requires us to estimate the fair values of the assets acquired and liabilities assumed. This includes acquired intangible assets such as customer-related intangibles, the liabilities assumed and contingent consideration, if any. Liabilities assumed may include litigation and other contingency reserves existing at the time of acquisition and require judgment in ascertaining the related fair values. Independent appraisals may be used to assist in the determination of the fair value of certain assets and liabilities. Such appraisals are based on significant estimates provided by us, such as forecasted revenues or profits utilized in determining the fair value of contract-related acquired intangible assets or liabilities. Significant changes in assumptions and estimates subsequent to completing the allocation of the purchase price to the assets and liabilities acquired, as well as differences in actual and estimated results, could result in material impacts to our financial results. Adjustments to the fair value of contingent consideration are recorded in earnings. Additional information related to the acquisition date fair value of acquired assets and liabilities obtained during the allocation period, not to exceed one year, may result in changes to the recorded values of acquired assets and liabilities, resulting in an offsetting adjustment to the goodwill associated with the business acquired. Defined Benefit Plans The computation of our pension and other post-retirement benefit costs and obligations is dependent on various assumptions. Inherent in the application of the actuarial methods are key assumptions, including discount rates, expected long-term rates of return on plan assets, mortality rates, rates of compensation increases and medical cost trend rates. Our management evaluates these assumptions annually and updates assumptions as necessary. The fair value of assets is determined based on observable inputs for similar assets or on significant unobservable inputs if not available. Two of the most significant assumptions are the expected long-term rate of return on plan assets and the discount rate. Our weighted average rates used were: The assumption for the expected long-term rate of return on plan assets is impacted by the expected asset mix of the plan; judgments regarding the correlation between historical excess returns and future excess returns and expected investment expenses. The discount rate assumption is based on current market rates for high-quality, fixed income debt instruments with maturities similar to the expected duration of the benefit payment period. The following table provides the impact changes in the weighted-average assumptions would have had on our net periodic pension benefits and settlement and contractual termination charges for fiscal 2019: Valuation of Assets We review long-lived ("assets, intangible assets, and goodwill") for impairment in accordance with our accounting policy disclosed in Note 1 - Summary of Significant Accounting Policies. Assessing the fair value of assets involves significant estimates and assumptions including estimation of future cash flows, the timing of such cash flows, and discount rates reflecting the risk inherent in projecting future cash flows. The valuation of long-lived and intangible assets involves management estimates about future values and remaining useful lives of assets, particularly purchased intangible assets. These estimates are subjective and can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and forecasts. Evaluation of goodwill for impairment requires judgment, including the identification of reporting units, assignment of assets, liabilities, and goodwill to reporting units and determination of the fair value of each reporting unit. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions include a significant change in the business climate, established business plans, operating performance indicators or competition which could materially affect the determination of fair value for each reporting unit. We estimate the fair value of our reporting units using a combination of an income approach, utilizing a discounted cash flow analysis, and a market approach, using market multiples. The discount rate used in an income approach is based on our weighted-average cost of capital and may be adjusted for the relevant risks associated with business-specific characteristics and any uncertainty related to a reporting unit's ability to execute on the projected future cash flows.

<s>[INST] The purpose of the MD&A is to present information that management believes is relevant to an assessment and understanding of our results of operations and cash flows for the fiscal year ended March 31, 2019 and our financial condition as of March 31, 2019. The MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and notes. The MD&A is organized in the following sections: Background Results of Operations Liquidity and Capital Resources OffBalance Sheet Arrangements Contractual Obligations Critical Accounting Policies and Estimates The following discussion includes a comparison of our results of operations and liquidity and capital resources for fiscal 2019 and fiscal 2018. A discussion of changes in our results of operations from fiscal 2017 to fiscal 2018 may be found in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of Exhibit 99.1 to our Current Report on Form 8K filed with the Securities and Exchange Commission on August 16, 2018. Background As the world's leading independent, endtoend IT services company, DXC leads digital transformations for clients by modernizing and integrating their mainstream IT, and by deploying digital solutions at scale to produce better business outcomes. The company’s technology independence, global talent, and extensive partner network enable 6,000 private and publicsector clients in 70 countries to thrive on change. DXC is a recognized leader in corporate responsibility. We generate revenue by offering a wide range of information technology services and solutions primarily in North America, Europe, Asia and Australia. We operate through two segments: GBS and GIS. We market and sell our services directly to clients through our direct sales force operating out of sales offices around the world. Our clients include commercial businesses of many sizes and in many industries and public sector enterprises. Results of Operations The following table sets forth certain financial data for fiscal 2019 and 2018: Fiscal 2019 Highlights Fiscal 2019 financial highlights include the following: Fiscal 2019 revenues were $20,753 million. Fiscal 2019 income from continuing operations and diluted EPS from continuing operations were $1,227 million and $4.35, respectively, including the cumulative impact of certain items of $1,125 million, or $3.99 per share, reflecting restructuring costs, transaction, separation and integrationrelated costs, amortization of acquired intangible assets, pension and other postretirement benefit ("OPEB") actuarial and settlement losses and a tax adjustment related to U.S. tax reform. Our cash and cash equivalents were $2,899 million at March 31, 2019. We generated $1,783 million of cash from operations during fiscal 2019. We returned $1,549 million to shareholders in the form of common stock dividends and share repurchases during fiscal 2019. Revenues The decrease in revenues for fiscal 2019 compared with fiscal 2018 reflects an ongoing decline in our traditional application maintenance business and legacy infrastructure services. Fiscal 2019 revenues included an unfavorable foreign currency exchange rate impact of 1.6%, primarily driven by the strengthening of the U.S. dollar against the Euro and British Pound. During fiscal 2019 and fiscal 2018, the distribution of our revenues across geographies was as follows: For a discussion of risks associated with our foreign operations, see Part I, Item 1A "Risk Factors" of this Annual Report. As a global company, approximately 63% of our fiscal 2019 revenues were earned internationally. As a result, the comparison of revenues denominated in currencies other than the U.S. dollar from period to period is impacted, and we expect will continue to be impacted, by fluctuations in foreign currency exchange rates. Constant currency revenues are a nonGAAP measure calculated by translating current period [/INST] Positive. </s>

TKK SYMPHONY ACQUISITION Corp

2019-03-11

2018-12-31

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Special Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. When used in this Form 10-K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on February 5, 2018 as a Cayman Islands exempted company and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar Business Combination with one or more businesses. We intend to utilize cash derived from the proceeds of the Initial Public Offering, our securities, debt or a combination of cash, securities and debt in effecting a Business Combination. The issuance of additional shares in a Business Combination: ● may significantly reduce the equity interest of our shareholders; ● may subordinate the rights of holders of ordinary shares if we issue preferred shares with rights senior to those afforded to our ordinary shares; ● will likely cause a change in control if a substantial number of our ordinary shares are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and most likely will also result in the resignation or removal of our present officers and directors; and ● may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities, it could result in: ● default and foreclosure on our assets if our operating revenues after a Business Combination are insufficient to pay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if the debt security contains covenants that required the maintenance of certain financial ratios or reserves and we breach any such covenant without a waiver or renegotiation of that covenant; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; and ● our inability to obtain necessary additional financing if the debt contains covenants restricting our ability to obtain such financing while the debt security is outstanding; We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to raise capital or to complete a Business Combination will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from February 5, 2018 (inception) through December 31, 2018 were organizational activities, those necessary to consummate the Initial Public Offering, described below, and identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination. We generate non-operating income in the form of interest income on marketable securities. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the period from February 5, 2018 (inception) through December 31, 2018, we had net income of $1,609,139, which consists of interest income on marketable securities held in the Trust Account $1,947,244, offset by operating costs of $276,966 and an unrealized loss on marketable securities held in our Trust Account $61,139. Liquidity and Capital Resources On August 20 and 22, 2018, we consummated the Initial Public Offering of 22,000,000 Units and the sale of an additional 3,000,000 Units pursuant to the underwriters’ partial exercise of their over-allotment option at a price of $10.00 per Unit, generating aggregate gross proceeds of $250,000,000. Simultaneously with the closings of the Initial Public Offering and the sale of the additional Units, we consummated the sales of an aggregate of 13,000,000 Private Placement Warrants to Symphony Holdings Limited at a price of $0.50 per warrant, generating gross proceeds of $6,500,000. In connection with the Initial Public Offering and the private placement, a total of $250,000,000 was placed in the Trust Account. We incurred $5,744,938 in Initial Public Offering related costs, including $5,000,000 of underwriting fees and $744,938 of other costs. For the period from February 5, 2018 (inception) through December 31, 2018, cash used in operating activities was $373,068. Net income of $1,609,139 was affected by interest earned on marketable securities held in the Trust Account of $1,947,244, an unrealized loss on marketable securities held in our Trust Account of $61,139 and changes in our operating assets and liabilities, which used $96,102 of cash from operating activities. As of December 31, 2018, we had marketable securities held in the Trust Account of $251,886,105 (including approximately $1,886,000 of interest income, net of unrealized losses) consisting of U.S. treasury bills with a maturity of 180 days or less. Interest income on the balance in the Trust Account may be used by us to pay taxes. Through December 31, 2018, we did not withdraw any funds from the interest earned on the Trust Account. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account to acquire a target business or businesses and to pay our expenses relating thereto, including a cash fee equal to 3.5% of the gross proceeds of Initial Public Offering payable to the upon consummation of our Business Combination for assisting us in connection with such Business Combination. To the extent that our ordinary shares are used in whole or in part as consideration to effect our Business Combination, the remaining proceeds held in the Trust Account as well as any other net proceeds not expended will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our Business Combination if the funds available to us outside of the Trust Account were insufficient to cover such expenses. As of December 31, 2018, we had cash of $406,994 held outside of the Trust Account. We intend to use the funds held outside the Trust Account primarily to identify and evaluate prospective acquisition candidates, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses, review corporate documents and material agreements of prospective target businesses, select the target business to acquire and structure, negotiate and consummate a Business Combination. In order to fund working capital deficiencies or finance transaction costs in connection with a Business Combination, the initial shareholders, the Company’s officers and directors or their affiliates may, but are not obligated to (except as described herein), loan us funds as may be required. In the event that our Business Combination does not close, we may use a portion of the working capital held outside the Trust Account to repay such loaned amounts but no proceeds from our Trust Account would be used for such repayment. Up to $1,000,000 of such loans may be convertible into warrants at a price of $0.50 per warrant at the option of the lender. The warrants would be identical to the Private Placement Warrants issued to our Sponsor. We do not expect to seek loans from parties other than the initial shareholders, the Company’s officers and directors or their affiliates as we do not believe third parties will be willing to loan such funds and provide a waiver against any and all rights to seek access to funds in our Trust Account. In February 2019, the Sponsor committed to provide us an aggregate of $300,000 in loans. The loans, as well as any future loans that may be made by the Sponsor (or its affiliates), will be evidenced by notes and would either be repaid upon the consummation of a Business Combination or up to $1,000,000 of the notes may be converted into warrants at a price of $0.50 per warrant at the option of the lender. We have principally financed our operations from inception using proceeds from the sale of our equity securities to our shareholders prior to the Initial Public Offering and such amount of proceeds from the Initial Public Offering that were placed in an account outside of the Trust Account for working capital purposes. As of December 31, 2018, we had $406,994 in our operating bank accounts, $251,886,105 in securities held in the Trust Account to be used for a Business Combination or to repurchase or redeem our ordinary shares in connection therewith and working capital of $503,096. In addition, in February 2019, our Sponsor committed to provide us an aggregate of $300,000 in loans. The loans, as well as any future loans that may be made by our Sponsor (or its affiliates), will be evidenced by notes and would either be repaid upon the consummation of a Business Combination or up to $1,000,000 of the notes may be converted into warrants. Based on the foregoing, we believe we will have sufficient cash to meet our needs for the next twelve months following the date from when the financial statements are issued. Off-balance sheet financing arrangements We have no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of December 31, 2018. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay an affiliate of our Chief Executive Officer a monthly fee of $15,000 for general and administrative services, including office space, utilities and administrative services provided to the Company. We began incurring these fees on August 15, 2018 and will continue to incur these fees monthly until the earlier of the completion of the Business Combination and our liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have identified the following critical accounting policy: Ordinary shares subject to possible redemption We account for our ordinary shares subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Ordinary shares subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable ordinary shares (including ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. Our ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, at December 31, 2018, the ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of our balance sheets. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on our financial statements.

<s>[INST] All statements other than statements of historical fact included in this Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forwardlooking statements. When used in this Form 10K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or the Company’s management, identify forwardlooking statements. Such forwardlooking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forwardlooking statements that involve risks and uncertainties. Overview We are a blank check company incorporated on February 5, 2018 as a Cayman Islands exempted company and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar Business Combination with one or more businesses. We intend to utilize cash derived from the proceeds of the Initial Public Offering, our securities, debt or a combination of cash, securities and debt in effecting a Business Combination. The issuance of additional shares in a Business Combination: may significantly reduce the equity interest of our shareholders; may subordinate the rights of holders of ordinary shares if we issue preferred shares with rights senior to those afforded to our ordinary shares; will likely cause a change in control if a substantial number of our ordinary shares are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and most likely will also result in the resignation or removal of our present officers and directors; and may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities, it could result in: default and foreclosure on our assets if our operating revenues after a Business Combination are insufficient to pay our debt obligations; acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if the debt security contains covenants that required the maintenance of certain financial ratios or reserves and we breach any such covenant without a waiver or renegotiation of that covenant; our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; and our inability to obtain necessary additional financing if the debt contains covenants restricting our ability to obtain such financing while the debt security is outstanding; We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to raise capital or to complete a Business Combination will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from February 5, 2018 (inception) through December 31, 2018 were organizational activities, those necessary to consummate the Initial Public Offering, described below, and identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination. We generate nonoperating income in the form of interest income on marketable securities. We incur expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the period from February 5, 2018 (inception) through December 31, 2018, we had net income of $1,609,139, which consists of interest income on marketable securities held in the Trust Account $1,947,244, offset by operating costs of $276,966 and an unrealized loss on marketable securities held in our Trust Account $6 [/INST] Negative. </s>

GLORY STAR NEW MEDIA GROUP HOLDINGS Ltd

2020-03-31

2019-12-31

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Explanatory Note For the purpose this Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations, we are providing the historical information of TKK for the year ended December 31, 2019 and from February 5, 2018 (inception) through December 31, 2018. The Management’s Discussion and Analysis of Financial Conditions and Results of Operations for Glory Star can be found in our Current Report on Form 8-K/A (Amendment No. 2) concurrently filed with the SEC on March 31, 2020. Recent Developments Share Exchange Agreement On February 14, 2020, TKK consummated the Business Combination contemplated by the Share Exchange Agreement pursuant to which the Company acquired 100% of the equity interests of Glory Star from the Sellers. Upon closing of the Business Combination, the Company acquired all of the issued and outstanding securities of Glory Star in exchange for (i) approximately 41,204,025 of our ordinary shares (“Closing Payment Shares”), or one ordinary share for approximately 0.04854 outstanding shares of Glory Star, of which 2,060,201 of the Closing Payment Shares (the “Escrow Shares”) shall be deposited into escrow to secure certain indemnification obligations of the Sellers, plus (ii) earnout payments consisting of up to an additional 5,000,000 of our ordinary shares if we meet certain financial performance targets for the 2019 fiscal year, which we believe we have met, and an additional 5,000,000 of our ordinary shares if we meet certain financial performance targets for the 2020 fiscal year (the “Earnout Shares”). In the event that a financial performance target is not met for the 2019 fiscal year and/or 2020 fiscal year but we meet certain financial performance targets for the 2019 fiscal year and 2020 fiscal year combined, the Sellers will be entitled to receive any Earnout Shares that they otherwise did not receive (the “Alternative Earnout”). In connection with the Share Exchange Agreement: - TKK entered into a Registration Rights Agreement (“Registration Rights Agreement”) with the Sponsor and the Sellers pursuant to which TKK will grant certain registration rights to the Sellers with respect to the registration of the Closing Payment Shares and Earnout Shares. - TKK entered into a Lock-Up Agreement (“Lock-Up Agreement”) with certain Sellers that directly or indirectly own in excess of 10% of Glory Star Group equity prior to the Closing pursuant to which each Seller party thereto agreed that such Seller will not, during the period from the Closing and ending on the earlier of (i) with respect to 50% of the Closing Payment Shares (including Escrow Shares) and Earnout Shares (“Restricted Securities”), (x) the six month anniversary of the date of the Closing, (y) the date on which the Closing sale price of our ordinary shares equals or exceeds $12.50 per share for any 20 trading days within any 30 trading day period commencing after the Closing, and (z) the date after the Closing on which we consummate a liquidation, merger, share exchange or other similar transaction with an unaffiliated third party (a “Subsequent Transaction”), and (ii) with respect to the remaining 50% of the Restricted Securities, (x) the one year anniversary of the date of the Closing and (y) the date after the Closing on which we consummate a Subsequent Transaction, sell, transfer, assign, pledge, hypothecate or otherwise dispose of, directly or indirectly, the Restricted Securities, or publicly disclose the intention to do any of the foregoing. Each Seller further agreed that the Escrow Shares will continue to be subject to such transfer restrictions until they are released from the escrow account. However, each Seller party thereto will be allowed to transfer any of our Restricted Securities (other than the Escrow Shares while they are held in the escrow account) by gift, will or intestate succession or to any affiliate, shareholder, members, party or trust beneficiary, provided in each such case that the transferee thereof agrees to be bound by the restrictions set forth in the applicable Lock-Up Agreement. - TKK entered into a Non-Competition and Non-Solicitation Agreement (“Non-Competition Agreement”) with certain Sellers that directly or indirectly own in excess of 30% of Glory Star’s equity prior to the Closing (including Glory Star Group’s chairman) and their principal shareholders (together with the applicable Seller, the “Subject Parties”). Under the Non-Competition Agreements, for a period of three (3) years after the Closing, each Subject Party and our affiliates will not, without our prior written consent, anywhere in the PRC or any other markets directly or indirectly engage in which we are engaged, or are actively contemplating to become engaged, in the Business (as defined below) (or own, manage, finance or control, or become engaged or serve as an officer, director, employee, member, partner, agent, consultant, advisor or representative of, an entity that engages in) of online media and entertainment services (collectively, the “Business”). However, the Subject Parties and their respective affiliates may own passive investments of no more than 3% of any class of outstanding equity interests in a competitor that is publicly traded, so long as the Subject Parties and their affiliates and their respective directors, officers, managers and employees who were involved with the our business, and the immediate family members of the Subject Parties or their respective affiliates, are not involved in the management or control of such competitor. Under the Non-Competition Agreements, during such restricted period, the Subject Parties also will not, without our prior written consent, (i) solicit or hire our employees, consultants or independent contractors as of the Closing (or during the year prior to the Closing) or otherwise interfere with our relationships with such persons, (ii) solicit or divert the our customers as of the Closing (or during the year prior to the Closing) relating to the Business or otherwise interfere with our contractual relationships with such persons, or (iii) interfere with or disrupt any of our vendors, suppliers, distributors, agents or other service providers for a purpose competitive with us as it relates to the Business. The Subject Parties will also agree in each Non-Competition Agreement to not disparage us and to keep confidential and not use our confidential information. Immediately after the Business Combination, our public shareholders own approximately 5.05% of GS Holdings, TKK’s former directors, officers and initial shareholders, including the Sponsor, and EarlyBirdCapital, Inc. (“EBC”) own approximately 12.16% of GS Holdings, and the Sellers own approximately 82.79% of GS Holdings. After giving effect to the Business Combination transaction and the issuance of the Closing Payment Shares described above, there are 49,767,866 of our ordinary shares issued and outstanding. EBC Note In connection with the Business Combination, on February 14, 2020, we entered into a Business Combination Marketing Agreement Fee Amendment (“Fee Amendment”) with EBC whereby EBC agreed to amend the fees payable under the Business Combination Marketing Agreement, dated August 15, 2018, by and between EBC and TKK (“Original Marketing Agreement”). Under the Original Marketing Agreement, EBC agreed to assist TKK in connection with TKK’s business combination with one or more businesses or entities in exchange for a cash fee equal to 3.5% of the gross proceeds received in the IPO. In addition, TKK agreed to reimburse EBC for up to $20,000 of its reasonable costs and expenses incurred by it. Under the Fee Amendment, EBC agreed to reduce its fee of $8.75 million due under the Original Agreement and forgo reimbursement of expenses in exchange for a convertible promissory note in the amount of $4.0 million without interest (“EBC Note”). The EBC Note is for a period of one year and is convertible, at EBC’s option, into our ordinary shares at the conversion price equal to the volume-weighted average price of our ordinary shares on Nasdaq or such other securities exchange or securities market on which our ordinary shares are then listed or quoted, for the ten trading days prior to such conversion date; provided, however, the conversion price shall not be less than $5.00 (the “Floor Price”). The EBC Note automatically converts into our ordinary shares on the maturity date. The EBC Note includes a covenant that we will use our best efforts to register the shares issuable under the EBC Note pursuant to a registration statement with the SEC as soon as practicable, and obtain effectiveness of such registration statement with 180 calendar days from the date of the EBC Note (“Effectiveness Deadline”). In the event such registration statement is not effective by the Effectiveness Deadline, the Floor Price shall automatically decrease to $4.00, and by one dollar ($1.00) for every 30-day period thereafter; provided, however, the Floor Price shall not be less than $1.00. Amended Sponsor Note On February 14, 2020, we entered into an amended and restated promissory note with the Sponsor (the “Amended Sponsor Note”) to (i) extend the maturity date from the closing of the Business Combination to a date that is one year from the closing of the Business Combination and (ii) increased the principal amount of the note to $1.4 million, which included $300,000 in advances we received from the Sponsor from November 2019 to January 2020. In addition, under the Amended Sponsor Note, we granted the Sponsor the right to convert the $1.4 million Amended Sponsor Note to our ordinary shares at the conversion price equal to the volume-weighted average price of our ordinary shares on Nasdaq or such other securities exchange or securities market on which our ordinary shares are then listed or quoted, for the ten trading days prior to such conversion date; provided, however, the conversion price shall not be less than $5.00. The Amended Sponsor Note automatically converts into our ordinary shares on the maturity date. Special Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding TKK’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. When used in this Form 10-K, words such as “anticipate,” “believe,” “estimate,” “expect,” “intend” and similar expressions, as they relate to us or TKK’s management, identify forward-looking statements. Such forward-looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, the Company’s management. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors detailed in our filings with the SEC. The following discussion and analysis of TKK’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview Prior to the Business Combination, TKK was a blank check company incorporated on February 5, 2018 as a Cayman Islands exempted company and formed for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar business combination with one or more businesses. Results of Operations TKK has not engaged in any operations or generated any revenues during the year ended December 31, 2019. TKK’s only activities from February 5, 2018 (inception) through December 31, 2019 were organizational activities, those necessary to consummate the initial public offering, described below, identifying a target company for a business combination and the proposed acquisition of Glory Star. TKK does not expect to generate any operating revenues until after the completion of its business combination. TKK generates non-operating income in the form of interest income on marketable securities. TKK incurs expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2019, TKK had net income of $3.28 million, which consists of interest income on marketable securities held in the Trust Account $5.61 million and an unrealized gain on marketable securities held in our Trust Account $19,313, offset by operating costs of $2.35 million. For the period from February 5, 2018 (inception) through December 31, 2018, TKK had net income of $1.61 million, which consists of interest income on marketable securities held in the Trust Account $1.95 million, offset by operating costs of $0.28 million and an unrealized loss on marketable securities held in our Trust Account of $61,139. Liquidity and Capital Resources On August 20 and 22, 2018, TKK consummated the initial public offering of 22,000,000 Units and the sale of an additional 3,000,000 Units pursuant to the underwriters’ partial exercise of their over-allotment option at a price of $10.00 per Unit, generating aggregate gross proceeds of $250 million. Simultaneously with the closings of the initial public offering and the sale of the additional Units, TKK consummated the sale of an aggregate of 13,000,000 private placement warrants to Symphony Holdings Limited at a price of $0.50 per warrant, generating gross proceeds of $6.5 million. In connection with the initial public offering and the private placement, TKK placed a total of $250 million in the trust account. TKK incurred $5.74 million in initial public offering related costs, including $5.0 million of underwriting fees and $0.74 million of other costs. For the year ended December 31, 2019, cash used in operating activities was $1.72 million. Net income of $3.28 million was affected by interest earned on marketable securities held in the trust account of $5.61 million, an unrealized gain on marketable securities held in TKK’s trust account of $19,313 and changes in our operating assets and liabilities, which provided $0.63 million of cash from operating activities. For the period from February 5, 2018 (inception) through December 31, 2018, cash used in operating activities was $0.37 million. Net income of $1.61 million was affected by interest earned on marketable securities held in the trust account of $1.95 million, an unrealized loss on marketable securities held in our trust account of $61,139 and changes in TKK’s operating assets and liabilities, which used $96,102 of cash from operating activities. As of December 31, 2019, TKK had cash of $34,527 held outside of the trust account and marketable securities held in the trust account of $256.52 million (including approximately $7.5 million of interest income and unrealized gains) consisting of U.S. treasury bills with a maturity of 180 days or less. Interest income on the balance in the trust account may be used by TKK to pay taxes. Through December 31, 2019, TKK did not withdraw any funds from the interest earned on the trust account. On September 6, 2019, TKK issued the Sponsor an unsecured promissory note in a principal amount of up to $1.1 million (the “Sponsor Note”) for working capital loans made or to be made by the sponsor, pursuant to which $0.35 million of previously provided advances were converted into loans under the Sponsor Note. The Sponsor Note bears no interest and is due on the earlier of (i) the consummation of a Business Combination or (ii) TKK’s liquidation. Up to $1.0 million of the loans under the Sponsor Note may be converted into warrants, each warrant entitles the holders to receive one half of one ordinary share, at $0.50 per warrant. As of December 31, 2019, the total outstanding balance due under the Note was $1.1 million. In November and December 2019, TKK Capital Holding, an affiliate of the Sponsor, advanced TKK an aggregate of $0.25 million to be used for working capital purposes and for the payment of transaction costs in connection with a Business Combination. The advances are unsecured, non-interest bearing and due on demand. As of December 31, 2019, there was $0.25 million of advances outstanding. On February 14, 2020, TKK entered into the Amended Sponsor Note to extend the maturity date from the closing of the Business Combination to a date that is one year from the closing of the Business Combination and (ii) increased the principal amount of the note to $1.4 million, which included $0.3 million in advances we received from the Sponsor from November 2019 to January 2020. In addition, under the Amended Sponsor Note, TKK granted the Sponsor the right to convert the $1.4 million Amended Sponsor Note to our ordinary shares at the conversion price equal to the volume-weighted average price of our ordinary shares on Nasdaq or such other securities exchange or securities market on which our ordinary shares are then listed or quoted, for the ten trading days prior to such conversion date; provided, however, the conversion price shall not be less than $5.00. The Amended Sponsor Note automatically converts into our ordinary shares on the maturity date. Off-balance sheet financing arrangements TKK has no obligations, assets or liabilities, which would be considered off-balance sheet arrangements as of December 31, 2019. TKK does not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. TKK has not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations TKK does not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay an affiliate of TKK’s Chief Executive Officer and Chairman a monthly fee of $15,000 for general and administrative services, including office space, utilities and administrative services provided to the Company. TKK began incurring these fees on August 15, 2018 and will continue to incur these fees monthly until the earlier of the completion of the business combination and our liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. TKK has identified the following critical accounting policies: Ordinary shares subject to possible redemption The Company accounts for its ordinary shares subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Ordinary shares subject to mandatory redemption are classified as a liability instrument and are measured at fair value. Conditionally redeemable ordinary shares (including ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of the Company’s balance sheets. Adjusted Net loss per ordinary share Adjusted net loss per ordinary share is computed by dividing adjusted net loss by the weighted average number of ordinary shares outstanding for the period. The Company applies the two-class method in calculating earnings per share. Ordinary shares subject to possible redemption at December 31, 2019 and 2018, which are not currently redeemable and are not redeemable at fair value, have been excluded from the calculation of basic adjusted net loss per share since such shares, if redeemed, only participate in their pro rata share of the Trust Account earnings. The Company has not considered the effect of (1) warrants sold in the Public Offering and private placement to purchase 19,000,000 ordinary shares and (2) rights sold in the Initial Public Offering that convert into 2,500,000 ordinary shares in the calculation of diluted adjusted net loss per ordinary share, since the exercise of the warrants and the conversion of the rights into ordinary shares are contingent upon the occurrence of future events. As a result, diluted adjusted net loss per ordinary share is the same as basic adjusted net loss per ordinary share for the periods presented. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on TKK’s financial statements.

<s>[INST] For the purpose this Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations, we are providing the historical information of TKK for the year ended December 31, 2019 and from February 5, 2018 (inception) through December 31, 2018. The Management’s Discussion and Analysis of Financial Conditions and Results of Operations for Glory Star can be found in our Current Report on Form 8K/A (Amendment No. 2) concurrently filed with the SEC on March 31, 2020. Recent Developments Share Exchange Agreement On February 14, 2020, TKK consummated the Business Combination contemplated by the Share Exchange Agreement pursuant to which the Company acquired 100% of the equity interests of Glory Star from the Sellers. Upon closing of the Business Combination, the Company acquired all of the issued and outstanding securities of Glory Star in exchange for (i) approximately 41,204,025 of our ordinary shares (“Closing Payment Shares”), or one ordinary share for approximately 0.04854 outstanding shares of Glory Star, of which 2,060,201 of the Closing Payment Shares (the “Escrow Shares”) shall be deposited into escrow to secure certain indemnification obligations of the Sellers, plus (ii) earnout payments consisting of up to an additional 5,000,000 of our ordinary shares if we meet certain financial performance targets for the 2019 fiscal year, which we believe we have met, and an additional 5,000,000 of our ordinary shares if we meet certain financial performance targets for the 2020 fiscal year (the “Earnout Shares”). In the event that a financial performance target is not met for the 2019 fiscal year and/or 2020 fiscal year but we meet certain financial performance targets for the 2019 fiscal year and 2020 fiscal year combined, the Sellers will be entitled to receive any Earnout Shares that they otherwise did not receive (the “Alternative Earnout”). In connection with the Share Exchange Agreement: TKK entered into a Registration Rights Agreement (“Registration Rights Agreement”) with the Sponsor and the Sellers pursuant to which TKK will grant certain registration rights to the Sellers with respect to the registration of the Closing Payment Shares and Earnout Shares. TKK entered into a LockUp Agreement (“LockUp Agreement”) with certain Sellers that directly or indirectly own in excess of 10% of Glory Star Group equity prior to the Closing pursuant to which each Seller party thereto agreed that such Seller will not, during the period from the Closing and ending on the earlier of (i) with respect to 50% of the Closing Payment Shares (including Escrow Shares) and Earnout Shares (“Restricted Securities”), (x) the six month anniversary of the date of the Closing, (y) the date on which the Closing sale price of our ordinary shares equals or exceeds $12.50 per share for any 20 trading days within any 30 trading day period commencing after the Closing, and (z) the date after the Closing on which we consummate a liquidation, merger, share exchange or other similar transaction with an unaffiliated third party (a “Subsequent Transaction”), and (ii) with respect to the remaining 50% of the Restricted Securities, (x) the one year anniversary of the date of the Closing and (y) the date after the Closing on which we consummate a Subsequent Transaction, sell, transfer, assign, pledge, hypothecate or otherwise dispose of, directly or indirectly, the Restricted Securities, or publicly disclose the intention to do any of the foregoing. Each Seller further agreed that the Escrow Shares will continue to be subject to such transfer restrictions until they are released from the escrow account. However, each Seller party thereto will be allowed to transfer any of our Rest [/INST] Positive. </s>

Twist Bioscience Corp

2018-12-20

2018-09-30

Item 7. Management’s discussion and analysis of financial condition and results of operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to those statements included elsewhere in this Form 10-K. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under “Risk factors” and elsewhere in this Form 10-K. The last day of our fiscal year is September 30, and we refer to our fiscal year ended September 30, 2016 as fiscal 2016 or 2016, September 30, 2017 as fiscal 2017 or 2017 and our fiscal year ended September 30, 2018 as fiscal 2018 or 2018. Overview We are a leading and rapidly growing synthetic biology company that has developed a disruptive DNA synthesis platform to industrialize the engineering of biology. The core of our platform is a proprietary technology that pioneers a new method of manufacturing synthetic DNA by “writing” DNA on a silicon chip. We have combined this technology with proprietary software, scalable commercial infrastructure and an e-commerce platform to create an integrated technology platform that enables us to achieve high levels of quality, precision, automation, and manufacturing throughput at a significantly lower cost than our competitors. We are leveraging our unique technology to manufacture a broad range of synthetic DNA-based products, including synthetic genes, tools for next generation sample preparation, and antibody libraries for drug discovery and development. Additionally, we believe our platform will enable new value-add opportunities, such as discovery partnerships for biologic drugs, and will enable new applications for synthetic DNA, such as digital data storage. We sell our synthetic DNA and synthetic DNA-based products to a customer base of over 700 customers across a broad range of industries. We launched the first application of our platform, synthetic genes and oligo pools, in April 2016 to disrupt the gene synthesis market and make legacy DNA synthesis methods obsolete. From inception to September 30, 2018, we have sold our products to more than 700 customers. In fiscal 2017, we served 286 customers including $0.3 million in sales to seven of the top 20 pharmaceutical companies by revenue, $4.3 million in sales to Ginkgo Bioworks, Inc., or Ginkgo Bioworks (which we believe is the largest global purchaser of synthetic DNA), $0.3 million in sales to three of the largest agricultural biotechnology companies, $2.7 million in sales to over 100 academic research institutions worldwide, and $7.3 million in sales to innovative customers using synthetic DNA for new and emerging applications, such as Microsoft Corporation and the University of Washington for use of DNA as a digital data storage medium. We are also an original equipment manufacturer, or OEM, of synthetic DNA to four synthetic DNA manufacturers that also compete with us, which we believe is a strong demonstration of the superiority of our platform. In fiscal 2018, we served 719 customers as follows: sales to the industrial chemicals sector, the academic research sector, the agricultural sector and the healthcare sector accounted for 59%, 23%, 2% and 16% of the total $25.4 million revenues for the year ended September 30, 2018. Sales to Ginkgo Bioworks amounted to $8.7 million, or 34% and sales to customers other than Ginkgo Bioworks was $16.7 million, or 66%, for the year ended September 30, 2018; an increase in revenue of 101% and 160%, respectively, as compared to the year ended September 30, 2017. We have also leveraged the versatility of our platform to expand our product portfolio into other markets in which we believe we have a competitive advantage. In February 2018, we launched an innovative and comprehensive preparation kit for next generation sequencing at the Advances in Genome Biology and Technology conference. Our kit leverages our platform to precisely synthesize oligo pools and uniformly amplify the desired target DNA segments, considerably improving the accuracy of the downstream sequencing analysis. We have also commercialized a custom DNA library solution which enables more effective biologic drug discovery and development for our customers. We believe we can further leverage our platform to develop other proprietary tools, such as our anti-GPCR library and antibody optimization solution, to provide an end-to-end solution in biologics drug discovery and early development, from target to Investigational New Drug (IND) application, adding value as a partner to biotech and pharmaceutical companies. We also aim to explore development of DNA as a digital data storage medium via internal research and industry partnerships. We have built a scalable commercial platform that enables us to reach a diverse customer base that we believe includes over 100,000 synthetic DNA users today. In order to address this diverse customer base, we have employed a multi-channel strategy comprised of a direct sales force targeting synthetic DNA customers, a direct sales force focusing on the NGS market and an e-commerce platform. We launched our proprietary, innovative, and easy-to-use e-commerce platform in October 2017 to existing customers and expanded access to the general public in January 2018. Our platform allows customers to design, validate, and place on-demand orders of customized DNA online. This is a critical part of our strategy to address our large and diverse customer base, as well as drive commercial productivity, enhance the customer experience, and promote loyalty. We generated revenues of $2.7 million in the year ended September 30, 2016, $10.8 million in the year ended September 30, 2017 and $25.4 million in the year ended September 30, 2018, while incurring net losses of $44.1 million, $59.3 million and $71.2 million in the years ended September 30, 2016, 2017 and 2018, respectively. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the success of our existing products and development and commercialization of additional products in the synthetic biology industry. As of September 30, 2018, we had $80.8 million in cash and cash equivalents. In fiscal year 2017, we received net cash proceeds of $65.6 million from the sale of shares of Series D convertible preferred stock, and as of September 30, 2018, we received additional net cash proceeds of $90.8 million from the sale of additional shares of Series D convertible preferred stock. After giving effect to the net proceeds from our initial public offering of October 2018, we believe that our existing cash and cash equivalents will be sufficient to fund our planned operating expenses, capital expenditure requirements and debt service payments for at least 12 months from December 20, 2018. We have based these estimates on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. See “Liquidity and capital resources.” See Item 1. Business above for additional information regarding our business, products, competitive market and regulatory matters. Key business metrics We regularly review the following key business metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate financial projections and make strategic decisions. We believe that the following metrics are representative of our current business; however, we anticipate these will change or may be substituted for additional or different metrics as our business grows. Value of orders received We believe that the value of orders we receive is a leading indicator of our ability to generate revenue. We define an order as a contract with a customer or purchase order from a customer, which outlines the promised goods at an agreed upon price. We regularly assess trends relating to the value of orders we receive, including with respect to our customer concentration. For example, we have experienced quarterly growth in the value of orders received from customers other than Ginkgo Bioworks, which has increased by approximately 20.4 times from the quarter ended June 30, 2016 to the quarter ended September 30, 2018. Since commercially launching our product in April 2016, orders from customers have rapidly increased over the last nine quarters. Commencing with our Beta Access program, we believe we have successfully achieved industry-leading volumes of synthetic DNA orders. In 2018, we launched our e-commerce platform to enable customers to conveniently order our products online. These steps have contributed to outstanding order growth over the last nine quarters, which is illustrated in the table below. Orders may never convert into actual revenue and the timing of delivery of our orders and recognition of revenue, if any, may vary based on the nature of the order, and there can be no assurance that orders will result in recognized revenue. The following table lists the value of orders received, including Ginkgo and non-Ginkgo orders, during the periods indicated: Number of customers We believe that the number of customers who have purchased from us since inception is representative of our ability to drive adoption of our products and convert DNA Makers to DNA Buyers. We define customers as separate legal entities or persons who have purchased and directly paid for our products. This means that if a parent company is a customer of ours, it is counted as one customer, and if its subsidiary also purchases our products from us, and the subsidiary makes a payment directly to us, we count the subsidiary as a separate customer. We apply this methodology of counting customers because it is not possible for our e-commerce platform and other data tracking software to distinguish accurately between affiliated purchasers. Percentage of revenue from new vs. repeat customers We believe that the percentage of revenue that we generate from both new and repeat customers is a leading indicator of our ability to drive adoption of our products amongst existing customers while also generating a robust pipeline of new customers. We define a new customer as a customer who, as a separate legal entity or person, has not previously purchased any products or services from us. We define a repeat customer as any customer who, as a separate legal entity or person, has previously purchased any products or services from us. Because our first commercial shipment was in April 2016, 100% of our revenue for fiscal 2016 was from new customers, therefore we had no revenue from repeat customers in fiscal 2016. The table below represents sales to individual customers. We shipped products to 97 customers in fiscal 2016, 286 customers in fiscal 2017 and 719 customers in fiscal 2018. Between September 30, 2015 and September 30, 2018, we sold products to more than 700 customers. Financial overview The following table summarizes certain selected historical financial results: Revenues We generate revenue from sales of synthetic genes, oligo pools, next generation sequencing tools and DNA libraries. We recognize revenue upon delivery to our customers and bill them directly for the shipments. Our ability to increase our revenues will depend on our ability to further penetrate the domestic and international markets, generate sales through our direct sales force, and over time from our e-commerce platform. Revenues by geography We have one reportable segment from the sale of synthetic DNA products. The following table shows our revenues by geography, based on our customers’ shipping addresses. North America consists of Canada and Mexico; EMEA consists of Europe, Middle East, and Africa; and APAC consists of Japan, China, South Korea, Singapore, Malaysia and Australia. Revenues by products The table below sets forth revenues by products: Revenues by industry Revenues by industry were as follows: Revenues and accounts receivable concentration Customer revenues equal to or greater than 10% of total revenues was as follows: * Less than 10 percent One customer accounted for greater than 10% of net accounts receivable as follows: Gene shipments Shipments and number of genes shipped in the three months ended December 31, 2016, March 31, 2017, June 30, 2017, September 30, 2017, December 31, 2017, March 31, 2018, June 30, 2018 and September 30, 2018 were as follows: Cost of revenues Cost of revenues reflect the aggregate cost incurred in the production and delivery of our products and consists of: production materials, personnel costs (salaries, benefits, bonuses and stock-based compensation), cost of expensed equipment and consumables, laboratory supplies, depreciation of capitalized equipment, production overhead costs and allocations of IT and facility costs. We expect that our cost of revenues will increase as we increase our revenues with new product developments. Other operating expenses Our operating expenses are classified in the following categories: Research and development, and selling, general and administrative. For each category, the largest component is personnel costs, which includes salaries, employee benefit costs, bonuses, and stock-based compensation expenses. Research and development Research and development expenses consist primarily of costs incurred for the development of our products, which include personnel costs, laboratory supplies, consulting costs and allocated overhead, including IT and facility costs. We expense our research and development expenses in the period in which they are incurred. We expect to increase our research and development expenses as we continue to develop new products. Selling, general and administrative Selling expenses consist of personnel cost, customer service expenses, direct marketing expenses, educational and promotional expense, market research and analysis. General and administrative expenses include executive, finance and accounting, legal and human resources. These expenses consist of personnel costs, audit and legal expenses, consulting costs and allocated IT and facility costs. We expense all selling, general and administrative expenses as incurred. We expect our selling and marketing cost will continue to increase in absolute dollars, primarily driven by our efforts to expand our commercial capability, with an increased presence both within and outside the United States, and to expand our brand awareness and customer base through targeted marketing initiatives. We expect general and administrative expenses will increase as well as we scale our operations. In addition, we expect to incur additional accounting, legal and other expenses that we did not incur as a private company. Interest expense Interest expense is attributable to borrowing under our senior secured term loan and our equipment financing facility. Interest income Interest income consists primarily of interest earned on our cash, cash equivalents, and short-term investments. Other income (expense), net Other income (expense), net consists of realized gains and losses on sales of short-term investments and change in the redeemable convertible preferred stock warrant liability. Results of operations The following table sets forth selected consolidated statements of operations data for the fiscal years indicated and the percentage change in such data from year to year. These historical operating results may not be indicative of the results for any future period. Comparison of the years ended September 30, 2016, 2017 and 2018 Revenues We commenced selling our products in April 2016. In the year ended September 30, 2016, we generated revenue of $2.3 million from shipments of our synthetic DNA products, primarily oligonucleotides, clonal and non-clonal synthetic genes, and DNA libraries. Revenue from customers in the United States was 78%, and outside the United States was 22%. Revenue increased to $10.8 million in the year ended September 30, 2017, as we continued to ramp up production capacity and sales of our synthetic DNA products, primarily oligonucleotides, clonal and non-clonal synthetic genes, DNA libraries and oligo pools. In fiscal 2017, revenues from customers in the United States accounted for 77% and 23% from customers outside the United States. Revenues increased from $10.7 million to $25.4 million in the year ended September 30, 2018, which was an increase of $14.7 million, or 136%. This revenue increase was driven by revenues from synthetic genes of $18.0 million and NGS tools of $2.7 million. The primary increase in synthetic genes revenue was attributed to volume increases of genes shipped to customers period-over-period, driven by increased investment in our sales force infrastructure and the launching of the e-commerce platform in fiscal 2018. In the year ended September 30, 2018, we shipped 247,102 genes compared to 125,462 genes in the year ended September 30, 2017, an increase of 96%. Gene pricing to our customers was relatively constant period-over-period. The primary reasons for NGS tools revenue growth period-over-period was attributed to the full commercial launching of the product in February 2018, increased investment in our sales force infrastructure and the volume of units shipped in fiscal 2018. We do not believe the pricing had a meaningful impact on the revenue changes for NGS tools period-over-period. Revenues from customers other than Ginkgo Bioworks increased $10.2 million or 160% from $6.5 million to $16.7 million and revenue from Ginkgo Bioworks increased $4.4 million, an increase of 102% from $4.3 million to $8.7 million compared to the prior year ended September 30, 2017. Revenue from repeat customers increased $17.9 million or 263% from $6.8 million to $24.6 million in the year ended September 30, 2017 and 2018, respectively. Cost of revenues In the year ended September 30, 2017, total cost of revenues increased to $24.0 million from $9.4 million in the year ended September 30, 2016, primarily due to payroll and stock compensation related expenses of $4.8 million due to an increase in headcount, increased consumption of reagents and production materials of $4.0 million, increased information technology and facilities costs of $2.4 million, increased consulting and outside services of $0.6 million, $1.7 million increase in depreciation expense related to additional equipment for increased production capacity, and increased maintenance costs of $0.4 million. In the year ended September 30, 2018, total cost of revenue increased by $8.2 million from $24.0 million to $32.2 million from the prior year. The increase was primarily due to payroll and stock compensation related expense increase of $3.6 million, increase of consumption of reagents and production materials of $2.8 million, consulting and outside services increase of $0.9 million and facilities cost increase of $0.9 million over prior year. All of these increases are attributable to our increased output of gene shipments year-over-year and the introduction of our NGS products in fiscal 2018. Research and development expenses Research and development expenses increased by $0.9 million or 5% from $18.2 million in the year ended September 30, 2016 to $19.2 million in the year ended September 30, 2017. This was primarily due to increased development activities for new product offerings, materials costs, and information technology and facilities costs. In fiscal 2017, information technology and facilities costs increased by $0.9 million compared to fiscal 2016, primarily due to the signing of lease agreements for additional facilities located in San Francisco and South San Francisco. Additional research and development expenses of $3.4 million were also incurred in fiscal 2017 in connection with the acquisition of Genome Compiler Corporation in the prior fiscal year. In fiscal 2016, we received $2.4 million Defense Advanced Research Projects Agency, or DARPA, payments, whereas in fiscal 2017 there were no DARPA payments to offset expenses. In fiscal 2017, laboratory materials used in research and development increased $0.5 million from $2.7 million to $3.2 million and allocations from facilities and information technology increased $0.9 million. For the year ended September 30, 2018, research and development expenses increased from $19.1 million to $20.3 million, an increase of 6%. The increase was driven primarily from an increase in personnel related costs of $1.3 million, subcontracting services increase of $0.5 million and other increases for $0.1 million offset by decrease of prototype supplies of ($0.8) million. The R&D group hired full time staffing and used less materials in research. In addition, there were $0.3 million in DARPA payments received during the 2018 fiscal year. Selling, general and administrative expenses Selling, general and administrative expenses increased by $7.8 million, or 43%, from $18.3 million in the year ended September 30, 2016 to $26.1 million in the year ended September 30, 2017, primarily due to increases in payroll related to increased headcount, professional and legal expenses, information technology and facilities expenses. Salaries and related costs increased by $1.9 million in fiscal 2017, as a result of increased headcount in our sales department. In addition, professional and legal expenses increased by $5.2 million due to commercial expansion of our products Selling, general and administrative expenses increased by $17.4 million, or 67%, from $26.1 million in the year ended September 30, 2017 to $43.5 million in the year ended September 30, 2018, primarily due to increases in payroll expenses related to increased headcount, advertising and marketing expenses, professional and legal expenses, stock compensation expenses and information technology related charges. Salaries and related costs increased by $8.2 million in fiscal 2018, as a result of increased headcount in our sales department. In addition, professional services expenses increased by $4.7 million due to commercial expansion of our products and setting up our infrastructure to become a public company. Our marketing related activities increased $1.7 million and remaining increases all relate to commercialization of sales group or corporate development towards preparation of going public. Interest, and other income (expense), net Interest income was $0.2 million in the year ended September 30, 2016, $0.4 million in the year ended September 30, 2017 and $1.0 million in the year ended September 30, 2018, resulting from our short-term investments. Interest expense was $0.7 million in fiscal 2016, $0.9 million in fiscal 2017 and $1.3 million in fiscal 2018 related to our outstanding debt. The change in the redeemable convertible preferred stock warrant liability was $0.1 million in fiscal 2016, $0.3 million in fiscal 2017 and less than $0.1 million in fiscal 2018. Provision for income taxes We recorded $0.3 million in 2017 and $0.2 million in 2018. Quarterly Results of Operations The following table shows unaudited quarterly consolidated statement of operations data for each of the last eight quarters. In the opinion of management, the information for each of these quarters has been prepared on the same basis as our audited financial statements and include all adjustments, consisting of normal recurring adjustments and accruals, necessary for the fair statement of financial information in accordance with generally accepted accounting principles. This information should be read in conjunction with the audited consolidated financial statements and related notes included in this Form 10-K. Historical results are not necessarily indicative of results that may be achieved in future periods, and operating results for quarterly periods are not necessarily indicative of operating results for a full year. You should read this unaudited consolidated statement of operations data in conjunction with our consolidated financial statements and the related notes included elsewhere in this Form 10-K. Liquidity and capital resources Sources of liquidity To date, we have financed our operations principally through private placements of our convertible preferred stock, borrowings from credit facilities and revenue from our commercial operations. Since our inception on February 4, 2013 and through September 30, 2018, we have received an aggregate of $290.5 million in net proceeds from the issuance of equity securities and an aggregate of $13.8 million from debt. As of September 30, 2018, we had a balance of $80.8 million of cash and cash equivalents and had no short-term investments. Preferred stock financings As of September 30, 2018, we had raised $290.5 million in net proceeds from the sale of our equity securities, including the sale of 10,326,454 shares of our Series D redeemable convertible preferred stock from January 2016 through September 2018 at a purchase price of $21.24 per share for gross proceeds of $219.4 million. On March 19, 2018 and May 29, 2018, we issued 2,353,544 and 941,417 shares of Series D redeemable convertible preferred stock for an aggregate purchase price of approximately $50.0 million and $20.0 million, respectively. On July 2, 2018 and July 3, 2018, we issued 517,778 and 47,070 shares of Series D redeemable convertible preferred stock for an aggregate purchase price of $11.0 million and $1.0 million, respectively. Debt financings We have entered into various credit facilities to obtain debt financing from time to time beginning in October 2013. In December 2015, we entered into a Second Amended and Restated Loan and Security Agreement, or the Third Loan, for amounts aggregating up to $15.0 million in a series of three advances. The Third Loan contains an acceleration clause under which the loan can become due and payable to Silicon Valley Bank, or SVB, in certain events of default, including in the event of a material adverse change in our business. The term of the loan was 41 months with an interest rate equal to the greater of (i) the prime rate or (ii) 3.25%, and there was a final payment fee of 6% of the amount loaned. In addition, we obtained a revolving facility from SVB of $5.0 million for which the principal amount outstanding under the revolving line would accrue interest at a floating per annum rate equal to one percentage point (1.00%) above the Prime Rate, which interest shall be payable monthly. The first advance under the Third Loan totaling $7.0 million, was drawn in December 2015 and comprised $3.3 million to refinance our prior loan with SVB and a new advance of $3.7 million. The debt provides interest only payments through December 31, 2016 at which time monthly principal payments become due. In connection with this advance, we issued warrants to purchase a total of 18,854 shares of Series C convertible preferred stock at an exercise price of $14.85 per share. We accounted for this transaction as a debt modification and did not incur any gains or losses relating to the modification. The second advance, totaling $4.0 million, was drawn in March 2016. In connection with this advance, we issued warrants to purchase a total of 7,531 shares of Series D convertible preferred stock at an exercise price of $21.24 per share. The Third Loan was paid off in full using proceeds from the Fourth Loan, detailed below. In September 2017, we entered into a Fourth Amended and Restated Loan and Security Agreement, or the Fourth Loan, with SVB, which allowed for borrowings aggregating up to $20.0 million in a series of three advances. The first advance-which was effectuated in September 2017-provided a principal amount of $10.0 million, the second optional advance allowed for a principal amount of $5.0 million and the third optional advance allowed for a principal amount of $5.0 million during their respective drawdown periods; however, the draw periods for the second and third tranches under this agreement have expired as of January 31, 2018 and June 30, 2018, respectively. In connection with the first advance, we issued warrants to purchase 64,127 shares of common stock at an exercise price of $6.24 per share. The Fourth Loan contains a subjective acceleration clause under which the Fourth Loan could become due and payable to SVB in the event of a material adverse change in our business. The term of the loan was 51 months with an interest rate of prime plus 3.00% and a final payment fee of $0.7 million. In addition, we obtained a revolving facility from SVB in September 2017 as part of the Fourth Loan and the facility which allows us to borrow up to $10.0 million. The principal amount outstanding under the revolving line accrues interest at a floating per annum rate equal to one percentage point (1.00%) above the prime rate, which interest shall be payable monthly. The amounts available under the revolving line are limited by an advance rate which is a percentage of our account receivables balance. As of September 30, 2018, we have not borrowed against the $10 million revolving facility. Our credit facilities contain customary representations and warranties and customary affirmative and negative covenants applicable to us and our subsidiaries, including, among other things, restrictions on changes in business, management, ownership or business locations, indebtedness, encumbrances, investments, mergers or acquisitions, dispositions, maintenance of collateral accounts, prepayment of other indebtedness, distributions and transactions with affiliates. The credit facilities contain customary events of default subject in certain cases to grace periods and notice requirements, including (a) failure to pay principal, interest and other obligations when due, (b) material misrepresentations, (c) breach of covenants, conditions or agreements in the credit facilities, (d) default under material indebtedness, (e) certain bankruptcy events, (f) a material adverse change; (g) attachment, levy or restraint on business, (h) default with respect to subordinated debt, (i) cross default under our credit facilities, and (j) government approvals being revoked. As part of the Fourth Loan, all rights, title and interest to our personal property with the exception of our intellectual property, have been pledged as collateral, including cash and cash equivalents, short-term investments, accounts receivable, contractual rights to payment, license agreements, general intangibles, inventory and equipment. We were in compliance with all covenants under the loan and security agreement as of September 30, 2018. Future maturities of the loan as of September 30, 2018 are as follows: Capital resources As of September 30, 2018, we had cash, cash equivalents and short-term investments of $80.8 million. Subsequently, on October 30, 2018, our registration statement on Form S-1 was declared effective by the SEC and our shares began trading on the NASDAQ Global Stock Market on October 31, 2018. A total of 5,750,000 shares were offered and sold at a price of $14.00 per share. As a result of the IPO, the Company received $69.6 million in net proceeds, after deducting underwriting discounts and commissions of $5.6 million and offering expenses of approximately $5.3 million payable by the Company. After giving effect to the net proceeds from the IPO, we believe that our existing cash and cash equivalents are sufficient to fund our operating expenses, capital expenditure requirements and debt service payments for at least 12 months from December 20, 2018. In the future, we may need to raise additional capital to finance our operations which cannot be assured. However, our operating plan may change as a result of factors currently unknown to us, and we may need to seek additional funds sooner than planned, through public or private equity or debt financings or other sources, such as strategic collaborations. Such financing may result in dilution to stockholders, imposition of debt covenants and repayment obligations, or other restrictions that may adversely affect our business. In addition, we may seek additional capital due to favorable market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. Our future capital requirements will depend on many factors. See “Risk factors-We will require additional financing to achieve our goals, and a failure to obtain this necessary capital when needed on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product manufacturing and development and other operations.” Operating capital requirements Our primary uses of capital are, and we expect will continue to be for the near future, compensation and related expenses, manufacturing costs, laboratory and related supplies, legal and other regulatory expenses and general overhead costs. As of September 30, 2017, we had $1.3 million in commitments for capital expenditures. As of September 30, 2018, we had $2.5 million in commitments for capital expenditures. Cash flows The following table summarizes our sources and uses of cash and cash equivalents: Operating activities Net cash used in operating activities was $38.6 million in 2016, and consisted primarily of a net loss of $44.1 million adjusted for non-cash items including depreciation and amortization expenses of $4.2 million, stock-based compensation expense of $0.9 million, change in operating assets and liabilities of approximately $0.2 million, and other non-cash items of $0.2 million. Net cash used in operating activities was $51.3 million in fiscal 2017, and consisted primarily of a net loss of $59.3 million adjusted for non-cash items including depreciation and amortization expenses of $5.0 million, stock-based compensation expense of $1.9 million, a change in operating assets and liabilities of approximately $0.1 million, and a net increase of non-cash items of $1.2 million. Net cash used in operating activities was $66.2 million in fiscal 2018, and consisted primarily of a net loss of $71.2 million adjusted for non-cash items including depreciation and amortization expenses of $5.7 million, stock-based compensation expense of $3.0 million, a change in operating assets and liabilities of approximately $4.2 million, and a net increase of non-cash items of $0.5 million. Investing activities In fiscal 2016, our investing activities used net cash of $33.3 million. The investing activity included the purchases of investments, laboratory property and equipment. In fiscal 2017, our investing activities used net cash of approximately $9.9 million. The use of net cash resulted primarily from the net impact of purchases and maturity of investments, and purchases of laboratory property, equipment and computers. In fiscal 2018, our investing activities provided net cash of approximately $26.9 million. Investing activities included the purchases and maturity of investments and purchases of laboratory property, equipment and computers. Financing activities Net cash provided by financing activities was $69.6 million in fiscal 2016, which consisted of $62.3 million from the issuance of redeemable convertible preferred stock, $0.2 million from the issuance of common stock, and $7.7 million from the issuance of debt, partially offset by the repayment of $0.4 million of debt. Net cash provided by financing activities was $63.8 million in fiscal 2017, which consisted of $65.6 million from the issuance of redeemable convertible preferred stock, $0.2 million from the issuance of common stock, $2.2 million from additional debt, off-set by the repayment of $4.2 million of debt. Net cash provided by financing activities was $88.6 million in fiscal 2018, which consisted of $90.9 million from the issuance of convertible preferred stock, $2.4 million in payment of deferred offering costs, and $0.3 million from the issuance of common stock and exercise of stock options. Off-balance sheet arrangements We do not have any off-balance sheet arrangements other than our indemnification agreements as described in Note 8 of the consolidated financial statements included elsewhere in this Form 10-K. Contractual obligations and other commitments Set forth below is information concerning our contractual commitments and obligations as of September 30, 2018: In September 2016, we entered into a collaboration agreement with Distributed Bio to offer therapeutic antibody design and optimization services, as well as an exclusive library targeting G-protein coupled receptors to our customers. Upon successful commercialization, we agreed on a profit-sharing and license arrangement for an Antibody Optimization Software and GPCR-Targeting Antibody Library, which includes royalty payments for discovered pharmaceutical products in a tiered structure, which ranges from 25% to 35% of net revenue generated. In March 2018, we entered into a stock purchase agreement related to the sale of additional shares of our Series D redeemable convertible preferred stock for the amount of $70.0 million. Pursuant to a side letter to the stock purchase agreement, we have committed, subject to certain conditions, to using commercially reasonable efforts to invest up to $5.0 million, $10.0 million and $10.0 million over a three year period in connection with the incorporation, business and/or operations of a wholly owned foreign enterprise in the PRC. Critical accounting policies and significant management estimates The discussion and analysis of our financial condition and results of operations are based upon our audited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, management evaluates the reasonableness of its estimates. Management bases its estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results may differ materially from these estimates under different assumptions or conditions. We believe the following critical accounting policies require that we make significant judgments and estimates in preparing our consolidated financial statements. Revenue recognition Effective October 1, 2017, we elected to early adopt the requirements of ASC 606 - Revenue from Contracts with Customers using the full retrospective method. We evaluated the impact on revenues, loss from operations, net loss attributable to common stockholders and basic and diluted earnings per share for all periods presented and concluded that there was no material impact on our consolidated financial statements for all periods presented. Our revenue is generated through the sale of synthetic biology tools, such as synthetic genes, or clonal genes and fragments, oligonucleotide pools, or oligo pools, next generation sequencing, or NGS tools and DNA libraries. We account for a contract when it has approval and commitment from both parties, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. Contracts with customers are generally in the written form of a purchase order or a quotation, which outline the promised goods and the agreed upon price. Such orders are often accompanied by a Master Supply or Distribution Agreement that establishes the terms and conditions, rights of the parties, delivery terms, and pricing. We assess collectability based on a number of factors, including past transaction history and creditworthiness of the customer. For all of our contracts to date, the customer orders a specified quantity of a synthetic DNA sequence; therefore, the delivery of the ordered quantity per the purchase order is accounted for as one performance obligation. Some contracts may contain prospective discounts when certain order quantities are exceeded; however, these future discounts are either not significant, not deemed to be incremental to the pricing offered to other customers, or not enforceable options to acquire additional goods. As a result, these discounts do not constitute a material right and do not meet the definition of a separate performance obligation. We do not offer retrospective discounts or rebates. The transaction price is determined based on the agreed upon rates in the purchase order or master supply agreements applied to the quantity of synthetic DNA that was manufactured and shipped to the customer. Our contracts include only one performance obligation-the delivery of the product to the customer. Accordingly, all of the transaction price, net of any discounts, is allocated to the one performance obligation. Therefore, upon delivery of the product, there are no remaining performance obligations. Our shipping and handling activities are performed before the customer obtains control of the goods and therefore are considered a fulfillment cost. We have elected to exclude all sales and value added taxes from the measurement of the transaction price. We have not adjusted the transaction price for significant financing since the time period between the transfer of goods and payment is less than one year. We recognize revenue at a point in time when control of the products is transferred to the customer. Management applies judgment in evaluating when a customer obtains control of the promised good which is generally when the product is delivered to the customer. Our customer contracts generally include a standard assurance warranty to guarantee that our products comply with agreed specifications. We reduce revenue by the amount of expected returns which have been insignificant. We have elected the practical expedient of not disclosing the consideration allocated to remaining performance obligations and an explanation of when those amounts are expected to be recognized as revenue since the duration of our contracts is less than one year. We do not have any contract assets or contract liabilities as of September 30, 2017 and September 30, 2018. For all periods presented, we did not recognize revenue from amounts that were included in the contract liability balance at the beginning of each period. In addition, for all periods presented, there was no revenue recognized in a reporting period from performance obligations satisfied in previous periods. Based on the nature of our contracts with customers which are recognized over a term of less than 12 months, we have elected to use the practical expedient whereby costs to obtain a contract are expensed as they are incurred. We state our revenues net of any taxes collected from customers that are required to be remitted to various government agencies. The amount of taxes collected from customers and payable to governmental entities is included on the balance sheet as part of “Accrued expenses and other current liabilities.” Income tax In preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our audited consolidated balance sheets. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. A valuation allowance reduces our deferred tax assets to the amount that management estimates is more likely than not to be realized. In determining the amount of the valuation allowance, we consider income over recent years, estimated future taxable income, feasible tax planning strategies and other factors in each taxing jurisdiction in which we operate. If we determine that it is more likely than not that we will not realize all or a portion of our remaining deferred tax assets, then we will increase our valuation allowance with a charge to income tax expense. Conversely, if we determine that it is likely that we will ultimately be able to utilize all or a portion of the deferred tax assets for which a valuation allowance has been provided, then the related portion of the valuation allowance will reduce income tax expense. Significant management judgment is required in determining our provision for income taxes and potential tax exposures, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish a valuation allowance, which could materially impact our financial position and results of operations. Our ability to utilize our deferred tax assets and the need for a related valuation allowance are monitored on an ongoing basis. Furthermore, computation of our tax liabilities involves examining uncertainties in the application of complex tax regulations. We recognize liabilities for uncertain tax positions based on the two-step process as prescribed by the authoritative guidance provided by FASB. The first step is to evaluate the tax position to determine whether there is sufficient available evidence to indicate if it is more likely than not that the position will be sustained on audit, including resolution of any related appeals or litigation processes. The second step requires us to measure and determine the approximate amount of the tax benefit at the largest amount that is more than 50% likely of being realized upon ultimate settlement with the tax authorities. It is inherently difficult and requires significant judgment to estimate such amounts, as this requires us to determine the probability of various possible outcomes. We reexamine these uncertain tax positions on a quarterly basis. This reassessment is based on various factors during the period including, but not limited to, changes in worldwide tax laws and treaties, changes in facts or circumstances, effectively settled issues under audit and any new audit activity. A change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision in the period. Stock-based compensation We have granted stock-based awards, consisting of stock options and restricted stock, to our employees, certain non-employee consultants and certain members of our board of directors. We measure stock-based compensation expense for restricted stock and stock options granted to our employees and directors on the date of grant and recognize the corresponding compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. We account for stock-based compensation arrangements with non-employee consultants using a fair value approach. The estimated fair value of unvested options granted to non-employee consultants is remeasured at each reporting date through the date of final vesting. As a result, the noncash charge to operations for nonemployee options with vesting conditions is affected in each reporting period by changes in the estimated fair value of our common stock. We adjust for actual forfeitures as they occur. We estimate the fair value of stock options granted to our employees and directors on the grant date, and rights to acquire stock granted under our Employee Stock Purchase Plan , and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of highly subjective assumptions which determine the fair value of stock-based awards. These assumptions include: • Expected Term. Our expected term represents the period that our stock-based awards are expected to be outstanding and is determined using the simplified method (based on the mid-point between the vesting date and the end of the contractual term), as we do not have sufficient historical data to use any other method to estimate expected term. • Expected Volatility. As we have very limited trading history of our common stock, the expected volatility is estimated based on the average volatility for comparable publicly traded biopharmaceutical companies over a period equal to the expected term of the stock option grants. The comparable companies are chosen based on their similar size, stage in the life cycle or area of specialty. • Risk-Free Interest Rate. The risk-free interest rate is based on the U.S. Treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of the stock option grants. • Expected Dividend. We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we use an expected dividend yield of zero. For options granted to non-employee consultants, the fair value of these options is also remeasured using the Black-Scholes option-pricing model reflecting the same assumptions as applied to employee options in each of the reported periods, other than the expected life, which is assumed to be the remaining contractual life of the option. Determination of the fair value of common stock on grant dates Prior to our IPO, the estimated fair value of our shares of common stock was determined by our board of directors and/or our compensation committee as of the grant date, with input from management, considering our most recently available independent third-party valuation of our common stock and our board of directors’ and/or compensation committee’s assessment of additional objective and subjective factors that it believed were relevant and which may have changed between the effective date of the most recent valuation and the date of the grant. Subsequent to the completion of our IPO, we use the closing price of common stock as reported on the Nasdaq Global Select Market on the grant date . The independent third-party valuations were generally performed quarterly in accordance with the guidance outlined in the AICPA Practice Aid, Valuation of Privately-Held Company Equity Securities Issued as Compensation, or AICPA’s Practice Aid. In conducting the valuations, the independent third-party valuation specialist considered all objective and subjective factors that it believed to be relevant for each valuation conducted in accordance with AICPA’s Practice Aid, including management’s best estimate of our business condition, prospects and operating performance at each valuation date. Other significant factors included: • the rights, preferences and privileges of our preferred stock as compared to those of our common stock, including the liquidation preferences of our preferred stock; • our results of operations, financial position and the status of research and development efforts; • arms-length transactions involving recent rounds of preferred stock financings; • the composition of, and changes to, our management team and board of directors; • the lack of liquidity of our common stock; • our stage of development and business strategy and the material risks related to our business and industry; • the valuation of publicly traded companies in the life sciences and biotechnology sectors, as well as recently completed mergers and acquisitions of peer companies; • any external market conditions affecting the life sciences and biotechnology industry sectors; • the likelihood of achieving a liquidity event for the holders of our common stock and stock options, such as an initial public offering, or IPO, or a sale of our company, given prevailing market conditions; and • the state of the IPO market for similarly situated privately held biotechnology companies. The independent third-party valuations utilized market-based valuation approaches, including the option pricing method, or OPM, the Probability-Weighted Expected Return Method, or PWERM, and a hybrid methodology utilizing both OPM and PWERM. The OPM treats the rights of the holders of preferred and common stock as equivalent to that of call options on any value of the enterprise above certain break points of value based upon the liquidation preferences of the holders of preferred stock, as well as their rights to participation and conversion. Under OPM, the value of a company’s common stock is determined by estimating the value of its portion of each of these call option rights. Under the PWERM, the value of a company’s common stock is estimated based upon an analysis of values for the company assuming various possible future events: IPO, strategic merger or sale, dissolution/no value to common and private company. The per share value of the company’s common stock is based upon the probability-weighted present value of expected future equity values, under each of the possible future event scenarios, as well as the rights and preferences of each share class. Under the hybrid method, the per share values calculated under the OPM and PWERM are weighted appropriately to arrive at a final per share fair value of the company’s common stock before the discount for lack of marketability is applied. The independent third-party valuations covering fiscal year 2016 through March 31, 2017 were prepared utilizing the OPM as the primary valuation method. The material assumptions used in the OPM include recent rounds of preferred stock financing, estimated future revenues, and the valuation of peer companies. Subsequent to March 31, 2017, the independent third-party valuations were prepared utilizing a hybrid allocation methodology (with both OPM and PWERM used) as the primary allocation method, with the same steps discussed above being applied. The material assumptions used in the hybrid method consist of the weighting of values determined under the OPM and PWERM. In the last valuation of our common stock in September 30, 2018 the PWERM valuation methodology was used 100% to value our stock. The material assumptions used in the PWERM include the estimated value, timing and weighting of potential liquidity events. All of our independent third-party valuations also included appropriate discounts to the value of our common stock for lack of marketability, prior to the IPO on October 31, 2018. Recently issued accounting pronouncements For a description of accounting changes and recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see Note 2, “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K for a further discussion of the impairment analysis of acquisition-related intangible assets.

<s>[INST] Overview We are a leading and rapidly growing synthetic biology company that has developed a disruptive DNA synthesis platform to industrialize the engineering of biology. The core of our platform is a proprietary technology that pioneers a new method of manufacturing synthetic DNA by “writing” DNA on a silicon chip. We have combined this technology with proprietary software, scalable commercial infrastructure and an ecommerce platform to create an integrated technology platform that enables us to achieve high levels of quality, precision, automation, and manufacturing throughput at a significantly lower cost than our competitors. We are leveraging our unique technology to manufacture a broad range of synthetic DNAbased products, including synthetic genes, tools for next generation sample preparation, and antibody libraries for drug discovery and development. Additionally, we believe our platform will enable new valueadd opportunities, such as discovery partnerships for biologic drugs, and will enable new applications for synthetic DNA, such as digital data storage. We sell our synthetic DNA and synthetic DNAbased products to a customer base of over 700 customers across a broad range of industries. We launched the first application of our platform, synthetic genes and oligo pools, in April 2016 to disrupt the gene synthesis market and make legacy DNA synthesis methods obsolete. From inception to September 30, 2018, we have sold our products to more than 700 customers. In fiscal 2017, we served 286 customers including $0.3 million in sales to seven of the top 20 pharmaceutical companies by revenue, $4.3 million in sales to Ginkgo Bioworks, Inc., or Ginkgo Bioworks (which we believe is the largest global purchaser of synthetic DNA), $0.3 million in sales to three of the largest agricultural biotechnology companies, $2.7 million in sales to over 100 academic research institutions worldwide, and $7.3 million in sales to innovative customers using synthetic DNA for new and emerging applications, such as Microsoft Corporation and the University of Washington for use of DNA as a digital data storage medium. We are also an original equipment manufacturer, or OEM, of synthetic DNA to four synthetic DNA manufacturers that also compete with us, which we believe is a strong demonstration of the superiority of our platform. In fiscal 2018, we served 719 customers as follows: sales to the industrial chemicals sector, the academic research sector, the agricultural sector and the healthcare sector accounted for 59%, 23%, 2% and 16% of the total $25.4 million revenues for the year ended September 30, 2018. Sales to Ginkgo Bioworks amounted to $8.7 million, or 34% and sales to customers other than Ginkgo Bioworks was $16.7 million, or 66%, for the year ended September 30, 2018; an increase in revenue of 101% and 160%, respectively, as compared to the year ended September 30, 2017. We have also leveraged the versatility of our platform to expand our product portfolio into other markets in which we believe we have a competitive advantage. In February 2018, we launched an innovative and comprehensive preparation kit for next generation sequencing at the Advances in Genome Biology and Technology conference. Our kit leverages our platform to precisely synthesize oligo pools and uniformly amplify the desired target DNA segments, considerably improving the accuracy of the downstream sequencing analysis. We have also commercialized a custom DNA library solution which enables more effective biologic drug discovery and development for our customers. We believe we can further leverage our platform to develop other proprietary tools, such as our antiGPCR library and antibody optimization solution, to provide an endtoend solution in biologics drug discovery and early development, from target to Investigational New Drug (IND) application, adding value as a partner to biotech and pharmaceutical companies. We also aim to explore development of DNA as a digital data storage medium via internal research and industry partnerships. We have built a scalable commercial platform that enables us to reach a diverse customer base that we believe includes over 100,000 synthetic DNA users today. In order to address this diverse customer base, we have employed a [/INST] Negative. </s>

Twist Bioscience Corp

2019-12-13

2019-09-30

Item 7. Management’s discussion and analysis of financial condition and results of operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to those statements included elsewhere in this Form 10-K. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under “Risk factors” and elsewhere in this Form 10-K. The last day of our fiscal year is September 30, and we refer to our fiscal year ended September 30, 2017 as fiscal 2017 or 2017, September 30, 2018 as fiscal 2018 or 2018 and our fiscal year ended September 30, 2019 as fiscal 2019 or 2019. Overview We are a leading and rapidly growing synthetic biology company that has developed a disruptive DNA synthesis platform to industrialize the engineering of biology. The core of our platform is a proprietary technology that pioneers a new method of manufacturing synthetic DNA by “writing” DNA on a silicon chip. We have combined this technology with proprietary software, scalable commercial infrastructure and an e-commerce platform to create an integrated technology platform that enables us to achieve high levels of quality, precision, automation, and manufacturing throughput at a significantly lower cost than our competitors. We are leveraging our unique technology to manufacture a broad range of synthetic DNA-based products, including synthetic genes, tools for next generation sample preparation, and antibody libraries for drug discovery and development. Additionally, we believe our platform will enable new value-add opportunities, such as discovery partnerships for biologic drugs, and will enable new applications for synthetic DNA, such as digital data storage. We sell our synthetic DNA and synthetic DNA-based products to a customer base of 1,305 customers across a broad range of industries. We launched the first application of our platform, synthetic genes and oligo pools, in April 2016 to disrupt the gene synthesis market and make legacy DNA synthesis methods obsolete. In fiscal 2017, we served 286 customers including $0.3 million in sales to seven of the top 20 pharmaceutical companies by revenue, $4.3 million in sales to Ginkgo Bioworks, Inc., or Ginkgo Bioworks (which we believe is the largest global purchaser of synthetic DNA), $0.3 million in sales to three of the largest agricultural biotechnology companies, $2.7 million in sales to over 100 academic research institutions worldwide, and $7.3 million in sales to innovative customers using synthetic DNA for new and emerging applications, such as Microsoft Corporation and the University of Washington for use of DNA as a digital data storage medium. We are also an original equipment manufacturer, or OEM, of synthetic DNA to four synthetic DNA manufacturers that also compete with us, which we believe is a strong demonstration of the superiority of our platform. In fiscal 2018, we served 717 customers, and sales to the industrial chemicals sector, the academic research sector, the agricultural sector and the healthcare sector accounted for 59%, 23%, 2% and 16% of the total $25.4 million revenues for the year ended September 30, 2018. Sales to Ginkgo Bioworks amounted to $8.7 million, or 34% and sales to customers other than Ginkgo Bioworks was $16.7 million, or 66%, for the year ended September 30, 2018; an increase in revenue of 101% and 160%, respectively, as compared to the year ended September 30, 2017. In fiscal 2019, we served 1,305 customers, and sales to the industrial chemicals sector, healthcare sector, the academic research sector, and the agricultural sector accounted for 40%, 32%, 26% and 2% of the total $54.4 million revenues for the year ended September 30, 2019. Sales to Ginkgo Bioworks amounted to $9.2 million, or 17% of our total revenue in fiscal 2019. We have leveraged the versatility of our platform to expand our product portfolio into other markets in which we believe we have a competitive advantage. In February 2018, we launched an innovative and comprehensive preparation kit for next generation sequencing at the Advances in Genome Biology and Technology conference. In February 2019, we announced an expansion of next generation sequencing product offerings including Twist Fast Hybridization and wash kits. Our kit leverages our platform to precisely synthesize oligo pools and uniformly amplify the desired target DNA segments, accelerating the hybridization process and considerably improving the accuracy of the downstream sequencing analysis. We have also commercialized a custom DNA library solution which enables more effective biologic drug discovery and development for our customers. We believe we can further leverage our platform to develop other proprietary tools, such as our GPCR library and antibody optimization solution, to provide services in biologics drug discovery and early development, from target to Investigational New Drug (IND) application, adding value as a partner to biotech and pharmaceutical companies. We also aim to explore the development of DNA as a digital data storage medium via internal research and industry partnerships. In July 2019 we announced the launch of our 300 nucleotide length Oligo pools. These longer Oligos are suited for many applications including drug discovery and development, data storage, CRISPR gene editing and protein engineering. We have built a scalable commercial platform that enables us to reach a diverse customer base that we believe includes over 100,000 synthetic DNA users today. To address this diverse customer base, we have employed a multi-channel strategy comprised of a direct sales force targeting synthetic DNA customers, international distributors, and an e-commerce platform. We launched our proprietary, innovative, and easy-to-use e-commerce platform in October 2017 to existing customers and expanded access to the general public in January 2018. Our platform allows customers to design, validate and place on-demand orders of customized DNA online. This is a key component of our strategy to address and support our diverse and growing customer base, as well as support commercial productivity, enhance the customer experience, and promote loyalty. On October 30, 2018, our registration statement on Form S-1 was declared effective by the SEC, and our shares began trading on the NASDAQ Global Stock Market on October 31, 2018. A total of 5,750,000 shares were offered and sold at a price of $14.00 per share. As a result of the initial public offering, or IPO, the Company received $69.6 million in net proceeds, after deducting underwriting discounts and commissions of $5.6 million and offering expenses of approximately $5.3 million payable by the Company. In May 2019, we completed an underwritten public offering of common stock. A total of 4,312,500 shares were offered and sold at a price of $21.00 per share, and the Company received net proceeds of $84.3 million, after deducting underwriting discounts and commissions of $5.4 million and offering expenses of $0.9 million. We generated revenues of $54.4 million in the year ended September 30, 2019, $25.4 million in the year ended September 30, 2018 and $10.8 million in the year ended September 30, 2017, while incurring net losses of $107.7 million, $71.2 million and $59.3 million in the years ended September 30, 2019, 2018 and 2017, respectively. Since our inception, we have incurred significant operating losses. Our ability to generate product revenue sufficient to achieve profitability will depend heavily on the success of our existing products and development and commercialization of additional products in the synthetic biology industry. As of September 30, 2019, we had $138.1 million cash, cash equivalents and short-term investments. We believe that our existing cash and cash equivalents will be sufficient to fund our planned operating expenses, capital expenditure requirements and debt service payments for at least one year from the issuance of these consolidated financial statements. However, the Company may need to obtain additional financing to fund operations beyond this period, and there can be no assurance that the Company will be successful in raising additional financing on terms which are acceptable to the Company. We have based these estimates on assumptions that may prove to be wrong, and we could exhaust our available capital resources sooner than we expect. See “Liquidity and capital resources.” See Item 1. Business above for additional information regarding our business, products, competitive market and regulatory matters. Key business metrics We regularly review the following key business metrics to evaluate our business, measure our performance, identify trends affecting our business, formulate financial projections and make strategic decisions. We believe that the following metrics are representative of our current business; however, we anticipate these will change or may be substituted for additional or different metrics as our business grows. Value of orders received We believe that the value of orders we receive is a leading indicator of our ability to generate revenue in subsequent quarters although there can be no assurance orders will translate into revenue. We define an order as a contract with a customer or purchase order from a customer, which outlines the promised goods at an agreed upon price. We regularly assess trends relating to the value of orders we receive, including with respect to our customer concentration. Since commercially launching our product in April 2016, orders from customers have rapidly increased. Commencing with our Beta Access program, we believe we have successfully achieved industry-leading volumes of synthetic DNA orders. In 2018, we launched our e-commerce platform to enable customers to conveniently order our products online. These steps have contributed to triple digit order growth over the last three years, which is illustrated in the table below. (NM)-Not meaningful Orders may never convert into actual revenue and the timing of delivery of our orders and recognition of revenue, if any, may vary based on the nature of the order, and there can be no assurance that orders will result in recognized revenue. The following table lists the value of orders received, including Ginkgo and non-Ginkgo orders, during the periods indicated: Number of customers We believe that the number of customers who have purchased from us since inception is representative of our ability to drive adoption of our products and convert DNA Makers to DNA Buyers. We define customers as separate legal entities or persons who have purchased and directly paid for our products. This means that if a parent company is a customer of ours, it is counted as one customer, and if its subsidiary also purchases our products from us, and the subsidiary makes a payment directly to us, we count the subsidiary as a separate customer. We apply this methodology of counting customers because it is not possible for our e-commerce platform and other data tracking software to distinguish accurately between affiliated purchasers. Percentage of revenue from new vs. repeat customers We believe that the percentage of revenue that we generate from both new and repeat customers is an indicator of our ability to drive adoption of our products amongst existing customers while also generating a robust pipeline of new customers. We define a new customer as a customer who, as a separate legal entity or person, has not had multiple purchases in the current fiscal year. We define a repeat customer as any customer who, as a separate legal entity or person, has purchased products or services from us more than once in the current fiscal year. The table below represents sales to individual customers. We shipped products to 286 customers in fiscal 2017, 717 customers in fiscal 2018 and 1,305 customers in fiscal 2019. Financial overview The following table summarizes certain selected historical financial results: Revenues We generate revenue from sales of synthetic genes, oligo pools, next generation sequencing tools and DNA libraries. We recognize revenue upon delivery (Shipment) to our customers and bill them directly for the shipments. Our ability to increase our revenues will depend on our ability to further penetrate the domestic and international markets, generate sales through our direct sales force and over time from our e-commerce platform and launch new products. Revenues by geography We have one reportable segment from the sale of synthetic DNA products. The following table shows our revenues by geography, based on our customers’ shipping addresses. North America consists of Canada and Mexico; EMEA consists of Europe, Middle East, and Africa; and APAC consists of Japan, China, South Korea, Singapore, Malaysia and Australia. Revenues by products The table below sets forth revenues by products: Revenues by industry Revenues by industry were as follows: Revenues and accounts receivable concentration Customer revenues equal to or greater than 10% of total revenues was as follows: One customer accounted for greater than 10% of net accounts receivable as follows: Product shipments including synthetic genes Shipments of all products and number of genes shipped in years ended September 30, 2019, 2018 and 2017 were as follows: Cost of revenues Cost of revenues reflect the aggregate cost incurred in the production and delivery of our products and consists of production materials, personnel costs (salaries, benefits, bonuses and stock-based compensation), cost of expensed equipment and consumables, laboratory supplies, depreciation of capitalized equipment, production overhead costs and allocations of IT and facility costs. We expect that our cost of revenues will increase as we increase our revenues with new product developments. Other operating expenses Our operating expenses are classified in the following categories: Research and development, and selling, general and administrative. For each category, the largest component is personnel costs, which includes salaries, employee benefit costs, bonuses, and stock-based compensation expenses. Research and development Research and development expenses consist primarily of costs incurred for the development of our products, which include personnel costs, laboratory supplies, consulting costs and allocated overhead, including IT and facility costs. We expense our research and development expenses in the period in which they are incurred. We expect to increase our research and development expenses as we continue to invest in new product development. Selling, general and administrative Selling expenses consist of personnel cost, customer service expenses, direct marketing expenses, educational and promotional expense, market research and analysis. General and administrative expenses include executive, finance and accounting, legal and human resources. These expenses consist of personnel costs, audit and legal expenses, consulting costs and allocated IT and facility costs. We expense all selling, general and administrative expenses as incurred. We expect our selling and marketing cost will continue to increase in absolute dollars, primarily driven by our efforts to expand our commercial capability, with an increased presence both within and outside the United States, and to expand our brand awareness and customer base through targeted marketing initiatives. We expect general and administrative expenses will increase as well as we scale our operations. Interest expense Interest expense is attributable to borrowing under our senior secured term loan and our equipment financing facility. Interest income Interest income consists primarily of interest earned on our cash, cash equivalents, and short-term investments. Other income (expense), net Other income (expense), net consists of realized foreign exchange gains and losses and loss on disposal of property and equipment. Results of operations The following table sets forth selected consolidated statements of operations data for the fiscal years indicated and the percentage change in such data from year to year. These historical operating results may not be indicative of the results for any future period. Comparison of the years ended September 30, 2019, 2018 and 2017 Revenues Revenues increased from $25.4 million to $54.4 million in the year ended September 30, 2019, which was an increase of $29.0 million, or 114%. The increase in revenue was primarily due to increase in NGS tools which grew from $2.7 million in 2018 to $21.0 million in 2019 and $8.7 million increase revenue in Synthetic genes to $26.7 million in year ended September 2019. The NGS tools revenue growth period-over-period was attributed to the full commercial product launch in February 2018, customer adoption in 2019 and higher volumes as an increasing number of customers adopted our NGS tools and scaled production. The increase in synthetic genes revenue was attributed to a 17% volume growth as we shipped 288,424 genes in in the year ended September 2019 as compared to 247,102 genes in the prior year. In addition, we also benefited from higher revenue in our 5.0KB clonal genes which was released to our customers in January 2019. Gene pricing to our customers was relatively constant period-over-period. Revenues increased from $10.7 million to $25.4 million in the year ended September 30, 2018, which was an increase of $14.7 million, or 136%. This revenue increase was driven by revenues from synthetic genes of $18.0 million and NGS tools of $2.7 million. The primary increase in synthetic genes revenue was attributed to volume increases of genes shipped to customers period-over-period, driven by increased investment in our sales force infrastructure and the launching of the e-commerce platform in fiscal 2018. In the year ended September 30, 2018, we shipped 247,102 genes compared to 125,462 genes in the year ended September 30, 2017, an increase of 96%. Gene pricing to our customers was relatively constant period-over-period. The primary reasons for NGS tools revenue growth period-over-period was attributed to the full commercial launching of the product in February 2018, increased investment in our sales force infrastructure and the volume of units shipped in fiscal 2018. We do not believe the pricing had a meaningful impact on the revenue changes for NGS tools period-over-period. Revenues from customers other than Ginkgo Bioworks increased $10.2 million or 160% from $6.5 million to $16.7 million and revenue from Ginkgo Bioworks increased $4.4 million, an increase of 102% from $4.3 million to $8.7 million compared to the prior year ended September 30, 2017. Revenue from repeat customers increased $17.9 million or 263% from $6.8 million to $24.6 million in the year ended September 30, 2017 and 2018, respectively. Revenue increased to $10.8 million in the year ended September 30, 2017, as we continued to ramp up production capacity and sales of our synthetic DNA products, primarily oligonucleotides, clonal and non-clonal synthetic genes, DNA libraries and oligo pools. In fiscal 2017, revenues from customers in the United States accounted for 77% and 23% from customers outside the United States. Cost of revenues In the year ended September 30, 2019, total cost of revenue increased by $15.2 million to $47.4 million from $32.2 million in the prior year. The increase was primarily due to higher consumption of reagents and production materials of $6.9 million associated with the increased product shipments and higher revenue. Payroll and stock compensation related expense increase of $7.7 million, facilities and information technology costs increased by $2.0 million including facilities move expenses of $0.4 million. In the year ended September 30, 2018, total cost of revenue increased by $8.2 million from $24.0 million to $32.2 million from the prior year. The increase was primarily due to payroll and stock compensation related expense increase of $3.6 million, increase of consumption of reagents and production materials of $2.8 million, consulting and outside services increase of $0.9 million and facilities cost increase of $0.9 million over prior year. In the year ended September 30, 2017, total cost of revenues increased to $24.0 million from $9.4 million in the year ended September 30, 2016, primarily due to payroll and stock compensation related expenses of $4.8 million due to an increase in headcount, increased consumption of reagents and production materials of $4.0 million, increased information technology and facilities costs of $2.4 million, increased consulting and outside services of $0.6 million, $1.7 million increase in depreciation expense related to additional equipment for increased production capacity, and increased maintenance costs of $0.4 million. Research and development expenses Research and development costs increased by $15.3 million to $35.7 million for the year ended September 30, 2019, as compared to the same period 2018. The increase was due to increase in personnel related costs of $8.6 million including $6.2 million for salaries and benefits, increased bonus of $0.8 million and $1.7 million stock-based compensation. Equipment depreciation, amortization and maintenance costs increased by $1.3 million, lab supplies rose $2.0 million and outside services increased by $1.8 million. Information technology and facilities costs increased by $0.9 million including facilities move expenses of approximately $0.4 million. In addition, there were $0.5 million in payments from Defense Advanced Research Projects Agency (DARPA) received during the 2019 fiscal year. For the year ended September 30, 2018, research and development expenses increased from $19.1 million to $20.3 million, an increase of 6%. The increase was driven primarily from an increase in personnel related costs of $1.3 million, subcontracting services increase of $0.5 million and other increases for $0.1 million offset by decrease of prototype supplies of ($0.8) million. The R&D group hired full time staffing and used less materials in research. In addition, there were $0.3 million in payments from DARPA received during the 2018 fiscal year. Research and development expenses increased by $0.9 million or 5% from $18.2 million in the year ended September 30, 2016 to $19.2 million in the year ended September 30, 2017. This was primarily due to increased development activities for new product offerings, materials costs, and information technology and facilities costs. In fiscal 2017, information technology and facilities costs increased by $0.9 million compared to fiscal 2016, primarily due to the signing of lease agreements for additional facilities located in San Francisco and South San Francisco. Additional research and development expenses of $3.4 million were also incurred in fiscal 2017 in connection with the acquisition of Genome Compiler Corporation in the prior fiscal year. In fiscal 2016, we received $2.4 million DARPA payments, whereas in fiscal 2017 there were no DARPA payments to offset expenses. In fiscal 2017, laboratory materials used in research and development increased $0.5 million from $2.7 million to $3.2 million and allocations from facilities and information technology increased $0.9 million. Selling, general and administrative expenses Selling, general and administrative expenses increased by $36.7 million to $80.0 million for the year end September 30, 2019, compared to the same period for 2018. The increase was primarily due to increases in personnel expenses of $18.4 million related to $10.3 million increase in salaries and benefits mainly associated with expanding our commercial organization, higher bonuses and sales commissions of $2.5 million, and increased stock-based compensation of $5.6 million. Marketing costs increased by $1.2 million as we continue to invest in our brand. External legal expenses increased by $11.8 million and higher insurance costs of $1.6 million associated with being public. Travel costs increased by $1.7 million mainly due to the increased staffing in our commercial organization. Selling, general and administrative expenses increased by $17.4 million, or 67%, from $26.1 million in the year ended September 30, 2017 to $43.5 million in the year ended September 30, 2018, primarily due to increases in payroll expenses related to increased headcount, advertising and marketing expenses, professional and legal expenses, stock compensation expenses and information technology related charges. Salaries and related costs increased by $8.2 million in fiscal 2018, as a result of increased headcount in our sales department. In addition, professional services expenses increased by $4.7 million due to commercial expansion of our products and setting up our infrastructure to become a public company. Our marketing related activities increased $1.7 million and remaining increases all relate to commercialization of sales group or corporate development towards preparation of going public. Selling, general and administrative expenses increased by $7.8 million, or 43%, from $18.3 million in the year ended September 30, 2016 to $26.1 million in the year ended September 30, 2017, primarily due to increases in payroll related to increased headcount, professional and legal expenses, information technology and facilities expenses. Salaries and related costs increased by $1.9 million in fiscal 2017, as a result of increased headcount in our sales department. In addition, professional and legal expenses increased by $5.2 million due to commercial expansion of our products Interest, and other income (expense), net Interest income was $3.0 million in the year ended September 30, 2019, $1.0 million in the year ended September 30, 2018 and $0.4 million in the year ended September 30, 2017, resulting from our short-term investments. Interest expense was $1.3 million in fiscal 2019, $1.3 million in fiscal 2018 and $0.9 million in fiscal 2017 related to our outstanding debt. Provision for income taxes We recorded provision for income taxes of $0.3 million in 2019, $0.2 million in 2018 and $0.3 million in 2017. Quarterly Results of Operations The following table shows unaudited quarterly consolidated statement of operations data for each of the last eight quarters. In the opinion of management, the information for each of these quarters has been prepared on the same basis as our audited financial statements and include all adjustments, consisting of normal recurring adjustments and accruals, necessary for the fair statement of financial information in accordance with generally accepted accounting principles. This information should be read in conjunction with the audited consolidated financial statements and related notes included in this Form 10-K. Historical results are not necessarily indicative of results that may be achieved in future periods, and operating results for quarterly periods are not necessarily indicative of operating results for a full year. You should read this unaudited consolidated statement of operations data in conjunction with our consolidated financial statements and the related notes included elsewhere in this Form 10-K. Liquidity and capital resources Sources of liquidity To date, we have financed our operations principally through private placements of our convertible preferred stock, borrowings from credit facilities, public equity raises and revenue from our commercial operations. Since our inception on February 4, 2013 and through September 30, 2019, we have received an aggregate of $444.4 million in net proceeds from the issuance of equity securities and an aggregate of $13.8 million from debt. As of September 30, 2019, we had a balance of $46.7 million of cash and cash equivalents and $91.4 million in short-term investments. Preferred stock financings As of September 30, 2019, we had raised $290.5 million in net proceeds from the sale of our equity securities, including the sale of 10,326,454 shares of our Series D redeemable convertible preferred stock from January 2016 through September 2018 at a purchase price of $21.24 per share for gross proceeds of $219.4 million. On March 19, 2018 and May 29, 2018, we issued 2,353,544 and 941,417 shares of Series D redeemable convertible preferred stock for an aggregate purchase price of approximately $50.0 million and $20.0 million, respectively. On July 2, 2018 and July 3, 2018, we issued 517,778 and 47,070 shares of Series D redeemable convertible preferred stock for an aggregate purchase price of $11.0 million and $1.0 million, respectively. Debt financings In September 2017, we entered into a Fourth Amended and Restated Loan and Security Agreement, or the Fourth Loan, with SVB, which allowed for borrowings aggregating up to $20.0 million in a series of three advances. The first advance-which was effectuated in September 2017-provided a principal amount of $10.0 million, the second optional advance allowed for a principal amount of $5.0 million and the third optional advance allowed for a principal amount of $5.0 million during their respective drawdown periods; however, the draw periods for the second and third tranches under this agreement have expired as of January 31, 2018 and June 30, 2018, respectively. In connection with the first advance, we issued warrants to purchase 64,127 shares of common stock at an exercise price of $6.24 per share. The Fourth Loan contains a subjective acceleration clause under which the Fourth Loan could become due and payable to SVB in the event of a material adverse change in our business. The term of the loan was 51 months with an interest rate of prime plus 3.00% and a final payment fee of $0.7 million. In addition, we obtained a revolving facility from SVB in September 2017 as part of the Fourth Loan and the facility which allows us to borrow up to $10.0 million. The principal amount outstanding under the revolving line accrues interest at a floating per annum rate equal to one percentage point (1.00%) above the prime rate, which interest shall be payable monthly. The amounts available under the revolving line are limited by an advance rate which is a percentage of our account receivables balance. As of September 30, 2019, we have not borrowed against the $10 million revolving facility. Our credit facilities contain customary representations and warranties and customary affirmative and negative covenants applicable to us and our subsidiaries, including, among other things, restrictions on changes in business, management, ownership or business locations, indebtedness, encumbrances, investments, mergers or acquisitions, dispositions, maintenance of collateral accounts, prepayment of other indebtedness, distributions and transactions with affiliates. The credit facilities contain customary events of default subject in certain cases to grace periods and notice requirements, including (a) failure to pay principal, interest and other obligations when due, (b) material misrepresentations, (c) breach of covenants, conditions or agreements in the credit facilities, (d) default under material indebtedness, (e) certain bankruptcy events, (f) a material adverse change; (g) attachment, levy or restraint on business, (h) default with respect to subordinated debt, (i) cross default under our credit facilities, and (j) government approvals being revoked. As part of the Fourth Loan, all rights, title and interest to our personal property with the exception of our intellectual property, have been pledged as collateral, including cash and cash equivalents, short-term investments, accounts receivable, contractual rights to payment, license agreements, general intangibles, inventory and equipment. We were in compliance with all covenants under the loan and security agreement as of September 30, 2019. Future maturities of the loan as of September 30, 2019 are as follows: Capital resources As of September 30, 2019, we had cash, cash equivalents and short-term investments of $138.1 million. On October 30, 2018, our registration statement on Form S-1 was declared effective by the SEC and our shares began trading on the NASDAQ Global Stock Market on October 31, 2018. A total of 5,750,000 shares were offered and sold at a price of $14.00 per share. As a result of the IPO, the Company received $69.6 million in net proceeds, after deducting underwriting discounts and commissions of $5.6 million and offering expenses of $5.3 million payable by the Company. In May 2019, we completed an underwritten public offering of common stock. A total of 4,312,500 shares were offered and sold at a price of $21.00 per share, and the Company received net proceeds of $84.3 million, after deducting an underwriting discount and commission totaling $5.4 million, and we incurred offering expenses of $0.9 million. We believe that our existing cash and cash equivalents are sufficient to fund our operating expenses, capital expenditure requirements and debt service payments for at least one year from the issuance of these consolidated financial statements. In the future, we may still need to obtain additional financing to fund operations beyond this period, and there can be no assurance that we will be successful in raising additional financing on terms which are acceptable to us. In addition, our operating plan may change as a result of factors currently unknown to us, and we may need to seek additional funds sooner than planned. Such financing may result in dilution to stockholders, imposition of debt covenants and repayment obligations, or other restrictions that may adversely affect our business. In addition, we may seek additional capital due to favorable market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. Our future capital requirements will depend on many factors. See “Risk factors-We will require additional financing to achieve our goals, and a failure to obtain this necessary capital when needed on acceptable terms, or at all, could force us to delay, limit, reduce or terminate our product manufacturing and development and other operations.” Operating capital requirements Our primary uses of capital are, and we expect will continue to be for the near future, compensation and related expenses, manufacturing costs, laboratory and related supplies, legal and other regulatory expenses and general overhead costs. We had $2.5 million in commitments for capital expenditures as of September 30, 2019 and 2018, respectively. Cash flows The following table summarizes our sources and uses of cash and cash equivalents: Operating activities Net cash used in operating activities was $87.9 million in fiscal 2019 and consisted primarily of a net loss of $107.7 million adjusted for non-cash items including depreciation and amortization expenses of $6.1 million, stock-based compensation expense of $11.2 million, a change in operating assets and liabilities of $3.0 million, and a net total of other non-cash items of $0.5 million. Net cash used in operating activities was $66.2 million in fiscal 2018 and consisted primarily of a net loss of $71.2 million adjusted for non-cash items including depreciation and amortization expenses of $5.7 million, stock-based compensation expense of $3.0 million, a change in operating assets and liabilities of $4.2 million, and a net total of other non-cash items of $0.5 million. Net cash used in operating activities was $51.3 million in fiscal 2017 and consisted primarily of a net loss of $59.3 million adjusted for non-cash items including depreciation and amortization expenses of $5.0 million, stock-based compensation expense of $1.9 million, a change in operating assets and liabilities of $0.1 million, and a net total of other non-cash items of $1.2 million. Investing activities In fiscal 2019, our investing activities used net cash of $104.8 million. The use of net cash resulted primarily from the net impact of purchases and maturity of investments and purchases of laboratory property, equipment and computers. In fiscal 2018, our investing activities provided net cash of $27.3 million. Investing activities included the purchases and maturity of investments and purchases of laboratory property, equipment and computers. In fiscal 2017, our investing activities used net cash of $10.0 million. The use of net cash resulted primarily from the net impact of purchases and maturity of investments, and purchases of laboratory property, equipment and computers. Financing activities Net cash provided by financing activities was $158.6 million in fiscal 2019, which consisted of $156.2 million from the issuance of common stock in public offerings, $2.2 million from the issuance of common stock and exercise of stock options, $2.7 million from issuance of common stock under the employee stock purchase plan, and principal payments on long term debt of $2.5 million. Net cash provided by financing activities was $88.8 million in fiscal 2018, which consisted of $90.9 million from the issuance of convertible preferred stock, $2.4 million in payment of deferred offering costs, and $0.3 million from the issuance of common stock and exercise of stock options. Net cash provided by financing activities was $63.8 million in fiscal 2017, which consisted of $65.6 million from the issuance of redeemable convertible preferred stock, $0.2 million from the issuance of common stock, $2.2 million from additional debt, off-set by the repayment of $4.2 million of debt. Off-balance sheet arrangements We do not have any off-balance sheet arrangements other than our indemnification agreements as described in Note 7 of the consolidated financial statements included elsewhere in this Form 10-K. Contractual obligations and other commitments Set forth below is information concerning our contractual commitments and obligations as of September 30, 2019: In September 2016, we entered into a collaboration agreement with Distributed Bio to offer therapeutic antibody design and optimization services, as well as an exclusive library targeting G-protein coupled receptors to our customers. Upon successful commercialization, we agreed on a profit-sharing and license arrangement for an Antibody Optimization Software and GPCR-Targeting Antibody Library, which includes royalty payments for discovered pharmaceutical products in a tiered structure, which ranges from 25% to 35% of net revenue generated. In March 2018, we entered into a stock purchase agreement related to the sale of additional shares of our Series D redeemable convertible preferred stock for the amount of $70.0 million. Pursuant to a side letter to the stock purchase agreement, we have committed, subject to certain conditions, to using commercially reasonable efforts to invest up to $5.0 million in the first year, $10.0 million in the second year and $10.0 million in the third year for an aggregate of $25.0 million over a three-year period in connection with the incorporation, business and/or operations of a wholly owned foreign enterprise in the PRC. Critical accounting policies and significant management estimates The discussion and analysis of our financial condition and results of operations are based upon our audited consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an ongoing basis, management evaluates the reasonableness of its estimates. Management bases its estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results may differ materially from these estimates under different assumptions or conditions. We believe the following critical accounting policies require that we make significant judgments and estimates in preparing our consolidated financial statements. Revenue recognition Effective October 1, 2017, we elected to early adopt the requirements of ASC 606 - Revenue from Contracts with Customers using the full retrospective method. We evaluated the impact on revenues, loss from operations, net loss attributable to common stockholders and basic and diluted earnings per share for all periods presented and concluded that there was no material impact on our consolidated financial statements for all periods presented. Our revenue is generated through the sale of synthetic biology tools, such as synthetic genes, or clonal genes and fragments, oligonucleotide pools, or oligo pools, next generation sequencing, or NGS tools and DNA libraries. We account for a contract when it has approval and commitment from both parties, the rights of the parties are identified, payment terms are identified, the contract has commercial substance and collectability of consideration is probable. Contracts with customers are generally in the written form of a purchase order or a quotation, which outline the promised goods and the agreed upon price. Such orders are often accompanied by a Master Supply or Distribution Agreement that establishes the terms and conditions, rights of the parties, delivery terms, and pricing. We assess collectability based on a number of factors, including past transaction history and creditworthiness of the customer. For all of our contracts to date, the customer orders a specified quantity of a synthetic DNA sequence; therefore, the delivery of the ordered quantity per the purchase order is accounted for as one performance obligation. Some contracts may contain prospective discounts when certain order quantities are exceeded; however, these future discounts are either not significant, not deemed to be incremental to the pricing offered to other customers, or not enforceable options to acquire additional goods. As a result, these discounts do not constitute a material right and do not meet the definition of a separate performance obligation. We do not offer retrospective discounts or rebates. The transaction price is determined based on the agreed upon rates in the purchase order or master supply agreements applied to the quantity of synthetic DNA that was manufactured and shipped to the customer. Our contracts include only one performance obligation-the delivery of the product to the customer. Accordingly, all of the transaction price, net of any discounts, is allocated to the one performance obligation. Therefore, upon delivery of the product, there are no remaining performance obligations. Our shipping and handling activities are performed before the customer obtains control of the goods and therefore are considered a fulfillment cost. We have elected to exclude all sales and value added taxes from the measurement of the transaction price. We have not adjusted the transaction price for significant financing since the time period between the transfer of goods and payment is less than one year. We recognize revenue at a point in time when control of the products is transferred to the customer. Management applies judgment in evaluating when a customer obtains control of the promised good which is generally when the product is delivered to the customer. Our customer contracts generally include a standard assurance warranty to guarantee that our products comply with agreed specifications. We reduce revenue by the amount of expected returns which have been insignificant. We have elected the practical expedient of not disclosing the consideration allocated to remaining performance obligations and an explanation of when those amounts are expected to be recognized as revenue since the duration of our contracts is less than one year. We do not have any contract assets or contract liabilities as of September 30, 2019 and September 30, 2018. For all periods presented, we did not recognize revenue from amounts that were included in the contract liability balance at the beginning of each period. In addition, for all periods presented, there was no revenue recognized in a reporting period from performance obligations satisfied in previous periods. Based on the nature of our contracts with customers which are recognized over a term of less than 12 months, we have elected to use the practical expedient whereby costs to obtain a contract are expensed as they are incurred. We state our revenues net of any taxes collected from customers that are required to be remitted to various government agencies. The amount of taxes collected from customers and payable to governmental entities is included on the balance sheet as part of “Accrued expenses and other current liabilities.” Income tax In preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our audited consolidated balance sheets. We then assess the likelihood that our deferred tax assets will be recovered from future taxable income and, to the extent we believe that recovery is not likely, we establish a valuation allowance. A valuation allowance reduces our deferred tax assets to the amount that management estimates is more likely than not to be realized. In determining the amount of the valuation allowance, we consider income over recent years, estimated future taxable income, feasible tax planning strategies and other factors in each taxing jurisdiction in which we operate. If we determine that it is more likely than not that we will not realize all or a portion of our remaining deferred tax assets, then we will increase our valuation allowance with a charge to income tax expense. Conversely, if we determine that it is likely that we will ultimately be able to utilize all or a portion of the deferred tax assets for which a valuation allowance has been provided, then the related portion of the valuation allowance will reduce income tax expense. Significant management judgment is required in determining our provision for income taxes and potential tax exposures, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish a valuation allowance, which could materially impact our financial position and results of operations. Our ability to utilize our deferred tax assets and the need for a related valuation allowance are monitored on an ongoing basis. Furthermore, computation of our tax liabilities involves examining uncertainties in the application of complex tax regulations. We recognize liabilities for uncertain tax positions based on the two-step process as prescribed by the authoritative guidance provided by FASB. The first step is to evaluate the tax position to determine whether there is sufficient available evidence to indicate if it is more likely than not that the position will be sustained on audit, including resolution of any related appeals or litigation processes. The second step requires us to measure and determine the approximate amount of the tax benefit at the largest amount that is more than 50% likely of being realized upon ultimate settlement with the tax authorities. It is inherently difficult and requires significant judgment to estimate such amounts, as this requires us to determine the probability of various possible outcomes. We reexamine these uncertain tax positions on a quarterly basis. This reassessment is based on various factors during the period including, but not limited to, changes in worldwide tax laws and treaties, changes in facts or circumstances, effectively settled issues under audit and any new audit activity. A change in recognition or measurement would result in the recognition of a tax benefit or an additional charge to the tax provision in the period. Stock-based compensation We have granted stock-based awards, consisting of stock options and restricted stock, to our employees, certain non-employee consultants and certain members of our board of directors. We measure stock-based compensation expense for restricted stock and stock options granted to our employees and directors on the date of grant and recognize the corresponding compensation expense of those awards over the requisite service period, which is generally the vesting period of the respective award. We account for stock-based compensation arrangements with non-employee consultants using a fair value approach. The estimated fair value of unvested options granted to non-employee consultants is remeasured at each reporting date through the date of final vesting. As a result, the noncash charge to operations for nonemployee options with vesting conditions is affected in each reporting period by changes in the estimated fair value of our common stock. We adjust for actual forfeitures as they occur. We estimate the fair value of stock options granted to our employees and directors on the grant date, and rights to acquire stock granted under our Employee Stock Purchase Plan, and the resulting stock-based compensation expense, using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model requires the use of highly subjective assumptions which determine the fair value of stock-based awards. These assumptions include: • Expected Term. Our expected term represents the period that our stock-based awards are expected to be outstanding and is determined using the simplified method (based on the mid-point between the vesting date and the end of the contractual term), as we do not have sufficient historical data to use any other method to estimate expected term. • Expected Volatility. As we have very limited trading history of our common stock, the expected volatility is estimated based on the average volatility for comparable publicly traded biopharmaceutical companies over a period equal to the expected term of the stock option grants. The comparable companies are chosen based on their similar size, stage in the life cycle or area of specialty. • Risk-Free Interest Rate. The risk-free interest rate is based on the U.S. Treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of the stock option grants. • Expected Dividend. We have never paid dividends on our common stock and have no plans to pay dividends on our common stock. Therefore, we use an expected dividend yield of zero. For options granted to non-employee consultants, the fair value of these options is also remeasured using the Black-Scholes option-pricing model reflecting the same assumptions as applied to employee options in each of the reported periods, other than the expected life, which is assumed to be the remaining contractual life of the option. Recently issued accounting pronouncements For a description of accounting changes and recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see Note 2, “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K for a further discussion of the impairment analysis of acquisition-related intangible assets.

<s>[INST] Overview We are a leading and rapidly growing synthetic biology company that has developed a disruptive DNA synthesis platform to industrialize the engineering of biology. The core of our platform is a proprietary technology that pioneers a new method of manufacturing synthetic DNA by “writing” DNA on a silicon chip. We have combined this technology with proprietary software, scalable commercial infrastructure and an ecommerce platform to create an integrated technology platform that enables us to achieve high levels of quality, precision, automation, and manufacturing throughput at a significantly lower cost than our competitors. We are leveraging our unique technology to manufacture a broad range of synthetic DNAbased products, including synthetic genes, tools for next generation sample preparation, and antibody libraries for drug discovery and development. Additionally, we believe our platform will enable new valueadd opportunities, such as discovery partnerships for biologic drugs, and will enable new applications for synthetic DNA, such as digital data storage. We sell our synthetic DNA and synthetic DNAbased products to a customer base of 1,305 customers across a broad range of industries. We launched the first application of our platform, synthetic genes and oligo pools, in April 2016 to disrupt the gene synthesis market and make legacy DNA synthesis methods obsolete. In fiscal 2017, we served 286 customers including $0.3 million in sales to seven of the top 20 pharmaceutical companies by revenue, $4.3 million in sales to Ginkgo Bioworks, Inc., or Ginkgo Bioworks (which we believe is the largest global purchaser of synthetic DNA), $0.3 million in sales to three of the largest agricultural biotechnology companies, $2.7 million in sales to over 100 academic research institutions worldwide, and $7.3 million in sales to innovative customers using synthetic DNA for new and emerging applications, such as Microsoft Corporation and the University of Washington for use of DNA as a digital data storage medium. We are also an original equipment manufacturer, or OEM, of synthetic DNA to four synthetic DNA manufacturers that also compete with us, which we believe is a strong demonstration of the superiority of our platform. In fiscal 2018, we served 717 customers, and sales to the industrial chemicals sector, the academic research sector, the agricultural sector and the healthcare sector accounted for 59%, 23%, 2% and 16% of the total $25.4 million revenues for the year ended September 30, 2018. Sales to Ginkgo Bioworks amounted to $8.7 million, or 34% and sales to customers other than Ginkgo Bioworks was $16.7 million, or 66%, for the year ended September 30, 2018; an increase in revenue of 101% and 160%, respectively, as compared to the year ended September 30, 2017. In fiscal 2019, we served 1,305 customers, and sales to the industrial chemicals sector, healthcare sector, the academic research sector, and the agricultural sector accounted for 40%, 32%, 26% and 2% of the total $54.4 million revenues for the year ended September 30, 2019. Sales to Ginkgo Bioworks amounted to $9.2 million, or 17% of our total revenue in fiscal 2019. We have leveraged the versatility of our platform to expand our product portfolio into other markets in which we believe we have a competitive advantage. In February 2018, we launched an innovative and comprehensive preparation kit for next generation sequencing at the Advances in Genome Biology and Technology conference. In February 2019, we announced an expansion of next generation sequencing product offerings including Twist Fast Hybridization and wash kits. Our kit leverages our platform to precisely synthesize oligo pools and uniformly amplify the desired target DNA segments, accelerating the hybridization process and considerably improving the accuracy of the downstream sequencing analysis. We have also commercialized a custom DNA library solution which enables more effective biologic drug discovery and development for our customers. We believe we can further leverage our platform to develop other proprietary [/INST] Positive. </s>

Synthorx, Inc.

2019-03-12

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. You should read the following discussion and analysis together with our financial statements and related notes included in “Item 8. Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. The following discussion contains forward-looking statements that involve risks and uncertainties. For a complete discussion of forward-looking statements, see the section above entitled “Forward Looking Statements.” Our actual results could differ materially from those expressed or implied in any forward-looking statements as a result of various factors, including those set forth under the caption “Item 1A. Risk Factors.” Overview We are a biopharmaceutical company focused on prolonging and improving the lives of people with cancer and autoimmune disorders. Our proprietary, first-of-its kind platform technology expands the genetic code by adding a new DNA base pair and is designed to create optimized biologics, which we refer to as Synthorins. A Synthorin is a protein optimized through incorporation of novel amino acids encoded by our new DNA base pair that enables site-specific modifications, which enhance the pharmacological properties of these therapeutics. Our lead product candidate, THOR-707, is a variant of IL-2 designed to kill tumor cells by increasing CD8+ T and NK cells without causing vascular leak syndrome observed with approved recombinant IL-2 (aldesleukin). Based on our preclinical studies, we believe our platform technology can generate a pipeline of additional therapeutics that are more effective, better tolerated or have enhanced ease of use when compared to drugs that have been engineered by other means. We have worldwide rights to our Expanded Genetic Alphabet platform technology and our Synthorins. We are initially using our Expanded Genetic Alphabet platform technology to develop cytokine Synthorins that target validated mechanisms of action with large market opportunities, in which existing therapies have significant drawbacks. We have designed cytokine Synthorin programs, including IL-2, IL-10 and IL-15, for the treatment of cancer, and another IL-2 Synthorin program for the treatment of autoimmune disorders. We plan to develop THOR-707 to treat multiple tumor types. We plan to file an IND with the FDA stating a general solid tumor indication in the second quarter of 2019 and, thereafter, initiate a Phase 1/2 clinical trial of THOR-707 in multiple solid tumor types as both a single agent and in combination with an immune checkpoint inhibitor. We plan to specify particular indications for THOR-707 after our initial clinical trials. In our studies of THOR-707 we plan to target indications historically sensitive to IL-2 and PD-1 inhibitors, such as melanoma, renal cell carcinoma, non-small cell lung cancer and urothelial cancer. Our second development program is focused on the development of an IL-2 Synthorin for autoimmune indications, initially in chronic graft versus host disease, or GVHD, atopic dermatitis and Crohn’s disease. We have several lead IL-2 AI Synthorin molecules that have demonstrated activity ex vivo on human immune cells and we are advancing these molecules into in vivo studies. We intend to nominate a lead IL-2 AI Synthorin product candidate in 2019 and start IND-enabling studies thereafter. We then plan to file an IND in 2020 and begin clinical development thereafter. We expect to begin in vitro and in vivo studies of our Synthorin IL-10 in the first half of 2019 and begin IND-enabling studies thereafter. We have also identified multiple IL-15 Synthorins and expect to identify a development candidate in the first half of 2019. To date, we have incurred significant net losses since our inception and as of December 31, 2018 had an accumulated deficit of $69.5 million. Our net losses for the years ended December 31, 2018 and December 31, 2017 were $56.6 million and $5.9 million, respectively. Our net loss in 2018 included a $36.0 million non-cash charge incurred from the increase in the fair value of a convertible preferred stock purchase right granted in April 2018 and settled in November 2018. Excluding this non-cash charge, our losses have resulted primarily from costs incurred in connection with raising capital, research and development activities and general and administrative expenses. We do not have any products approved for sale and have not generated any revenue from product sales or otherwise. We expect to incur operating losses for the foreseeable future as we pursue the preclinical and clinical development of our programs. Furthermore, we anticipate these losses will increase substantially as we continue our research and development of, and eventually seek regulatory approvals for, our lead product candidate, THOR-707, and any other future product candidates, and as we expand our clinical, regulatory, quality and manufacturing capabilities, incur significant commercialization expenses for marketing, sales, manufacturing and distribution, if we obtain marketing approval for any of our product candidates, and incur additional costs associated with operating as a public company. Accordingly, until such time as we can generate significant revenue from sales of our product candidates, if ever, we expect to finance our cash needs through public or private equity offerings, debt financings, collaborations and licensing arrangements or other capital sources. In December 2018, we completed our initial public offering in which we sold 13,699,636 million shares of our common stock at $11.00 per share and received net proceeds, after underwriting discount and offering costs, of $137.5 million. Further, in April and November 2018, we issued a total of 19,483,456 shares of Series C convertible preferred stock at a price of $3.2699 per share, resulting in aggregate proceeds, net of offering costs, of $63.4 million. Upon the closing of our initial public offering, all 26,737,354 outstanding shares of our convertible preferred stock automatically converted into 16,687,477shares of common stock. Financial Operations Overview Research and Development Expenses To date, our research and development expenses have related primarily to development of our Expanded Genetic Alphabet platform technology and discovery efforts, preclinical studies and other preclinical activities related to our portfolio of Synthorins, including our lead product candidate THOR-707. Research and development expenses are recognized as incurred and payments made prior to the receipt of goods or services to be used in research and development are capitalized until the goods or services are received. Research and development expenses include: ▪ external research and development expenses incurred under agreements with contract research organizations and consultants to conduct our preclinical, toxicology and other preclinical studies; ▪ costs related to manufacturing THOR-707 for preclinical and clinical studies, including fees paid to third-party manufacturers and raw material suppliers; ▪ laboratory supplies; ▪ salaries, payroll taxes, employee benefits, and stock-based compensation charges for those individuals involved in research and development efforts; ▪ license fees and research funding to TSRI; and ▪ facilities, depreciation and other allocated expenses, which include direct and allocated expenses for rent, maintenance of facilities, insurance, equipment and other supplies. Our direct research and development expenses consist principally of external costs, such as fees paid to contract research organizations, or CROs, and consultants in connection with our preclinical and toxicology studies, and costs related to manufacturing materials for preclinical studies. Prior to our identification of potential product candidates in our IL-2 IO program in late 2017, we did not track external costs by program. Subsequent to the identification of potential product candidates, a significant majority of our direct research and development costs are related to these IL-2 IO Synthorins and, more specifically, THOR-707. We deploy our personnel and facility related resources across all of our research and development activities. We plan to substantially increase our research and development expenses for the foreseeable future as we continue the development of THOR-707 and the discovery and development of new product candidates. We cannot determine with certainty the timing of initiation, the duration or the completion costs of future clinical trials and preclinical studies of product candidates due to the inherently unpredictable nature of preclinical and clinical development. Clinical and preclinical development timelines, the probability of success and development costs can differ materially from expectations. We anticipate that we will make determinations as to which product candidates and development programs to pursue and how much funding to direct to each product candidate or program on an ongoing basis in response to the results of ongoing and future preclinical studies and clinical trials, regulatory developments and our ongoing assessments as to each product candidate’s commercial potential. General and Administrative Expenses General and administrative expenses consist primarily of salaries and employee-related costs, including stock-based compensation, for personnel in executive, finance and other administrative functions. Other significant costs include legal fees relating to intellectual property and corporate matters, professional fees for accounting and consulting services, insurance costs and facility-related costs. We anticipate that our general and administrative expenses will increase in the future to support our continued research and development activities and, if any product candidates receive marketing approval, commercialization activities. We also anticipate increased expenses related to audit, legal, regulatory, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums, and investor relations costs associated with operating as a public company. Change in Fair Value of Preferred Stock Purchase Right Liability In April 2018, we entered into a Series C Preferred Stock Purchase Agreement that contained future purchase rights that were required to be accounted for as liabilities and remeasured to fair value at each reporting date, with any change in the fair value reported as a component of other income (expense). In November 2018, the investors elected to purchase the additional shares under the purchase agreement, and no future purchase rights were outstanding at December 31, 2018. At the time the purchase right was executed, we performed a final valuation of the purchase right based on the our initial public offering price of $11.00 per share. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate our estimates and judgments used in our accounting practices and reflect the effects of revisions in the period in which they are deemed necessary. We base our estimates on historical experience, known trends and events, and various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in Note 2 to our financial statements appearing in Part II, Item 8 of this Annual Report on Form 10-K, we believe the following accounting policies and estimates to be most critical to the preparation of our financial statements because they are particularly dependent on estimates and assumptions made by management about matters that are highly uncertain at the time the accounting estimates are made. Research and Development Expenses A substantial portion of our research and development activities are performed under agreements we enter into with external service providers, including CROs, which conduct many of our research and development activities. We accrue for costs incurred under these contracts based on factors such as estimates of work performed and efforts expended pursuant to quotes and contracts, milestones achieved and experience with similar contracts. This process involves reviewing open contracts and purchase orders, communicating with our personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The financial terms of the agreements with our vendors are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the research and development expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid expense accordingly. Advance payments for goods and services that will be used in future research and development activities are expensed when the activity has been performed or when the goods have been received rather than when the payment is made. Although we do not expect our estimates to be materially different from amounts actually incurred, if our estimates of the status and timing of services performed differ from the actual status and timing of services performed, it could result in us reporting amounts that are too high or too low in any particular period. To date, there have been no material differences between our estimates of such expenses and the amounts actually incurred. Preferred Stock Purchase Right Liability In April 2018, we entered into a convertible preferred stock financing where, in addition to the initial closing, investors agree to buy, and we agreed to sell, additional shares of that convertible preferred stock at a fixed price in the event that certain agreed upon milestones were achieved. We determined the purchase right met the definition of a freestanding instrument and estimated the fair value of the purchase right liability to be $4.9 million. We recorded the initial value on our balance sheet as a liability with the remainder of the proceeds raised in April 2018 being allocated to convertible preferred stock. Subsequently, we revalued the preferred stock purchase right liability at each reporting period in 2018 and recorded the changes in the fair value of the liability in the statements of operations and comprehensive loss. In November 2018, the investors elected to purchase the additional shares, settling the liability. Prior to settlement, we estimated the fair value of the preferred stock purchase right liability using a valuation model that considered the probability of occurrence of the exercise of the right, an assumed discount rate, the estimated time period the preferred stock right would be outstanding, consideration received for the shares purchased subject to the right, the number of shares to be issued to satisfy the preferred stock purchase right and at what price, any changes in the fair value of the underlying convertible preferred stock, the number of shares to be issued to satisfy the preferred stock purchase right and at what price, and probability of the consummation of an initial public offering, as applicable. At the time the purchase right was executed, we performed a final valuation of the purchase right based on our initial public offering price of $11.00 per share. There are significant judgments and estimates inherent in our determination of the fair value of our preferred stock purchase right liability. If we had made different assumptions, the carrying value of our preferred stock, net loss and net loss per common share could have been significantly different. Stock-Based Compensation Expense Stock-based compensation expense represents the grant date fair value of equity awards and employee stock purchase plan rights. We estimate the fair value of equity awards and our employee stock purchase plan rights using the Black-Scholes option pricing model and recognize forfeitures as they occur. Estimating the fair value of equity awards and employee stock purchase plan rights using valuation models, such as the Black-Scholes option pricing model, is affected by assumptions regarding a number of variables, including the risk-free interest rate, the expected stock price volatility, the expected term of stock options and purchase intervals of our employee stock purchase plan, the expected dividend yield and the fair value of the underlying common stock on the date of grant. Changes in the assumptions can materially affect the fair value and ultimately how much stock-based compensation expense is recognized. We recognize the expense for equity awards over the requisite vesting period and over the offering period for employee purchase plan rights, on a straight-line basis. Stock-based compensation expense for awards subject to performance-based milestones is recognized over the remaining service period when we determine that achievement of the performance criteria is probable, and any change in our probability assessment would result in a cumulative catch-up adjustment. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 The following table summarizes our results of operations for the years ended December 31, 2018 and 2017: Research and Development Expenses. Research and development expenses were $16.8 million and $3.9 million for the years ended December 31, 2018 and 2017, respectively. The increase of $12.9 million was due primarily to increases of $7.6 million of manufacturing, preclinical and sponsored research expenses related to THOR-707 and, to a lesser degree, our other development programs, $2.4 million of laboratory supplies, $2.4 million of personnel related expenses and $0.3 million of facility related and other expenses. General and Administrative Expenses. General and administrative expenses were $4.1 million and $1.9 million for the years ended December 31, 2018 and 2017, respectively. The increase of $2.2 million was due primarily to increases of $1.1 million in personnel related expenses, $0.7 million in professional services related to accounting services, corporate legal fees and patent legal fees and $0.3 million of facility related and other administrative expenses. Change in fair value of preferred stock purchase right liability. The $36.0 million of other expense recognized for the year ended December 31, 2018 was due to the increase in the fair value of the outstanding Series C preferred stock purchase right from issuance in April 2018, through settlement in November 2018. At the time of settlement, we performed a final valuation of the purchase right based on our initial public offering price of $11.00 per share and reclassified the liability to convertible preferred stock. Comparison of the Years Ended December 31, 2017 and 2016 The following table summarizes our results of operations for the years ended December 31, 2017 and 2016: Research and Development Expenses. Research and development expenses were $3.9 million and $1.9 million for the years ended December 31, 2017 and 2016, respectively. The increase of $2.1 million was due primarily to increases of $0.7 million of personnel related expenses, $0.5 million of preclinical and sponsored research expenses related to early stage development programs, $0.5 million of laboratory supplies and $0.4 million of facility related and other expenses in connection with our August 2017 facility sublease. General and Administrative Expenses. General and administrative expenses were $1.9 million and $1.2 million for the years ended December 31, 2017 and 2016, respectively. The increase of $0.7 million was due primarily to increases of $0.5 million of increases in professional services related to corporate legal fees and patent legal fees, $0.2 million in personnel related expenses and $0.1 million of facility related and other administrative expenses, offset by a decrease of $0.1 million of general and administrative consulting fees. Liquidity and Capital Resources We have incurred net losses and negative cash flows from operations since our inception and anticipate we will continue to incur net losses for the foreseeable future. Since inception, we have financed our operations primarily through the sale of our equity securities and we will need to raise substantial additional capital in the future. In 2018, we raised proceeds, net of offering costs, of $137.5 million from our initial public offering in December 2018, and $63.4 million from the sale of our Series C convertible preferred stock in April and November 2018. As of December 31, 2018 we had $188.4 million of cash and cash equivalents, an increase of $184.7 million from the $3.7 million of cash and cash equivalents at December 31, 2017. The change in our cash and cash equivalents for the years ended December 31, 2018 and 2017 is summarized below. Operating Activities Net cash used in operating activities was $16.5 million for the year ended December 31, 2018, as compared to $5.1 million for 2017. The increase in net cash used in operating activities during 2018 was primarily due to an increase in our net loss to $19.9 million, adjusted for $36.7 million of noncash charges, for 2018, as compared to a net loss of $5.6 million, adjusted for $0.2 million of noncash charges, for 2017. The increase in our net loss in 2018 relative to 2017 was primarily due to our increased research and development efforts as we continued the development of our programs and discovery efforts, including increasing personnel supporting these activities. Partially offsetting the impact on our cash and cash equivalents at December 31, 2018 from our increased net loss was an increase in our current liabilities at December 31, 2018, due to the timing of payments for our expenses. Investing Activities Net cash used in investing activities was due to property and equipment purchases in each period. The purchases primarily consisted of laboratory equipment. Financing Activities and Funding Requirements Net cash provided by financing activities was $202.1 million for the year ended December 31, 2018, as compared to $5.0 million in 2017. The increase in cash provided by financing activities in 2018 relative to 2017, was primarily due to the $137.5 million of net proceeds from our initial public offering in December 2018 and the $63.4 million of net proceeds from issuances of our Series C convertible preferred stock in April and November 2018. In 2017 we received net proceeds of $5.0 million from the issuance of our Series B convertible preferred stock. We believe that our existing cash and cash equivalent balance will be sufficient to meet our anticipated cash requirements through at least the next 12 months. However, our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially. We have based this estimate on assumptions that may prove to be wrong, and we could deplete our capital resources sooner than we expect. Additionally, the process of testing product candidates in clinical trials is costly, and the timing of progress and expenses in these trials is uncertain. Our future capital requirements will depend on many factors, including: ▪ the initiation, progress, timing, costs and results of drug discovery, preclinical studies and clinical trials of THOR-707 and any other future product candidates; ▪ the number and characteristics of product candidates that we pursue; ▪ the outcome, timing and costs of seeking regulatory approvals; ▪ the cost of manufacturing THOR-707 and future product candidates for clinical trials in preparation for marketing approval and in preparation for commercialization; ▪ the costs of any third-party products used in our combination clinical trials that are not covered by such third party or other sources; ▪ the costs associated with hiring additional personnel and consultants as our preclinical and clinical activities increase; ▪ the receipt of marketing approval and revenue received from any potential commercial sales of THOR-707 or other product candidates; ▪ the cost of commercialization activities for THOR-707 and future product candidates we develop if we receive marketing approval, including marketing, sales and distribution costs; ▪ the emergence of competing therapies and other adverse market developments; ▪ the ability to establish and maintain strategic licensing or other arrangements and the financial terms of such agreements; ▪ the amount and timing of any payments we may be required to make pursuant to the TSRI Agreement, or other future license agreements; ▪ the costs involved in preparing, filing, prosecuting, maintaining, expanding, defending and enforcing patent claims, including litigation costs and the outcome of such litigation; ▪ the extent to which we in-license or acquire other products and technologies; and ▪ the costs of operating as a public company. Until we are able to generate sufficient cash from our operations, we expect to finance our cash needs through a combination of equity offerings, debt financings, collaborations and licensing arrangements or other sources. However, we may be unable to raise additional funds or enter into such other arrangements when needed on favorable terms or at all. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our stockholders will be or could be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect the rights of our common stockholders. Debt financing and equity financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends. If we raise funds through collaborations, or other similar arrangements with third parties, we may have to relinquish valuable rights to our platform technology, future revenue streams, research programs or product candidates or may have to grant licenses on terms that may not be favorable to us and/or may reduce the value of our common stock. If we are unable to raise capital or enter into such other arrangements when needed would have a negative impact on our financial condition and could force us to delay, limit, reduce or terminate our product development or future commercialization efforts or grant rights to develop and market product candidates or to our platform technology that we would otherwise prefer to develop and market ourselves. Contractual Obligations and Commitments The following table summarizes our contractual obligations at December 31, 2018: (1) Our operating lease obligations relate to our current corporate headquarters and laboratory space in La Jolla, California which we sublease from COI Pharmaceuticals, Inc., a related party, and the lease we signed in September 2018 for additional office and laboratory space that commenced in November 2018. (2) We have payment obligations under our TSRI Agreement that are contingent upon future events such as sublicensing or our achievement of specified regulatory and commercial milestones and are required to make royalty payments in connection with the sale of products developed under that agreement. As of December 31, 2018, we were unable to estimate the timing or likelihood of achieving the milestones or making future product sales and, therefore, any related payments are not included in the table. For additional information regarding the TSRI Agreement, including our payment obligations thereunder, see Part I, Item 1 of this Annual Report on Form 10-K under the caption “Our License and Collaboration Agreements.” (3) We also enter into agreements with various vendors for goods and services in the normal course of business through purchase orders or other documentation, or that are undocumented expect for an invoice. Such unconditional purchase obligations are generally outstanding for periods less than one year and are settled by cash payments upon delivery of the goods and services and are not reflected in this table. In addition, in July 2014, we entered into a Research Funding and Option Agreement with TSRI, which was amended in September 2015, September 2016, October 2017 and August 2018. Floyd Romesberg, Ph.D., one of our directors, is a professor of chemistry at TSRI. Pursuant to this agreement, as amended, we provide funding to TSRI to conduct certain research activities under a research program and TSRI has granted us an option to acquire rights and licenses to certain intellectual property arising from the research program under the agreement. As of December 31, 2018, we had $0.3 million in future obligations to TSRI under this agreement for expenses and related costs in connection with the research program. As a result of the August 2018 amendment, we became obligated to pay an additional $0.4 million to TSRI through July 2019 and as of December 31, 2018, had paid $0.1 million of the obligation. The Research Funding and Option Agreement, as amended, is more fully described in Part I, Item 1 of this Annual Report on Form 10-K under the caption “Our License and Collaboration Agreements.” Off-Balance Sheet Arrangements During the periods presented we did not have, nor do we currently have, any off-balance sheet arrangements as defined by applicable regulations of the SEC. Other Information Jumpstart Our Business Startups Act We are an emerging growth company, as defined in the Jumpstart Our Business Startups Act, as amended, or the JOBS Act, enacted in April 2012. Under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards issued subsequent to the enactment of the JOBS Act until such time as those standards apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards and, therefore, will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. We intend to rely on other exemptions provided by the JOBS Act, including without limitation, not being required to comply with the auditor attestation requirements of Section 404(b) of Sarbanes-Oxley. We will remain an emerging growth company for up to five years following the completion of our initial public offering although, if we have more than $1.07 billion in annual revenue, the market value of our common stock that is held by non-affiliates exceeds $700 million as of June 30th of any year, or we issue more than $1.0 billion of non-convertible debt over a three-year period before the end of that five-year period, we would cease to be an emerging growth company as of the following December 31st.

<s>[INST] Overview We are a biopharmaceutical company focused on prolonging and improving the lives of people with cancer and autoimmune disorders. Our proprietary, firstofits kind platform technology expands the genetic code by adding a new DNA base pair and is designed to create optimized biologics, which we refer to as Synthorins. A Synthorin is a protein optimized through incorporation of novel amino acids encoded by our new DNA base pair that enables sitespecific modifications, which enhance the pharmacological properties of these therapeutics. Our lead product candidate, THOR707, is a variant of IL2 designed to kill tumor cells by increasing CD8+ T and NK cells without causing vascular leak syndrome observed with approved recombinant IL2 (aldesleukin). Based on our preclinical studies, we believe our platform technology can generate a pipeline of additional therapeutics that are more effective, better tolerated or have enhanced ease of use when compared to drugs that have been engineered by other means. We have worldwide rights to our Expanded Genetic Alphabet platform technology and our Synthorins. We are initially using our Expanded Genetic Alphabet platform technology to develop cytokine Synthorins that target validated mechanisms of action with large market opportunities, in which existing therapies have significant drawbacks. We have designed cytokine Synthorin programs, including IL2, IL10 and IL15, for the treatment of cancer, and another IL2 Synthorin program for the treatment of autoimmune disorders. We plan to develop THOR707 to treat multiple tumor types. We plan to file an IND with the FDA stating a general solid tumor indication in the second quarter of 2019 and, thereafter, initiate a Phase 1/2 clinical trial of THOR707 in multiple solid tumor types as both a single agent and in combination with an immune checkpoint inhibitor. We plan to specify particular indications for THOR707 after our initial clinical trials. In our studies of THOR707 we plan to target indications historically sensitive to IL2 and PD1 inhibitors, such as melanoma, renal cell carcinoma, nonsmall cell lung cancer and urothelial cancer. Our second development program is focused on the development of an IL2 Synthorin for autoimmune indications, initially in chronic graft versus host disease, or GVHD, atopic dermatitis and Crohn’s disease. We have several lead IL2 AI Synthorin molecules that have demonstrated activity ex vivo on human immune cells and we are advancing these molecules into in vivo studies. We intend to nominate a lead IL2 AI Synthorin product candidate in 2019 and start INDenabling studies thereafter. We then plan to file an IND in 2020 and begin clinical development thereafter. We expect to begin in vitro and in vivo studies of our Synthorin IL10 in the first half of 2019 and begin INDenabling studies thereafter. We have also identified multiple IL15 Synthorins and expect to identify a development candidate in the first half of 2019. To date, we have incurred significant net losses since our inception and as of December 31, 2018 had an accumulated deficit of $69.5 million. Our net losses for the years ended December 31, 2018 and December 31, 2017 were $56.6 million and $5.9 million, respectively. Our net loss in 2018 included a $36.0 million noncash charge incurred from the increase in the fair value of a convertible preferred stock purchase right granted in April 2018 and settled in November 2018. Excluding this noncash charge, our losses have resulted primarily from costs incurred in connection with raising capital, research and development activities and general and administrative expenses. We do not have any products approved for sale and have not generated any revenue from product sales or otherwise. We expect to incur operating losses for the foreseeable future as we pursue the preclinical and clinical development of our programs. Furthermore, we anticipate these losses will increase substantially as we continue our research and development of, and eventually seek regulatory approvals for, our lead product [/INST] Negative. </s>

Maxar Technologies Inc.

2019-03-01

2018-12-31

ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW We are a global leader of advanced space technology solutions and are at the nexus of the new space economy, developing and sustaining the infrastructure and delivering the information, services and systems that unlock the promise of space for commercial and government markets. As a trusted partner, we provide vertically integrated capabilities and expertise including satellites, Earth imagery, robotics, geospatial data and analytics to help customers anticipate and address their most complex mission-critical challenges with confidence. Maxar trades on the NYSE and TSX under the ticker “MAXR”. Our businesses are organized and managed in three reportable segments: Space Systems, Imagery and Services, as described below under “Segment Results”. RECENT DEVELOPMENTS Security Control Agreement and Facility Clearance and the U.S. Domestication On January 26, 2017, we, together with our U.S. based subsidiary, Maxar Holdings and the U.S. Department of Defense entered into a Security Control Agreement (“SCA”) and began operating under the agreement. The SCA allows our subsidiaries to hold facility clearances necessary to pursue and execute classified U.S. government space and defense contracts. In February 2017, we received facility security clearance for the offices of Maxar Holdings, and the proxy board at Radiant Geospatial Solutions LLC was dissolved. On February 2, 2018, the Defense Security Service granted facility clearance for our satellite manufacturing facility in Palo Alto, California. On January 1, 2019, we completed our previously announced U.S. Domestication. The domiciliation into the United States marked a major milestone in our long-term U.S. access plan, enhanced our ability to provide and support classified applications for U.S. government agencies and fulfilled a commitment made in acquiring DigitalGlobe, which was approved by our shareholders at that time. We will continue to operate in compliance with the SCA until which time the U.S. Department of Defense determines that such agreement is no longer necessary following the U.S. Domestication. From our inception until September 30, 2018, we have reported to securities regulators in both Canada and the U.S. using IFRS financial statements. Upon the U.S. Domestication, and including this Annual Report on Form 10-K, we have retrospectively converted our Consolidated Financial Statements from IFRS to accounting principles generally accepted in the U.S. (“U.S. GAAP”). Key Leadership Changes On January 14, 2019, we announced the appointment of Daniel Jablonsky as President and Chief Executive Officer of Maxar, effective immediately. Mr. Jablonsky, who most recently served as President of DigitalGlobe, a wholly owned subsidiary of Maxar, also joined the Maxar Board of Directors. He succeeds Howard Lance, who resigned from his roles as President and Chief Executive Officer and as a Director of Maxar. In December 2018, we announced that our Board of Directors elected retired U.S. Air Force Gen. Howell M. Estes III as Chair, effective January 1, 2019, coincident with the U.S. Domestication. Mr. Estes, who has served as a director of our Board since the acquisition of DigitalGlobe, succeeds Robert L. Phillips, who will continue to serve as a director. In July 2018, we announced the appointment of Biggs Porter as Executive Vice President and Chief Financial Officer of Maxar, effective August 15, 2018. Anil Wirasekara, who previously served as Chief Financial Officer from 1994 to October 2017, assumed the duties of Interim Chief Financial Officer after William McCombe stepped down as Chief Financial Officer in February 2018. WorldView-4 Satellite During December 2018, our WorldView-4 satellite experienced a failure in its control moment gyros, preventing the satellite from collecting imagery. As a result, during December 2018, we recorded an impairment loss of $162 million for the remaining book value of the satellite, related assets and future premium payments. The WorldView-4 satellite is insured for $183 million, and we intend to seek full recovery for the loss of WorldView-4 under our insurance policies. Contingency planning and mitigation efforts are underway to assess the use of our other satellites and outside resources to replace imagery collected by WorldView-4 and meet as much of the existing customer commitments and obligations as possible. Acquisition of DigitalGlobe On October 5, 2017, we completed the DigitalGlobe Transaction and renamed the combined company Maxar Technologies Ltd. The transaction created a global leader in Earth imaging and geospatial solutions by combining DigitalGlobe’s over 15-year lead in technology and image library development, as well as its high-resolution Earth imaging capabilities, with our existing position as a world leader in commercial communications satellites. We are uniquely positioned to grow in the U.S., Canadian and global earth observation and geospatial services markets through our end-to-end space systems, Earth imagery and geospatial solutions. As a result of the DigitalGlobe Transaction, we increased our scale and we believe, credibility with U.S. government agencies and international government customers. The DigitalGlobe Transaction also added more predictable geospatial data and services revenue while diversifying our product and service offering. With a larger set of customers and end markets, we are better able to increase share in existing markets and grow in adjacent markets. Our vision is to be the world’s leader in the new space economy. We aim to achieve this by integrating innovative technologies, unique capabilities and end-to-end offerings across our businesses to help our customers address their most complex mission-critical challenges with confidence. Segment Results Subsequent to the closing of the DigitalGlobe Transaction, in the fourth quarter of 2017, our reportable segments changed to better align with our product and service offerings. The changes to our segments provide investors with increased transparency and allow for easier comparisons with our industry peer group. Our Chief Operating Decision Maker (“CODM”) measures performance of our reportable segments based on revenue and adjusted EBITDA. Our three reportable segments are Space Systems, Imagery and Services. In January 2019, with the appointment of Mr. Jablonsky as our President and Chief Executive Officer, our CODM changed. Our CODM may decide to evaluate our business differently in the future, which could result in changes to our reportable segments. Space Systems In the Space Systems segment, we are a leading supplier of space-based and ground-based infrastructure and information solutions. Our products include communication and imaging satellites, satellite payloads and antenna subsystems, space-based and airborne surveillance solutions, robotic systems and associated ground infrastructure and support services. Our offerings serve multiple markets, primarily for communications and surveillance and intelligence applications. In the communications market, our solutions provide cost-efficient global delivery of a broad range of services, including television and radio distribution, broadband internet, and mobile communications. In the surveillance and intelligence market, we offer end-to-end solutions to monitor changes and activities around the globe to support the operational needs of government agencies, both military and civilian, and commercial customers. We also supply spacecraft and subsystems to the U.S. government, Canadian government and other customers for scientific research and development missions, as well as robotic systems for the space and terrestrial markets. Our principal customers in the Space Systems segment are government agencies worldwide as well as satellite operators and satellite manufacturers. Imagery In the Imagery segment, we are a leading supplier of high resolution Earth imagery and radar data sourced from our own advanced satellite constellation and third-party providers. Our imagery solutions provide customers with accurate and mission-critical information about our changing planet, and support a wide variety of uses, including mission planning, mapping and analysis, environmental monitoring, disaster management, crop management, oil and gas exploration and infrastructure management. Our principal customers in the Imagery segment are U.S., Canadian and other international government agencies (primarily defense and intelligence agencies), as well as a wide variety of commercial customers in multiple markets. Services In the Services segment, we provide geospatial services that combine imagery, analytic expertise and innovative technology to deliver integrated intelligence solutions to customers. We provide analytic solutions that accurately document change and enable geospatial modeling and analysis that predict where events will occur to help customers protect lives and make resource allocation decisions. Our primary customer in the Services segment is the U.S. government, but we also support intelligence requirements for other international governments, global development organizations and commercial customers. RESULTS OF OPERATIONS The following table provides selected annual financial information for fiscal years 2016, 2017 and 2018. *Not meaningful. Product and service revenue *Not meaningful. Total revenue increased $510 million in 2018 compared to 2017. The increase in revenue was primarily driven by the inclusion of a full year of revenue related to DigitalGlobe’s imagery and services business as compared with only approximately three months of revenue in 2017. The increase in service revenue is primarily driven by a $725 million increase in revenue related to DigitalGlobe’s imagery and services business as well as an increase of $50 million in service revenue in the Space Systems segment. These increases were offset by a decrease in product revenue in the Space Systems segment of $268 million which was primarily driven by the changes in the GeoComm market. Further discussion of the drivers behind the decrease in revenue within the Space Systems segment is included within the “Results by Segment” section below. Total revenue increased $73 million in 2017 compared to 2016. The increase in revenue was primarily driven by the acquisition of DigitalGlobe’s imagery and services business which contributed $222 million to services revenue. This increase was partially offset by a decrease of product revenue of $166 million in the Space Systems segment compared to 2016. Further discussion of the drivers behind the decrease in revenue within the Space Systems segment is included within the “Results by Segment” section below. See Note 16, “Segment Information” to the Consolidated Financial Statements in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” for product and service revenue by segment. Product and service costs *Not meaningful. Total cost of product and services increased $153 million in 2018 compared to 2017. The increase is primarily related to the inclusion of a full year of costs related to DigitalGlobe’s imagery and services business compared to only approximately three months in 2017 which drove an increase of $185 million in the year over year costs. This was partially offset by a net decrease in costs from the Space Systems segment. Further discussion is included within the “Results by Segment” section below. Total cost of product and services decreased $29 million in 2017 compared to 2016. The decrease in costs was primarily driven by the lower volumes in the Space System segment which drove a decrease of product and service. This decrease primarily was offset by an increase of $57 million related to the inclusion of approximately three months of results from DigitalGlobe’s imagery and services business compared to no costs in 2016. Further discussion is included within the “Results by Segment” section below. Selling, general and administrative Selling, general and administrative expense was $507 million in 2018 compared to $387 million in 2017. The increase is primarily related to the inclusion of a full year of selling, general and administrative costs related to DigitalGlobe’s imagery and service business compared with only approximately three months in 2017 which drove an increase of $157 million. This increase was partially offset by a decrease in stock-based compensation which was primarily related to a one-time expense of $33 million in 2017 due to the accelerated vesting of certain DigitalGlobe stock-based compensation awards. The increase in selling, general and administrative was also partially offset by a decrease in acquisition and integration costs related to the DigitalGlobe Transaction of $26 million in 2017 which did not recur in 2018. This was partially offset by an increase in costs of $23 million in the Space Systems segment. Selling, general and administrative expense was $387 million in 2017 compared to $223 million in 2016. The increase is primarily related to one-time costs of $60 million incurred in connection with the DigitalGlobe Transaction, including professional and legal fees, consulting fees, and increased company headcount. The increase was also driven by an increase in stock-based compensation expense related to a one-time expense of $33 million in 2017 which was the result of the accelerated vesting of certain DigitalGlobe stock-based compensation awards which were recognized in our consolidated results. There was also an increase in selling, general and administrative expense of $57 million due to the inclusion of approximately three months of selling, general and administrative costs from DigitalGlobe’s imagery and services business. Depreciation and amortization The following table shows depreciation and amortization expense for the fiscal years indicated. *Not meaningful. Depreciation and amortization expense increased $288 million in 2018 compared to 2017. The increase is primarily due to the inclusion of a full year of depreciation and amortization expense related to the acquisition of DigitalGlobe as compared to approximately three months of depreciation and amortization expense in 2017. Depreciation and amortization expense increased $89 million in 2017 compared to 2016. The increase is primarily due to the inclusion of approximately three months of depreciation and amortization expense related to the acquisition of DigitalGlobe as compared to no such expense in 2016. Impairment losses During the year ended December 31, 2018, we recognized $1.1 billion in impairment losses and inventory obsolescence. This is compared to no impairment losses in 2017 or 2016. In 2018, these losses were partially offset by a gain on the sale of one of our Palo Alto facilities. The outlook on our geostationary communications (“GeoComm”) business within SSL declined substantially during 2018, resulting in net impairment charges of $232 million and inventory impairment of $66 million. In December 2018, we lost the imaging capability of our WorldView-4 satellite, resulting in a loss of $162 million on the satellite, related assets, and future premium payments. Subsequent to October 1, we experienced the largest quarterly drop in share price to take place in 2018. As a result of the sustained decline in our stock price and the further decline in the GeoComm business, we recognized $636 million in goodwill impairment. Refer to “Critical accounting policies and estimates” below for further discussion of the impairment. Interest expense, net *Not meaningful. 1 Under DigitalGlobe’s predecessor contract to the EnhancedView Contract, DigitalGlobe had received advanced payments from the U.S. government during the construction phase of the WorldView-1 satellite, which was more than one year before capacity was made available to them. The effect of imputing interest on these advanced payments is to increase contract liabilities with an offsetting charge to finance expense. As capacity is provided to the customer, revenue is recognized and the contract liabilities balance decreases. Interest expense, net increased $103 million in 2018 compared to 2017. The increase is primarily due to higher levels of long-term debt primarily related to the DigitalGlobe Transaction, and an increase of $18 million in interest expense on advance payments from customers. The increase was partially offset by a loss on debt extinguishment in the prior year period of $23 million. Interest expense, net increased $66 million in 2017 compared to 2016. The increase is primarily due to higher levels of long-term debt outstanding after closing the DigitalGlobe Transaction on October 5, 2017, a $23 million loss on debt extinguishment, as well as higher non-cash accretion interest on advance payments received from customers. Other expense (income), net *Not meaningful. Other expense (income), net decreased $40 million in 2018 compared to 2017, primarily due to the non-recurrence of a $24 million gain on settlement in 2017 related to an amendment of one of our other postretirement benefit plans in addition to a $13 million loss in 2018 related to foreign exchange. Other expense (income), net increased $46 million in 2017 compared to 2016, primarily due to the $24 million gain on settlement in 2017 related to the 2017 amendment of one of our other postretirement benefit plans in addition to a $14 million gain on foreign exchange from the prior year. See Note 17, “Employee Benefit Plans” to the Consolidated Financial Statements in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” for discussion of this amendment. The increase was also driven by an increase in the foreign exchange gain of $14 million in 2017 compared to a loss of $3 million in 2016. Income tax benefit *Not meaningful. Income tax benefit changed from a benefit of $162 million for the year ended December 31, 2017 to a benefit of $62 million for the year ended December 31, 2018, primarily due to a change in the valuation allowance as a result of the DigitalGlobe Transaction in the prior year, offset by the deferred tax benefit of current year tax losses and investment tax credits in Canada. Income tax benefit changed from a benefit of $1 million for the year ended December 31, 2016 to a benefit of $162 million for the year ended December 31, 2017, primarily due to a change in the valuation allowance as a result of the DigitalGlobe Transaction in 2017. Our effective tax rate for 2018 was lower than 2017 primarily due to the change in the valuation allowance as a result of the acquisition of DigitalGlobe in 2017, offset partially by the impairment of non-deductible goodwill in 2018 and the change in valuation allowance related to current year tax losses in the U.S. Our effective tax rate for 2017 was higher than 2016 primarily due to the change in the valuation allowance as a result of the acquisition of DigitalGlobe in 2017. RESULTS BY SEGMENT We analyze financial performance by segments, which group related activities within our business. We report our financial performance based on three reportable segments: Space Systems, Imagery and Services. Inter-segment transactions have been eliminated from the segmented financial information discussed below. Adjusted EBITDA disclosures throughout this section, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are non-GAAP measures. See “Non-GAAP Financial Measures” below for further discussion of Adjusted EBITDA disclosures. Space Systems The following table provides selected financial information for the Space Systems segment. Changes in revenues from year to year are influenced by the size, timing and number of satellite contracts awarded in the current and preceding years and the length of the construction period for satellite contracts awarded. Revenues on satellite contracts are recognized using the cost to cost method to determine the percentage of completion over the construction period, which typically range between 20 to 36 months and up to 48 months in special situations. Adjusted EBITDA margins can vary from quarter to quarter due to the mix of our revenues and changes in our estimated costs to complete as our risks are retired and as our estimated costs to complete are increased or decreased based on contract performance. There has been a step down in total number and dollar value of geostationary communication satellite awards compared to historical averages prior to 2015. Revenues have decreased year-over-year as programs awarded prior to 2015 have been completed and have been replaced by a lower level of award value since 2015. Many satellite operators in the communications industry have continued to defer new satellite construction awards to evaluate geostationary and other competing satellite system architectures and other market factors. We expect revenue and EBITDA margin to decline in the future absent any new awards. Space Systems segment revenue decreased $141 million, in 2018 compared to 2017, partially offset by an increase in revenue primarily due to the Legion satellite constellation. Revenue decreased due to an increase in estimated liquidated damages, and a significant increase in estimated costs to complete programs primarily as a result of supplier performance issues and delays experienced during the second half of 2018, as well as unanticipated impacts of lower volume in our Palo Alto factory, which resulted in higher overhead burden on existing programs and reduced labor productivity. An increase in estimated costs to complete directly impacts revenue, as revenue is recognized over time under the cost-to-cost method. Revenue attributable to our Legion satellite constellation is eliminated in consolidation. Space Systems segment revenue decreased $151 million, in 2017 compared to 2016. The decrease related primarily to a lower level of geostationary communications satellite construction activity in 2017 partially offset by higher revenue from contracts with the U.S. government and other customers to supply spacecraft and to perform design studies for scientific research and development missions. Adjusted EBITDA margin percentage from the Space Systems segment decreased in 2018 compared to 2017 from 12% to 0%. The decrease from 2017 to 2018 is primarily related to an increase in estimated costs to complete programs as a result of supplier performance issues and delays experienced during the second half of 2018, as well as unanticipated impacts of lower volume in our Palo Alto factory, which resulted in lower productivity and overhead absorption. In addition, we incurred $28 million of liquidated damages in 2018, compared to a recovery of liquidated damages during 2017, which also contributed to the decrease in Adjusted EBITDA. Adjusted EBITDA margin percentage from the Space Systems segment for 2017 was 12% compared to 11% for 2016. In 2017, Adjusted EBITDA included a credit of $24 million relating to the curtailment of a postretirement benefit plan and a loss provision of $10 million relating to a financial guarantee contract. In 2016, Adjusted EBITDA included a contract loss provision of $8 million resulting from a change in the estimate of development and engineering costs to complete a firm fixed price program. The change in margin percentage was also impacted by cost containment and restructuring efforts, and the mix of construction contracts in progress. Imagery The following table provides selected financial information for the Imagery segment. Revenues from the Imagery segment increased $615 million in 2018 compared to 2017. The increase was primarily driven by the inclusion of DigitalGlobe’s imagery business for a full year compared to only one quarter of results in 2017. DigitalGlobe’s imagery business drove an increase in revenues of $613 million to the Imagery segment before intercompany eliminations. Excluding revenue from DigitalGlobe’s imagery business, revenue from the Imagery segment before intercompany eliminations increased $2 million period over period. Revenues from the Imagery segment increased $188 million in 2017 compared to 2016 due to the inclusion of financial results from DigitalGlobe’s imagery business for the period October 5, 2017 to December 31, 2017. During this period, DigitalGlobe contributed revenues of $189 million to the Imagery segment before intercompany eliminations. Revenue from the Imagery segment before intercompany eliminations and excluding revenue from DigitalGlobe remained relatively consistent period over period. Adjusted EBITDA margin percentage from the Imagery segment for 2018 was 61%, compared to 62% in 2017. The decrease in margin percentage reflected the blend of margins from DigitalGlobe’s imagery business for a full year as compared with only approximately three months in 2017. Adjusted EBITDA margin percentage from the Imagery segment for 2017 was 62%, compared to 55% in 2016. The increase in margin percentage reflected the blend of margins from DigitalGlobe’s imagery business for the period October 5, 2017 to December 31, 2017 and our legacy radar imagery business. Services The following table provides selected financial information for the Services segment. Services segment revenue increased $122 million in 2018 compared to the same period in 2017. The increase was primarily driven by the inclusion of DigitalGlobe’s services business for a full year compared to only one quarter of results in 2017. The inclusion of the DigitalGlobe’s services business drove an increase in revenues of $112 million year over year before intercompany eliminations. Excluding the revenue from DigitalGlobe’s services business, the Services segment revenue increased $10 million period over period, primarily driven by an increase in volume of U.S. government sales. Revenues from the Services segment increased $44 million in 2017 compared to the same period in 2016 due to the inclusion of financial results from DigitalGlobe’s services business for the period October 5, 2017 to December 31, 2017. During this period, DigitalGlobe contributed revenues of $32 million to the Services segment before intercompany eliminations. Excluding the revenue from the inclusion of DigitalGlobe’s services business, the Services segment revenue increased $12 million period over period, primarily driven by an increase in volume of U.S. government sales. Adjusted EBITDA margin percentage from the Services segment for 2018 was 9%, compared to 16% in 2017. The decrease in margin percentage reflected the blend of margins from DigitalGlobe’s services business for a full year as compared with only approximately three months in 2017. Adjusted EBITDA margin percentage from the Services segment for 2017 was 16%, compared to 19% in 2016. The decrease in margin percentage reflected the blend of margins from DigitalGlobe’s services business for the period October 5, 2017 to December 31, 2017 and our legacy services business. Corporate expense Corporate expenses include items such as corporate office costs, regulatory costs, executive and director compensation, certain stock-based compensation and fees for audit, legal and consulting services. Corporate costs are not allocated to our segments. Corporate expenses for the year ended December 31, 2018 was $54 million compared to $65 million for the same period of 2017. This decrease of $11 million or 17% is primarily attributable to the non-recurrence of a one-time stock-based compensation expense of $33 million in 2017 which was the result of the accelerated vesting of certain DigitalGlobe stock-based compensation awards. This decrease was offset by an increase of corporate expenses due to additional headcount as a result of the DigitalGlobe Transaction, and the expansion and ramp up of corporate functions to support our increased scale. Corporate expense for the year ended December 31, 2017 was $65 million compared to $26 million for the same period of 2016. This increase of $39 million is primarily attributable to additional headcount as a result of the DigitalGlobe Transaction, and the expansion and ramp up of corporate functions to support our increased scale. BACKLOG Our backlog by segment is as follows: Order backlog, representing the estimated dollar value of firm funded contracts for which work has not been performed (also known as the remaining performance obligations on a contract), was $2.4 billion as of December 31, 2018 (December 31, 2017 - $3.3 billion). Order backlog generally does not include unexercised contract options and potential orders under indefinite delivery/indefinite quantity contracts. Approximately 50% of the total $2.4 billion backlog as of December 31, 2018 is expected to be converted into revenue in 2019. Backlog in the Space Systems segment is primarily comprised of multi-year awards, such as satellite builds. Fluctuations in the backlog are driven primarily by the timing of large program wins. Most of the Imagery and Services segment contracts are annual contracts, which renew at various times throughout the year. As a result, the timing of when contracts are awarded and when option years are exercised may cause backlog to fluctuate significantly from period to period. Unfunded contract options represent estimated amounts of revenue to be earned in the future from negotiated contracts with unexercised contract options and indefinite delivery/indefinite quantity contracts. Unfunded contract option as of December 31, 2018 was primarily comprised of the option years in the EnhancedView Contract (September 1, 2020 through August 31, 2023). We believe it is the U.S. government’s intention to exercise all option years, subject only to annual congressional appropriation of funding and the federal budget process. As each option year is exercised, it will be added to backlog. Although backlog reflects business that is considered to be firm, terminations, amendments or cancellations may occur, which could result in a reduction in our total backlog. LIQUIDITY & CAPITAL RESOURCES Our sources of liquidity include cash provided by operations, collection or securitization of orbital receivables, access to existing credit facilities and, when available and efficient, to the capital markets. We generally maintain limited cash on hand and use available cash to pay down borrowings on our Syndicated Credit Facility. Our primary short-term cash requirement is to fund working capital, including requirements on long-term construction contracts (including our geostationary satellite contracts), fixed overhead costs, and to fund increased capital expenditures, including the construction of our legion satellite constellation. Working capital requirements can vary significantly from period to period, particularly as a result of the timing of receipts and disbursements related to long term construction contracts. Our medium-term to long-term cash requirements are to service and repay debt and to invest, including in facilities, equipment, technologies, and research and development for growth initiatives. These investments include investments in to replace the capability or capacity of satellites which have or will go out of service in the future. Cash is also used to pay dividends and finance other long-term strategic business initiatives. Our first maturity of long term debt is not until the fourth quarter of 2020. Our ability to fund these needs will depend, in part, on our ability to generate cash in the future, which depends on our future financial results. Our future results are subject to general economic, financial, competitive, legislative and regulatory factors that may be outside of our control. Our future access to, and the availability of credit on acceptable terms and conditions is impacted by many factors, including capital market liquidity and overall economic conditions. We believe that our cash from operating activities generated during the year, together with available borrowings under our Revolving Credit Facility, will be adequate for the next twelve months to meet our anticipated uses of cash flow, including working capital, capital expenditure, debt service costs, dividend, and other commitments. While we intend to reduce debt over time using cash provided by operations, we may also seek to meet long-term debt obligations, if necessary, by obtaining capital from a variety of additional sources or by refinancing existing obligations. These sources include public or private capital markets, bank financings, proceeds from dispositions or other third-party sources. Summary of cash flows Operating activities Cash provided by operating activities increased $34 million from the year ended December 31, 2017 to the corresponding period in 2018. The increase was primarily due to the inclusion of DigitalGlobe’s operating results and changes in deferred taxes, partially offset by a decrease in contract liabilities due to revenue recognized. Cash flows from operating activities can vary significantly from period to period as a result of our working capital requirements, given our portfolio of large construction programs and the timing of milestone receipts and payments with customers and suppliers in the ordinary course of business. Investment in working capital is also necessary to build our business and manage lead times in construction activities. We expect working capital account balances to continue to vary from period to period. We efficiently fund our working capital requirements with the Revolving Credit Facility (as defined below). Investing activities Investing activities decreased $2.2 billion from the year ended December 31, 2017 to the corresponding period in 2018. The major investing activities included expenditures on property, plant and equipment of $156 million and $49 million, for the years ended December 31, 2018 and 2017, respectively, and investments in software of $62 million and $23 million, for the years ended December 31, 2018 and 2017, respectively. Property, plant and equipment expenditures in 2018 primarily related to the build of our Legion satellite constellation, net of intercompany eliminations. We had investing activities of $2.2 billion related to the DigitalGlobe Transaction in 2017. Financing activities During the year ended December 31, 2018, cash provided by financing activities was $13 million, mainly including net proceeds from bank borrowings of $104 million, proceeds from securitization of orbital receivables of $18 million, debt repayment of $27 million, settlement of orbital securitization of $15 million, and dividend payments of $65 million. During the year ended December 31, 2017, cash provided by financing activities was $2.2 billion mainly including proceeds from the Syndicated Credit Facility (as defined below) of $3.2 billion, debt repayment of $782 million, payment of debt issuance costs of $63 million, and dividend payments of $47 million. Credit facilities The following table summarizes our long-term debt: In October 2017, we entered into the Syndicated Credit Facility. The Syndicated Credit Facility is comprised of: (i) a four-year senior secured first lien revolving credit facility in an aggregate principal amount of $1.15 billion and a four-year senior secured first lien operating facility in an aggregate principal amount of $100 million (collectively, the “Revolving Credit Facility”), (ii) a senior secured first lien term A facility (“Term Loan A”) in an aggregate principal amount of $500 million consisting of a $250 million tranche with a three-year maturity and a $250 million tranche with a four-year maturity, and (iii) a seven-year senior secured first lien term B facility (“Term Loan B”) in an aggregate principal amount of $2.0 billion. Loans under the Revolving Credit Facility are available in U.S. dollars and, at our option, in Canadian dollars. Term Loan A and Term Loan B are repayable in U.S. dollars. Borrowings under the Revolving Credit Facility and Term Loan A bear interest at a rate equal to U.S. LIBOR (for U.S. dollar borrowings) and CDOR or Canadian Bankers’ Acceptances (for Canadian dollar borrowings), plus a margin of 120 - 350 basis points per annum, based on our total leverage ratio. Term Loan B bears interest at U.S. LIBOR plus 275 basis points per annum. On April 5, 2018, we entered into interest rate swaps at a notional value of $1.0 billion maturing in April 2021 or April 2022. As of December 31, 2018, we had hedged approximately 32.8% of our floating rate exposure on our outstanding debt at an average base rate of 2.56% (excluding the margin specified in the Syndicated Credit Facility). The Revolving Credit Facility and Term Loan A are payable at maturity. Term Loan B will amortize in equal quarterly installments in aggregate annual amounts equal to 1% of the original principal amount of the loan, with the final balance payable at maturity. The Revolving Credit Facility, Term Loan A, and Term Loan B may be repaid by us, in whole or in part, together with accrued interest, without premium or penalty. The Syndicated Credit Facility is guaranteed by us and certain of our designated subsidiaries. The security for the Syndicated Credit Facility, subject to customary exceptions, includes substantially all our tangible and intangible assets and our subsidiary guarantors. We are required to make mandatory prepayments of the outstanding principal and accrued interest upon the occurrence of certain events and to the extent of a specified percentage of annual excess cash flow that is not reinvested or used for other specified purposes. The Syndicated Credit Facility is subject to customary affirmative and negative covenants, default provisions, representations and warranties and other terms and conditions. The Revolving Credit Facility includes an aggregate $200 million sub limit under which letters of credit can be issued. As of December 31, 2018 and 2017, we had $18 million and $26 million, respectively, of issued and undrawn letters of credit outstanding under the Revolving Credit Facility. On December 21, 2018, we amended our Syndicated Credit Facility (the “Amended Agreement”). The Amended Agreement revised the financial covenants to increase the maximum consolidated debt leverage ratios permitted under the Syndicated Credit Facility for a period of time selected by us (the “Covenant Relief Period”) and increased the interest rate incurred by us thereunder at certain consolidated debt leverage ratios. The Amended Agreement increased the maximum consolidated debt leverage ratio to 5.5x through the quarter ended December 31, 2018, 6.0x through the quarter ended September 30, 2020, and 5.5x thereafter. The interest coverage ratio remained the same at a minimum of 2.5x through the quarter ending June 30, 2019 and 2.75x thereafter. The Amended Agreement also adjusted the definition of EBITDA for the purpose of calculating the financial ratios under U.S. GAAP. In addition to increased flexibility on our financial covenants, during the Covenant Relief Period, the Amended Agreement restricts the use of certain asset sale proceeds, limits the type of new debt issuances, certain restricted payments and permitted acquisitions under the Syndicated Credit Facility. As of December 31, 2018, we were in compliance with our debt covenants. Securitization liability We have in place a revolving securitization facility agreement with an international financial institution. Under the terms of the Syndicated Credit Facility, we may offer to sell eligible orbital receivables from time to time with terms of seven years or less discounted to face value using prevailing market rates. In the year ended December 31, 2018 we sold orbital receivables for net proceeds of $18 million. There were no drawdowns executed in the year ended December 31, 2017. In 2016, we executed two drawdowns and sold orbital receivables with book value of $112 million for net proceeds of $123 million. The orbital receivables that were securitized remain on our balance sheet because the accounting criteria for surrendering control of the orbital receivables were not met. The net proceeds received have been recognized as a securitization liability that has been subsequently measured at amortized cost using the effective interest rate method. The securitized orbital receivables and the securitization liability are being drawn down as payments are received from the customers and passed on to the international financial institution. We continue to recognize orbital interest revenue on the orbital receivables that are subject to the securitization transactions and recognizes interest expense to accrete the securitization. Cash requirements related to interest costs, income taxes, and pensions and other postretirement obligations Refer to Consolidated Statements of Cash Flows in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” for cash payments for interest costs and income taxes, and Part II, Item 7A, “Quantitative and Qualitative Disclosure about Market Risk” for discussion of potential impacts of fluctuations in interest rates. Funding of pension plans Funding requirements under applicable laws and regulations are a major consideration in making contributions to our U.S. and Canadian pension plans. Failure to satisfy the minimum funding thresholds with respect to appropriate laws and regulations could result in restrictions on our ability to amend the plans or make benefit payments. With respect to our U.S. and Canadian qualified pension plans, we intend to contribute annually not less than the required minimum funding thresholds. The total estimated contributions expected to be paid to the plans for the year ended December 31, 2019 is $14 million. CONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENCIES We enter into contractual obligations in the normal course of business. The following table provides a summary of our payment obligations in each of the next five years and thereafter specifically related to long-term debt, operating leases and other obligations. 1Our Operating leases are primarily related to the rental of office and manufacturing space. Other obligations relate to other financial liabilities reflected on our consolidated balance sheets as of December 31, 2018, which is primarily comprised of non-trade payables and deferred fair value losses on foreign exchange forward contracts. We have significant purchase obligations for goods and services, under agreements with defined terms as to quantity, price and timing of delivery. Most of these conditional purchase obligations are for purchase or construction of property, plant and equipment or intangible assets, operational commitments related to remote ground terminals, or with subcontractors on long-term construction contracts that we have with customers. As of December 31, 2018, our banks have issued letters of credit for $81 million (December 31, 2017 - $108 million) in the normal course of business, of which $59 million (December 31, 2017 - $78 million) was guaranteed by Export Development Canada (“EDC”), a Canadian government corporation. During the year, we also provided an indemnity to EDC in partial support of selected satellite financings provided by EDC. The indemnity is not recognized on the balance sheet and if it were called upon, the maximum value of the indemnity as of December 31, 2018 was $48 million. We have received, in aggregate, C$9 million of government grants under a non-refundable contribution agreement with Investissement Québec relating to the expansion of our satellite systems facility in Montreal. The government grants can become conditionally repayable if certain average employment targets to December 31, 2018 are not met. As of December 31, 2018, we have met the required employment targets. In prior years, our Canadian operations have received funding under contract from the Government of Canada under several programs that support the development of new commercial technologies and products for delivery to customers of the Government of Canada. A portion of this funding is subject to possible repayment in the form of royalties, generally not exceeding 5% of future revenues, on commercialization of that intellectual property by us. For the years ended December 31, 2018 and 2017, we received $3 million and $13 million, respectively, of funding under the under these programs. We are party to various legal proceedings and claims that arise in the ordinary course of business as either a plaintiff or defendant. We analyze all legal proceedings and the allegations therein. The outcome of any of these proceedings, either individually or in the aggregate, is not expected to have a material adverse effect on our financial position, results of operations or liquidity. Refer to Part I, Item 3, “Legal Proceedings” of this Annual Report on Form 10-K for further discussion of legal proceedings. For further information on our contractual obligations, contingencies and commitments, see Note 21, “Commitments and contingencies” to the Consolidated Financial Statements in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data. OFF-BALANCE SHEET ARRANGEMENTS As of December 31, 2018, we had foreign exchange forward purchase contracts of $96 million, foreign exchange sales contracts of $253 million, operating leases for our premises and financial guarantee contracts to export credit agencies in the form of indemnities or letters of credit. Such arrangements are not expected to have a material effect on our liquidity or capital resources, financial position or results of operations. We use derivative financial instruments to manage existing foreign currency exposures. We consider the management of financial risks to be an important part of our overall corporate risk management policy. Foreign exchange forward contracts are used to hedge our exposure to currency risk on sales, purchases, cash, net investments and loans denominated in a currency other than the functional currency of our domestic and foreign operations. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. For a summary of our significant accounting policies, see Note 2, “Summary of significant accounting policies” to the Consolidated Financial Statements in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data”. We consider the following accounting policies to be critical to an understanding of our financial condition and results of operations because these policies require the most difficult, subjective or complex judgments on the part of management in their application. Actual results could differ from our estimates and assumptions, and any such differences could be material to our consolidated financial statements. Revenue recognition The recognition and measurement of revenue requires the use of judgments and estimates. Specifically, judgment is used in interpreting complex arrangements with nonstandard terms and conditions and determining when all criteria for revenue recognition have been met. Space Systems Revenues in the Space Systems segment is primarily generated from long-term construction contracts. Due to the long-term nature of these contracts, we generally recognize revenue over time using the cost-to-cost method to measure progress. This requires us to make estimates regarding the revenue and cost associated with the design, manufacture and delivery of our products and services. Our long-term construction contracts generally consist of a single performance obligation due to the integrated nature of the contracts. Our cost estimation process is based on the professional knowledge of our engineering, program management and financial professionals, and draws on their significant experience and judgment. We prepare estimates at completion for our contracts and calculate estimated revenues and costs of the life of our contracts. Since our contracts typically span a period of several years, estimation of revenue, cost, and progress toward completion requires the use of judgment. Judgements and estimates are re-assessed at least quarterly with most estimates being updated on a monthly basis. Adjustments in estimates could have a material impact on revenue recognition based on the significance of the adjustments. Factors considered in these estimates include our historical performance, the availability, productivity and cost of labor, the nature and complexity of work to be performed, availability and cost of materials, components and subcontracts, the risk and impact of delayed performance and the level of indirect cost allocations. Imagery Revenue in the Imagery segment is generated from service contracts in which revenue is recognized based on satellite capacity made available to the customer in a particular period, when imagery is delivered to the customer, or ratably over the subscription period. Many of our imagery service contracts relate to the transfer of a series of distinct goods or services over time for which management has determined are a single performance obligation. Some of our contracts contain multiple performance obligations, which requires us to estimate the standalone selling prices of each performance obligation in order to allocate consideration transferred from the customer. We have not historically been able to use third-party evidence for determining standalone selling price due to the unique nature of our products and services and lack of visibility into competitor pricing. Standalone selling prices are determined based on management estimates that involve significant judgment. Multiple factors are considered based on the nature of the deliverables included within the contract, which include market conditions, competitive landscape, geographic or regional specific factors, internal costs, profit margin objectives and pricing practices used by us. Pension and other postretirement benefits The determination of projected benefit obligations, the fair value of plan assets for our pension and other postretirement benefit plans (“OPEB”) and pension and OPEB expense requires the use of estimates and actuarial assumptions. We perform an annual review of our estimates and actuarial assumptions in consultation with our actuaries. We believe that the accounting estimates related to our pension and OPEB plans are critical accounting estimates because they are highly susceptible to change from period to period based on the performance of plan assets, actuarial valuations, market conditions and contracted benefit changes. The selection of assumptions is based on historical trends and known economic and market conditions at the time of valuation, as well as independent studies of trends performed by our actuaries. However, actual results may differ substantially from the estimates that were based on the critical assumptions. The principal estimates and assumptions used in the measurement and recording of our pension and other postretirement benefit plans that have a significant effect on our consolidated financial statements are the discount rate and expected return on plan assets. Discount rates for the U.S. SSL pension and other postretirement plans for are calculated by actuaries using the Standard FTSE Pension Discount Curve. A singular discount rate is then determined such that the resulting liability from discounting using the curve matches the liability resulting from discounting the same cash flows using the aforementioned singular discount rate. Discount rates for the Canadian MDA pension and other postretirement plans are determined by actuaries using a model that extrapolates the yields on high quality corporate bonds with longer maturities based on a spread adjustment to high quality provincial bonds as there is a limited market for high quality long-term corporate bonds in Canada. These rates are then reviewed by management. The expected return on plan assets is intended to be our best estimate and is determined based on an approach combining expected long-term asset mix returns with expected alpha from active management, net of fees. A total expected return on plan assets is then calculated for each plan based on the two sources of returns. For further information regarding our pension and other postretirement benefit plans see Note 2, “Summary of significant accounting policies” and Note 17, “Employee benefit plans” to the Consolidated Financial Statements in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data”. Goodwill Goodwill is tested annually for impairment as of October 1, or more frequently if events or circumstances indicate the carrying value may be impaired. We identify potential impairment by comparing the fair value of each of our reporting units with its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. Subsequent to October 1, and before we had completed our annual goodwill impairment test, we experienced triggering events suggesting that the fair value of our equity had decreased substantially since October 1. These triggering events required an additional goodwill impairment test, which was completed as of December 31. The triggering events included a sustained decline in our stock price, further declines in the GeoComm business, and the loss of the WorldView-4 satellite. We assess goodwill for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. Our reporting units as of December 31, 2018 were comprised of: Imagery, Services, MDA, SSL GeoComm, and the remainder of SSL (“SSL Other”). When evaluating goodwill for impairment, we estimate the fair value of each reporting unit using an income approach. We evaluate the aggregate fair value of our reporting units against market data to support our fair value estimates. The income approach utilizes a discounted cash flow approach, which requires the use of significant judgments and estimates, including future cash flows, terminal growth rates, and discount rates. The projections for future cash flows are generated using our strategic growth plan and include assumptions about future revenue growth, operating margins, capital expenditures, income tax rates, and working capital requirements. The terminal growth rate is used to calculate the value of cash flows beyond the last projected period in our discounted cash flow analysis and reflects our best estimates for stable, perpetual growth of our reporting units. The discount rate is an estimate of the overall after-tax rate of return required by a market participant whose weighted average cost of capital includes both debt and equity, including a risk premium. The risk premium is a subjective adjustment that, by its very nature does not include market related data, but instead examines the prospects of the reporting unit relative to the broader industry to determine if there are specific factors, which may make it more “risky” relative to the industry. Based on the significant decrease in our stock price as of December 31, 2018, our fair valuation was negatively impacted. The decrease in the stock price is reflective of a downturn in market participant expectations. We correlate our risk adjusted discount rates with market participant expectations. As a result of sustained declines in the price of our common stock, we applied higher risk adjusted discount rates to the projected cash flows of our reporting units. The higher discount rates, inclusive of increased risk premiums, reduced the fair values of each of our reporting units. In addition, pressures in the GeoComm business have negatively impacted our MDA and SSL Other reporting units. We determined that goodwill was impaired as of December 31, 2018 for our MDA, Imagery and SSL Other reporting units and recorded non-cash impairment charges of $477 million, $142 million and $17 million, respectively. Goodwill for the Services reporting unit was not impaired because its fair value exceeded its carrying value. If the discount rate for the Services reporting unit were one percentage point higher, goodwill for the reporting unit would result in a small amount of impairment. There was no goodwill allocated to the SSL GeoComm reporting unit based on the relative fair value of SSL GeoComm compared to the relative fair value of the other reporting units in the Space Systems segment. The discounted cash flow approach requires management to make certain assumptions based upon information available at the time the valuations are performed. Actual results could differ from these assumptions. Management believes the assumptions used are reflective of what a market participant would have used in calculating fair value considering current economic conditions. Additional risks for goodwill across all reporting units include, but are not limited to, the risks discussed in Item 1A, “Risk Factors” contained within this Annual Report on Form 10-K, and: · a decline in our stock price and resulting market capitalization, if we determine the decline is sustained and is indicative of a reduction in the fair value below the carrying value of our reporting units; · our failure to reach our internal forecasts could impact our ability to achieve our forecasted levels of cash flows and reduce the estimated discounted value of our reporting units; · adverse technological events that could impact our performance; · volatility in equity and debt markets resulting in higher discount rates; and · significant adverse changes in the regulatory environment or markets in which we operate. It is not possible at this time to determine if a further impairment charge would result from these factors. We will continue to monitor our goodwill for potential impairment indicators in future periods. Impairment of Long-Lived Assets We review the carrying amount of long-lived tangible and intangible assets to be held and used in the business for impairment if events or circumstances warrant such a review. Indicators of impairment include, but are not limited to: a significant change in the extent or manner in which an asset (or asset group) is used; a significant adverse change in the operations of our satellites; a change in government spending or customer demand that could affect the value of the asset group; a significant decline in the observable market value of an asset group; or a significant adverse change in legal factors or in the business climate that could affect the value of the asset group. We identified triggering events for impairment during the third quarter of 2018 related to property, plant and equipment and intangible assets of our GeoComm business, a reporting unit in the Space Systems segment. At the beginning of the year, we forecasted the GeoComm business would be awarded three to four contracts for GeoComm satellites, or approximately thirty percent of the overall 2018 industry awards. During the second half of the year, it became clear that industry and macroeconomic factors had declined substantially from earlier forecasts. We were awarded one award during 2018, and industry awards were lower than expected. Due to the decline in the GeoComm market, and the uncertainty surrounding the future of our GeoComm business, an impairment loss was recognized on our intangible assets primarily due to future cash flows associated with the intangible assets not being sufficient to cover the total book value of those assets. During the fourth quarter of 2018 further degradation of the GeoComm business occurred primarily relating to specifically identified assets pegged for future usage by the business. In the fourth quarter, we determined that the businesses cash flows associated with GeoComm operations linked to the tangible and intangible assets were not sufficient to cover their book value. Those assets were further impaired. For the year ended December 31, 2018, we recognized impairment losses totaling $122 million and $121 million related to intangible assets and property plant and equipment, respectively. Impairment losses of property, plant and equipment related to obsolescence and reduced future use of equipment and buildings. Impairment loss for property, plant and equipment was based on fair value less cost of disposal for those assets in an orderly liquidation. Fair value was based on observable inputs where possible (Level 2), in which market data could be applied. However, due to the specialized nature of the majority of these assets, inputs for a portion of the valuation were unobservable (Level 3). During December 2018, the WorldView-4 satellite experienced a failure in its control moment gyros, preventing the satellite from collecting imagery. As a result, during December 2018, we recorded an impairment loss of $162 million for the remaining book value of the satellite, related assets, and future premium payments. There were no impairments of long-lived assets during the years ended December 31, 2017 and 2016. Income Taxes We are subject to income taxes in Canada, the United States, Luxembourg, and other foreign jurisdictions. We compute the provision for income taxes using the asset and liability method, under which deferred tax assets and liabilities are determined based on the temporary differences between the financial reporting and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured at the currently enacted tax rates that are expected to apply in years in which they are expected to be paid for or realized. All deferred income taxes are classified as non-current on our consolidated balance sheets. Significant judgments are required in order to determine the realizability of tax assets. In assessing the need for a valuation allowance, we evaluate all significant available positive and negative evidence, including historical operating results, estimates of future sources of taxable income, carry-forward periods available, the existence of prudent and feasible tax planning strategies, and other relevant factors. The recognition of uncertain tax positions is evaluated based on whether it is considered more likely than not that position taken, or expected to be taken, on a tax return will be sustained upon examination through litigation or appeal. For those positions that meet the recognition criteria, they are measured as the largest amount that is more than fifty percent likely to be realized upon ultimate settlement. We believe that the uncertain tax positions recognized are adequate to cover all open tax years based on our assessment. If the expected outcome of the matter changes, we will adjust income tax expense accordingly in the period in which the expected outcome has changed. We classify interest and penalties related to income taxes as income tax expense. We earn investment and other tax credits with respect to its research and development expenses. The benefit of these tax credits is recorded as a reduction of income tax expense. On December 22, 2017, the 2017 Tax Act was enacted. The 2017 Tax Act includes a broad range of tax reform proposals affecting businesses, including a reduction in the U.S. federal corporate tax rate from 35% to 21% effective January 1, 2018, a one-time mandatory deemed repatriation tax on earnings of certain foreign subsidiaries that were previously tax deferred, limitations on interest expense deductions, a new base erosion focused minimum tax applicable to certain payments to foreign related parties, and the creation of new taxes on earnings of non-U.S. subsidiaries. The SEC staff issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the 2017 Tax Act (“SAB 118”), which provides guidance on accounting for the tax effects of the 2017 Tax Act. In accordance with the guidance, we were required to determine a reasonable estimate of the effect of the tax law changes in the period of enactment. In addition, SAB 118 allowed us to record provisional amounts during a measurement period not to extend beyond one year from the enactment date. Both the initial estimate of the impact of the tax law changes and the provisional amounts recognized in the measurement period were not material on a net basis. RECENT ACCOUNTING PRONOUNCEMENTS See Note 3, “New standards and interpretations not yet adopted” to the Consolidated Financial Statements in Part II, Item 8, “Consolidated Financial Statements and Supplementary Data” for a discussion of recent accounting pronouncements. NON-GAAP FINANCIAL MEASURES In addition to results reported in accordance with U.S. GAAP, we use certain non-GAAP financial measures as supplemental indicators of our financial and operating performance. These non-GAAP financial measures include EBITDA and Adjusted EBITDA. We define EBITDA as earnings before interest, taxes, depreciation and amortization, and Adjusted EBITDA as EBITDA adjusted for certain items affecting comparability as specified in the calculation. Management believes that exclusion of these items assists in providing a more complete understanding of our underlying results and trends, and management uses these measures along with the corresponding U.S. GAAP financial measures to manage our business, evaluate our performance compared to prior periods and the marketplace, and to establish operational goals. Adjusted EBITDA is a measure being used as a key element of our incentive compensation plan. The Syndicated Credit Facility also uses Adjusted EBITDA in the determination of our debt leverage covenant ratio. The definition of Adjusted EBITDA in the Syndicated Credit Facility includes a more comprehensive set of adjustments. We believe that these non-GAAP measures, when read in conjunction with our U.S. GAAP results, provide useful information to investors by facilitating the comparability of our ongoing operating results over the periods presented, the ability to identify trends in our underlying business, and the comparison of our operating results against analyst financial models and operating results of other public companies. EBITDA and Adjusted EBITDA are not recognized terms under U.S. GAAP and may not be defined similarly by other companies. EBITDA and Adjusted EBITDA should not be considered alternatives to net income (loss) as indications of financial performance or as alternate to cash flows from operations as measures of liquidity. EBITDA and Adjusted EBITDA have limitations as an analytical tool and should not be considered in isolation or as a substitute for our results reported under U.S. GAAP. The table below reconciles our net (loss) income to EBITDA and Adjusted EBITDA for the years ended December 31 2018, 2017 and 2016: 1Interest expense includes interest income of $1 million for each of the periods ended December 31, 2018 and 2017.

<s>[INST] We are a global leader of advanced space technology solutions and are at the nexus of the new space economy, developing and sustaining the infrastructure and delivering the information, services and systems that unlock the promise of space for commercial and government markets. As a trusted partner, we provide vertically integrated capabilities and expertise including satellites, Earth imagery, robotics, geospatial data and analytics to help customers anticipate and address their most complex missioncritical challenges with confidence. Maxar trades on the NYSE and TSX under the ticker “MAXR”. Our businesses are organized and managed in three reportable segments: Space Systems, Imagery and Services, as described below under “Segment Results”. RECENT DEVELOPMENTS Security Control Agreement and Facility Clearance and the U.S. Domestication On January 26, 2017, we, together with our U.S. based subsidiary, Maxar Holdings and the U.S. Department of Defense entered into a Security Control Agreement (“SCA”) and began operating under the agreement. The SCA allows our subsidiaries to hold facility clearances necessary to pursue and execute classified U.S. government space and defense contracts. In February 2017, we received facility security clearance for the offices of Maxar Holdings, and the proxy board at Radiant Geospatial Solutions LLC was dissolved. On February 2, 2018, the Defense Security Service granted facility clearance for our satellite manufacturing facility in Palo Alto, California. On January 1, 2019, we completed our previously announced U.S. Domestication. The domiciliation into the United States marked a major milestone in our longterm U.S. access plan, enhanced our ability to provide and support classified applications for U.S. government agencies and fulfilled a commitment made in acquiring DigitalGlobe, which was approved by our shareholders at that time. We will continue to operate in compliance with the SCA until which time the U.S. Department of Defense determines that such agreement is no longer necessary following the U.S. Domestication. From our inception until September 30, 2018, we have reported to securities regulators in both Canada and the U.S. using IFRS financial statements. Upon the U.S. Domestication, and including this Annual Report on Form 10K, we have retrospectively converted our Consolidated Financial Statements from IFRS to accounting principles generally accepted in the U.S. (“U.S. GAAP”). Key Leadership Changes On January 14, 2019, we announced the appointment of Daniel Jablonsky as President and Chief Executive Officer of Maxar, effective immediately. Mr. Jablonsky, who most recently served as President of DigitalGlobe, a wholly owned subsidiary of Maxar, also joined the Maxar Board of Directors. He succeeds Howard Lance, who resigned from his roles as President and Chief Executive Officer and as a Director of Maxar. In December 2018, we announced that our Board of Directors elected retired U.S. Air Force Gen. Howell M. Estes III as Chair, effective January 1, 2019, coincident with the U.S. Domestication. Mr. Estes, who has served as a director of our Board since the acquisition of DigitalGlobe, succeeds Robert L. Phillips, who will continue to serve as a director. In July 2018, we announced the appointment of Biggs Porter as Executive Vice President and Chief Financial Officer of Maxar, effective August 15, 2018. Anil Wirasekara, who previously served as Chief Financial Officer from 1994 to October 2017, assumed the duties of Interim Chief Financial Officer after William McCombe stepped down as Chief Financial Officer in February 2018. WorldView4 Satellite During December 2018, our WorldView4 satellite experienced a failure in its control moment gyros, preventing the satellite from collecting imagery. As a result, during December 2018, we recorded an impairment loss of $162 million for the remaining book value of the satellite, related assets and future premium payments. The WorldView4 satellite [/INST] Negative. </s>

Maxar Technologies Inc.

2020-03-02

2019-12-31

ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW We are a leading provider of solutions in Earth Intelligence and Space Infrastructure. We help government and commercial customers to monitor, understand and navigate the changing planet; deliver global broadband communications; and explore and advance the use of space. Our approach combines decades of deep mission understanding and a proven commercial and defense foundation to deliver our services with speed, scale and cost effectiveness. Our businesses are organized and managed in three reportable segments: Earth Intelligence, Space Infrastructure and MDA, as described below under “Segment Results.” RECENT DEVELOPMENTS Definitive Agreement to Sell MDA On December 29, 2019, we entered into a Stock Purchase Agreement (“MDA Agreement”), with Neptune Acquisition Inc., a corporation existing under the laws of the Province of British Columbia and an affiliate of Northern Private Capital Ltd. (“MDA Purchaser”) that provides for, among other things, the MDA Purchaser to purchase MDA, our Canadian subsidiary, from us for an aggregate purchase price of approximately C$1.0 billion (“MDA Transaction”). The MDA Transaction is subject to customary purchase price adjustments for working capital, cash and debt, and as otherwise described below. Pursuant to the MDA Agreement, the MDA Purchaser will acquire all of the outstanding shares in the entities that operate our MDA business. The closing of the MDA Transaction is conditioned on customary closing conditions and on specified regulatory approvals, including review by the Committee on Foreign Investment in the United States, Hart-Scott-Rodino review by the U.S. Department of Justice and the U.S. Federal Trade Commission, and Canadian government reviews under the Radiocommunication Act and the Competition Act. The closing of the MDA Transaction is not subject to a financing condition and is expected to close in the Spring or early Summer of 2020. The MDA Agreement contains specified termination rights for us and the MDA Purchaser, including, among others, if the consummation of the MDA Transaction has not occurred by June 29, 2020, subject to extension to September 29, 2020 for the purpose of obtaining regulatory approvals in the U.S. and Canada and appealing any injunctions preventing the consummation of the MDA Transaction. The MDA Agreement contains a negative purchase price adjustment of up to C$65 million for a complete loss or failure of RADARSAT-2, such that it cannot be used for its intended commercial purposes. The MDA Agreement provides that the MDA Purchaser will be required to pay us a reverse termination fee of C$55 million under specified circumstances, including, among others, where the MDA Agreement is terminated because (i) the MDA Purchaser has materially breached its representations and warranties or the MDA Purchaser fails to perform its covenants in all material respects, subject to a cure period, or (ii) all of the conditions to closing of the MDA Transaction (other than those conditions that by their terms are to be satisfied at closing) have been satisfied or waived, we have confirmed in writing to the MDA Purchaser that we stand ready, willing and able to consummate the MDA Transaction and the MDA Purchaser fails to consummate the closing (including for a failure of the MDA Purchaser’s debt financing) within two business days of receipt of the notice from us. Senior Secured 2023 Notes In December 2019, we issued $1.0 billion in principal amount of 9.75% Senior Secured Notes due 2023 (“2023 Notes”) in a private placement to institutional buyers. The 2023 Notes were issued at a price of 98%. The 2023 Notes bear interest at the rate of 9.75% per year, payable semi-annually in cash in arrears, which interest payments will commence in June 2020. The 2023 Notes are guaranteed on a senior secured basis by each of our existing and future subsidiaries that guarantee the Syndicated Credit Facility. The proceeds from the 2023 Notes and the sale of our owned properties in Palo Alto, California were used to repay the outstanding borrowings under our existing senior secured first lien term A facility (“Term Loan A”) and the majority of the outstanding borrowings on the Revolving Credit Facility. Concurrent Amendment to Revolving Credit Facility On November 4, 2019, we further amended our Original Syndicated Credit Facility (the “Third Amending Agreement”), certain portions of which became effective immediately and certain portions of which became effective in December 2019 upon the issuance of the 2023 Notes (“Effective Date”). The Third Amending Agreement, during the Covenant Relief Period, (i) modified the priority of the application of certain voluntary prepayments resulting from certain asset sales (but which did not affect the prepayments owed to the Term Loan B), and (ii) restricted use of proceeds of future borrowings. In addition, the Third Amending Agreement increased the maximum consolidated debt leverage ratios permitted under the Original Syndicated Credit Facility to 7.25x at the end of the fiscal quarter ended December 31, 2019, 7.50x at the end of the fiscal quarter ending March 31, 2020, 7.75x at the end of each fiscal quarter thereafter until the fiscal quarter ending September 30, 2021, 7.50x at the end of each fiscal quarter thereafter until the quarter ending September 30, 2022, 6.50x at the end of each fiscal quarter thereafter until the fiscal quarter ending March 31, 2023, and 5.75x for each fiscal quarter thereafter (subject to a 0.25x reduction in each maximum level upon a disposition of a business line for greater than $500 million). The Third Amending Agreement also extended the maturity of the Revolving Credit Facility by two years to December 2023, updated the Interest Coverage Ratio to be less than 2.0x at the end of each fiscal quarter, restricted investment capacity in certain permitted investments, restricted future increases in quarterly dividend payment levels and modified certain margin and standby fee terms. In addition, we canceled the operating credit facility and reduced committed borrowing capacity under the Revolving Credit Facility from $1.25 billion to $500 million. Sale Leaseback Agreements On December 10, 2019, we completed the sale and subsequent leaseback of our owned properties in Palo Alto, California for proceeds of $291 million. We recognized a gain on the sale of the properties of $136 million, which was adjusted for off-market leaseback terms and is included in Gain on sale of assets in the Consolidated Statements of Operations. We recorded operating lease assets and liabilities of $63 million, representing the fair value of the minimum lease payments associated with the agreements to lease assets back over a period of two to ten years; and recognized a deferred financing liability of $33 million for the above-market rent stipulated in the lease agreements which included in Long-term debt on the Consolidated Balance Sheet. Tax Benefit Preservation Plan On May 12, 2019, our Board of Directors approved a Tax Benefit Preservation Plan (“Tax Plan”), which our Stockholders subsequently approved on October 31, 2019, with the intent to preserve the value of certain deferred tax benefits (“Tax Benefits”) including those generated by net operating losses. The Tax Plan is intended to act as a deterrent to any person or entity acquiring shares of the Company equal to or exceeding 4.9%. For each common stock outstanding as of May 28, 2019, a dividend of one preferred stock purchase right (“The Rights”) is granted. The Tax Plan gives current stockholders the right to purchase one one-hundredth of a 32 share of Series A Junior Participating Preferred Stock at a set price of $30.92 which, upon exercise, provides for one additional share of common stock at a 50% discount on the exercise date with no cash settlement options. The Rights under the Tax Plan will expire on October 5, 2020. The Tax Plan reduces the likelihood that changes in our investor base have the unintended effect of limiting the use of our Tax Benefits. There is no impact to the financial statements as a result of the Tax Plan. Security Control Agreement and Facility Clearance and the U.S. Domestication On January 26, 2017, we, together with our U.S.-based subsidiary, Maxar Holdings, and the U.S. Department of Defense entered into a Security Control Agreement (“SCA”) and began operating under the agreement. On February 2, 2018, the Defense Security Service granted facility clearance for our satellite manufacturing facility in Palo Alto, California. On January 1, 2019, we completed our previously announced U.S. Domestication. The U.S. Domestication marked a major milestone in our long-term U.S. Access Plan, enhanced our ability to provide and support classified applications for U.S. government agencies and fulfilled a commitment made in acquiring DigitalGlobe. On January 8, 2020, the SCA was terminated by the U.S. Department of Defense, who determined that the SCA was no longer necessary as a result of the U.S. Domestication. The SCA was replaced by a simple Board Resolution that will continue to govern our foreign ownership and controlling interests. Key Leadership Changes On January 14, 2019, we announced the appointment of Daniel Jablonsky as President and Chief Executive Officer of Maxar. Mr. Jablonsky, who most recently served as President of DigitalGlobe, a wholly owned subsidiary of Maxar, also joined the Maxar Board of Directors. He succeeds Howard Lance, who resigned from his roles as President and Chief Executive Officer and as a Director of Maxar. In December 2018, we announced that our Board of Directors elected retired U.S. Air Force Gen. Howell M. Estes III as Chairman of the Board of Directors, effective January 1, 2019, coincident with the U.S. Domestication. Gen. Estes, who has served as a director of our Board of Directors since the acquisition of DigitalGlobe, succeeds Robert L. Phillips, who will continue to serve as a director. In July 2018, we announced the appointment of Biggs Porter as Executive Vice President and Chief Financial Officer of Maxar, effective August 15, 2018. Anil Wirasekara, who previously served as Chief Financial Officer from 1994 to October 2017, assumed the duties of Interim Chief Financial Officer after William McCombe stepped down as Chief Financial Officer in February 2018. WorldView-4 Satellite During December 2018, our WorldView-4 satellite experienced a failure in its control moment gyros, preventing the satellite from collecting imagery. As a result, during December 2018, we recorded an impairment loss of $162 million for the remaining book value of the satellite, related assets and future premium payments. On May 3, 2019, we announced that our insurance carriers accepted our $183 million claim for loss arising from the WorldView-4 satellite on orbit failure and agreed to pay us the full amount. As of December 31, 2019, we have collected the full insurance proceeds. Acquisition of DigitalGlobe On October 5, 2017, we completed the DigitalGlobe Transaction and renamed the combined company Maxar Technologies Ltd. The transaction created a global leader in Earth imaging and geospatial solutions by combining DigitalGlobe’s over 15-year lead in technology and ImageLibrary development, as well as its high-resolution Earth imaging capabilities, with our existing position as a world leader in commercial communications satellites. We believe we are uniquely positioned to grow in the U.S. and global Earth observation and geospatial services markets through our end-to-end space systems, Earth imagery and geospatial solutions. As a result of the DigitalGlobe Transaction, we increased our scale and we believe, credibility with U.S. government agencies and international government customers. The DigitalGlobe Transaction also added more predictable geospatial data and services revenue while diversifying our product and service offering. With a larger set of customers and end markets, we are better able to increase share in existing markets and grow in adjacent markets. Our vision is to be the world’s leader in the new space economy. We aim to achieve this by integrating innovative technologies, unique capabilities and end-to-end offerings across our businesses to help our customers address their most complex mission-critical challenges with confidence. Segment Results In January 2019, with the appointment of Mr. Jablonsky as our President and Chief Executive Officer, our CODM changed. During the fourth quarter of 2019, following a number of changes, the CODM changed the way in which he assesses performance and allocates resources. As a result, we have revised our reportable segments to reflect how the CODM currently reviews financial information and makes operating decisions. Our CODM measures performance of our reportable segments based on revenue and Adjusted EBITDA. Our operating and reportable segments are: Earth Intelligence, Space Infrastructure and MDA. With our announcement of the MDA Transaction on December 30, 2019, the MDA segment has been classified within Income (loss) from discontinued operations, net of tax in the Consolidated Statements of Operations. All prior-period amounts have been adjusted to reflect the reportable segment change. Earth Intelligence In the Earth Intelligence segment, we are a global leader in high resolution space-based optical and radar imagery products and analytics. We launched the world’s first high resolution commercial imaging satellite in 1999 and currently operate a four-satellite imaging constellation, providing us with a 110 petabyte historical ImageLibrary of the highest-resolution, commercially available imagery. Our imagery solutions provide customers with timely, accurate and mission-critical information about our changing planet and support a wide variety of government and commercial applications, including mission planning, mapping and analysis, environmental monitoring, disaster management, crop management, oil and gas exploration and infrastructure management. Our principal customers in the Earth Intelligence segment are U.S. and other international government agencies (primarily defense and intelligence agencies), as well as a wide variety of commercial customers in multiple markets. We are a market leader in the commercial satellite Earth observation industry. We also provide geospatial services that combine imagery, analytic expertise and innovative technology to deliver intelligence solutions to customers. Our cleared developers, analysts, and data scientists provide analytic solutions that accurately document change and enable geospatial modeling and analysis that help predict where events will occur. Our primary customer of geospatial services is the U.S. government, but we also support intelligence requirements for other U.S. allied governments, global development organizations and commercial customers. The Earth Intelligence segment includes the financial results of the legacy Imagery and Services segments, excluding the legacy Canadian radar imagery business. Space Infrastructure In the Space Infrastructure segment, we are a leading provider of Space Infrastructure. We design, build, integrate and test solutions for space-based communications satellites, on-orbit servicing, robotic assembly and space exploration. We address a broad spectrum of needs for our customers, including mission systems engineering, product design, spacecraft manufacturing, assembly integration and testing. We provide advanced, reliable, and affordable spacecraft that enable our commercial customers to deliver valuable global services, and we are successfully partnering with the U.S. government in new space opportunities. Our principal customers in the Space Infrastructure segment are commercial satellite operators and government agencies worldwide. The Space Infrastructure segment includes the financial results of our legacy Space Solutions business (previously referred to as Space Systems/Loral LLC or SSL) which was previously included within our legacy Space Systems segment. MDA In the MDA segment, we are a leading provider of Space Infrastructure in Canada. We develop and deliver advanced surveillance and intelligence solutions, defense and maritime systems, radar geospatial imagery, space robotics, satellite antennas and communication subsystems. The MDA segment includes the financial results of the MDA and legacy radar imagery business. We have a long history in space robotics, having developed the Canadarms for NASA’s Space Shuttle program and Canadarm2, which is currently in service on the International Space Station. Our principal customers in the MDA segment are the Canadian government and other government and commercial customers worldwide. As discussed above, in connection with the MDA Transaction, the financial results from this segment were classified as discontinued operations for all periods presented in this Annual Report on Form 10-K. RESULTS OF OPERATIONS The following table provides selected annual financial information for the years ended December 31, 2019, 2018 and 2017. *Not meaningful. Product and service revenue Total revenues decreased to $1,666 million from $1,804 million, or by $138 million, for the year ended December 31, 2019 compared to the same period in 2018. The decrease was primarily driven by a decrease in revenue in our Space Infrastructure segment partially offset by an increase in revenue in our Earth Intelligence segment. Further discussion of the drivers behind the decrease in revenues within the “Results by Segment” section below. Total revenues increased to $1,804 million from $1,257 million, or by $547 million for the year ended December 31, 2018 as compared to the same period in 2017. The increase in revenues was primarily driven by the inclusion of a full year of revenue related to the DigitalGlobe Transaction as compared with only approximately one quarter of revenues in 2017. The increase in revenue from the Earth Intelligence segment was partially offset by a decrease in revenue in the Space Infrastructure segment. Further discussion of the drivers behind the decrease in revenues within the Space Infrastructure segment is included within the “Results by Segment” section below. See Note 17, “Segment Information” to the Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data” for product and service revenues by segment. Product and service costs Total cost of product and services decreased to $975 million from $1,088 million, or by $113 million, for the year ended December 31, 2019 compared to 2018. The decrease is primarily driven by lower costs within the Space Infrastructure segment driven by lower volume which was partially offset by an increase in costs in our Earth Intelligence segment which was primarily driven by an increase in the labor associated with providing geospatial services. Total cost of product and services increased to $1,088 million from $924 million, or by $164 million, for the year ended December 31, 2018 compared to 2017. The increase is primarily related to the inclusion of a full year of costs related to the DigitalGlobe Transaction compared to only approximately one quarter in 2017. Selling, general and administrative Selling, general and administrative expense decreased to $325 million from $446 million, or by $121 million, for the year ended December 31, 2019 compared to 2018. The decrease was primarily driven by a decrease in research and development spend of $78 million, a $19 million decrease in integration expense related to the DigitalGlobe Transaction and a decrease in labor related expenses due to a reduction of headcount from actions taken during the first quarter of 2019. Selling, general and administrative expense increased to $446 million from $337 million, or by $109 million for the year ended December 31, 2018 compared to 2017. The increase was primarily driven by inclusion of a full year of costs related to the DigitalGlobe Transaction compared to only approximately one quarter in 2017. Depreciation and amortization Depreciation and amortization expense decreased to $376 million from $439 million, or by $63 million, for the year ended December 31, 2019 compared to the same period in 2018. The decrease was primarily driven by a decrease in depreciation and amortization expense following asset impairments in the second half of 2018. Depreciation and amortization expense increased to $439 million from $152 million, or by $287 million, for the year ended December 31, 2018 compared to 2017. The increase is primarily due to the inclusion of a full year of depreciation and amortization expense related to the acquisition of DigitalGlobe as compared to approximately one quarter of depreciation and amortization expense in 2017. Impairment losses *Not meaningful. During the year ended December 31, 2019, we recognized impairment losses of $14 million primarily related to orbital receivables within the Space Infrastructure segment due to a decrease in customer credit ratings. During the year ended December 31, 2018, we recognized $586 million of impairment losses. We recorded a non-cash goodwill impairment loss of $159 million related to our Earth Intelligence and Space Infrastructure segments which was a result of the sustained decline in our stock price and the further decline in the geostationary satellite manufacturing business (“GeoComm”) in our Space Infrastructure segment. We also recognized impairment losses of $122 million related to intangible assets and $121 million related to property, plant and equipment within the Space Infrastructure segment. Additionally, we recorded a $22 million impairment related to orbital receivables within the Space Infrastructure segment primarily due to a decrease in customer credit rating. In December 2018, we lost the imaging capability of our WorldView-4 satellite, resulting in a loss of $162 million on the satellite, related assets, and future premium payments. Satellite insurance recovery During the year ended December 31, 2019, we received insurance recoveries of $183 million related to the loss of imaging capability of our WorldView-4 satellite in December 2018. Gain on sale of assets *Not meaningful. During the year ended December 31, 2019 we recorded a gain of $136 million related to the sale and subsequent leaseback of our owned properties in Palo Alto, California. During the year ended December 31, 2018, we recorded a gain of $33 million related to the sale of one of our buildings in Palo Alto, California. Interest expense, net *Not meaningful. Under DigitalGlobe’s predecessor contract to the EnhancedView Contract, DigitalGlobe had received advanced payments from the U.S. government during the construction phase of the WorldView-1 satellite, which was more than one year before capacity was made available to them. The effect of imputing interest on these advanced payments is to increase contract liabilities with an offsetting charge to interest expense. As capacity is provided to the customer, revenue is recognized and the contract liabilities balance decreases. The contract liability balance associated with the EnhancedView Contract is expected to be recognized as revenue through August 31, 2020. Interest expense, net increased to $219 million from $200 million, or by $19 million, for the year ended December 31, 2019 compared to 2018. The increase is primarily due to a $23 million increase in interest on long-term debt and a $22 million loss on debt extinguishment. These increases were partially offset by an increase in capitalized interest of $12 million primarily related to the building of our WV-Legion constellation and a $11 million decrease in interest on advance payments from customers. Interest expense, net increased to $200 million from $97 million, or by $103 million, for the year ended December 31, 2018 compared to 2017. The increase is driven by higher levels of long-term debt primarily related to the DigitalGlobe Transaction, and an increase of $18 million in interest expense on advance payments from customers. The increase was partially offset by a loss on debt extinguishment in the prior year period of $23 million. Other (income) expense, net Other (income) expense, net remained relatively unchanged year over year as it increased to income of $1 million for the year ended December 31, 2019 compared to a net loss of $1 million for the year ended December 31, 2018. Other expense (income), net changed to an expense of $1 million compared to income of $30 million for the year ended December 31, 2018 compared to the same period in 2017. This is primarily due to the $26 million gain on settlement in 2017 related to the 2017 amendment of one of our other postretirement benefit plans in the Space Infrastructure segment which did not reoccur in 2018. Income tax benefit Income tax expense (benefit) increased to an expense of $5 million from a benefit of $48 million, or by $53 million, for the year ended December 31, 2019 compared to 2018, primarily due to the recognition of a 2018 tax benefit associated with interest expense in continuing operations and the applicability of the base erosion and anti-abuse tax (“BEAT”) to certain payments made in 2019. Income tax benefit decreased to a benefit of $48 million from a benefit of $168 million, or by $120 million, for the year ended December 31, 2018 compared to 2017 primarily due to a reduction in our valuation allowance in the year ended December 31, 2017 attributable to the acquisition of DigitalGlobe, offset partially by the additional tax benefit relating to increased interest expense. Our effective tax rate for 2019 differed from 2018 primarily due to the recognition of the Canadian tax benefit associated with deductible interest expense and the applicability of BEAT to certain payments made in 2019. Our effective tax rate for 2018 differed from 2017 primarily due to the change in the valuation allowance as a result of the acquisition of DigitalGlobe in 2017, offset partially by the additional tax benefit relating to increased interest expense following the acquisition of DigitalGlobe. Equity in (income) loss from joint ventures, net of tax *Not meaningful. Equity in income from joint ventures, net of tax increased to $11 million from $2 million, or by $9 million, for the year ended December 31, 2019 compared to the same period in 2018. The increase, which was substantially all in the fourth quarter of 2019, is primarily related to growth in our Vricon joint venture of which we own approximately 50%. Equity in loss (income) from joint ventures, net of tax increased to income of $2 million compared to a loss of $1 million, or by $3 million, for the year ended December 31, 2018 compared to the same period in 2017. The increase is primarily related to the impact of a full year of Vricon’s results in 2018 as opposed to approximately one quarter of results in 2017. Income (loss) from discontinued operations, net of tax *Not meaningful. Income from discontinued operations, net of tax increased to $26 million in net income from a net loss of $377 million, or by $403 million, for the year ended December 31, 2019 compared to the same period in 2018. This increase was primarily driven by the decrease in impairment losses recorded in 2019 of $12 million compared to a goodwill impairment of $477 million in 2018. The 2019 results were impacted by a decrease in revenue of $53 million which was partially offset by a decrease in costs. The 2019 results were also impacted by a liability for contingencies of $32 million. Income from discontinued operations, net of tax decreased to a loss of $377 million from net income of $116 million, or by $493 million, for the year ended December 31, 2018 compared to the same period in 2017. This decrease was primarily driven by a goodwill impairment of $477 million which was partially offset by a decrease in costs. RESULTS BY SEGMENT We analyze financial performance by segments, which group related activities within our business. We report our financial performance based on three reportable segments: Earth Intelligence, Space Infrastructure and MDA. As of December 31, 2019, the MDA segment was classified as discontinued operations and is not included in the table or discussion below. Intrasegment transactions have been eliminated from the segmented financial information discussed below. *Not meaningful. Adjusted EBITDA disclosures throughout this section, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” are non-GAAP measures. See “Non-GAAP Financial Measures” below for further discussion of Adjusted EBITDA disclosures. Earth Intelligence The following table provides selected financial information for the Earth Intelligence segment. *Not meaningful. Revenues from the Earth Intelligence segment increased to $1,085 million from $1,059 million, or by $26 million, for the year ended December 31, 2019 compared to the same period in 2018. The increase was primarily driven by new contract awards and expansion of programs with the U.S. government of $63 million, offset by a net decrease of $36 million in revenues from our direct access program primarily due to the loss of WorldView-4 revenues. Revenues from the Earth Intelligence segment increased to $1,059 million from $331 million, or by $728 million, for the year ended December 31, 2018 compared to the same period in 2017. The increase was primarily driven by the inclusion of DigitalGlobe’s results for a full year compared to only one quarter of results in 2017. Adjusted EBITDA from the Earth Intelligence segment increased to $548 million from $516 million, or by $32 million, for the year ended December 31, 2019 compared to the same period in 2018. The increase is primarily related to a decrease in selling, general and administrative costs of $28 million partially related to headcount reductions taken in the first half of the year and a shift of certain functions to corporate, and an increase in equity in income from our Vricon joint venture of $9 million. These increases were partially offset by a net decrease in margins from our revenue contracts, which were primarily driven by the loss of WorldView-4 revenues, which had higher margins. Adjusted EBITDA from the Earth Intelligence segment increased to $516 million from $152 million, or by $364 million, for the year ended December 31, 2018 compared to the same period in 2017. The increase was primarily driven by the inclusion of DigitalGlobe’s results for a full year compared to only one quarter of results in 2017. Space Infrastructure The following table provides selected financial information for the Space Infrastructure segment. Changes in revenues from year to year are influenced by the size, timing and number of satellite contracts awarded in the current and preceding years and the length of the construction period for satellite contracts awarded. Revenues on satellite contracts are recognized using the cost-to-cost method to determine the percentage of completion over the construction period, which typically ranges between 20 to 36 months and up to 48 months in special situations. Adjusted EBITDA margins can vary from quarter to quarter due to the mix of our revenues and changes in our estimated costs to complete as our risks are retired and as our estimated costs to complete are increased or decreased based on contract performance. Revenues from the Space Infrastructure segment decreased to $706 million from $823 million, or by $117 million, for the year ended December 31, 2019 compared to the same period in 2018. Revenues decreased primarily as a result of the impact of reduced volume in our GeoComm business and an increase in estimated costs to complete programs. The reduced volume was a result of new business not fully replacing existing backlog contracts that were completed during the period. Revenues from the Space Infrastructure segment decreased to $823 million from $932 million, or by $109 million, for the year ended December 31, 2018 compared to the same period in 2017. Revenues decreased primarily as a result of the impact of reduced volume in our GeoComm business, an increase in estimated costs to complete programs and $28 million of liquidated damages which were recorded during 2018. Adjusted EBITDA from the Space Infrastructure segment was a loss of $17 million compared to a loss of $75 million, or an increase of $58 million, for the year ended December 31, 2019 compared to the same period in 2018. The increase is primarily related to reduced research and development spend of $72 million and headcount reductions from restructuring initiatives resulting in lower costs and the impact of no new liquidated damages being incurred compared to $28 million of liquidated damages in 2018. These increases were partially offset by decreases from the effects of lower revenues and higher estimated costs to complete on certain projects along with losses incurred on developmental builds. Adjusted EBITDA from the Space Infrastructure segment was a loss of $75 million compared to a loss of $59 million, or a change of $16 million, for the year ended December 31, 2018 compared to the same period in 2017. The decrease from 2017 to 2018 is primarily related to an increase in estimated costs to complete programs as a result of supplier performance issues and delays experienced during the second half of 2018, as well as unanticipated impacts of lower volume, which resulted in lower productivity and overhead absorption. In addition, we incurred $28 million of liquidated damages in 2018, compared to a recovery of liquidated damages during 2017 and research and development expenses were $13 million higher in 2018 compared to the same period in 2017. In 2017, Adjusted EBITDA included a credit of $26 million relating to the curtailment of a postretirement benefit plan which did not reoccur in 2018. Corporate and other expenses Corporate and other expenses include items such as corporate office costs, regulatory costs, executive and director compensation, foreign exchange gains and losses, retention costs, and fees for legal and consulting services. Corporate and other expenses increased to $86 million from $49 million, or by $37 million, for the year ended December 31, 2019 compared to the same period in 2018. The increase was primarily driven by an increase in retention costs related to the Space Infrastructure segment of $24 million and an increase as a result of a shift of certain functions to corporate and other increases in selling, general and administrative expense of approximately $12 million. Corporate and other expenses increased to $49 million from $8 million, or by $41 million for the year ended December 31, 2018 compared to the same period in 2017. The increase in corporate expenses was primarily driven by additional headcount as a result of the DigitalGlobe Transaction, and the expansion and ramp up of corporate functions to support our increased scale. Intersegment eliminations Intersegment eliminations are related to projects between our segments, primarily WV-Legion. Intersegment eliminations have increased for the years ended December 31, 2019 and 2018 compared to the same period of 2018 and 2017, respectively, primarily related to an increase in satellite construction activity. BACKLOG Our backlog by segment from continuing operations is as follows: Order backlog, representing the estimated dollar value of firm funded contracts for which work has not been performed (also known as the remaining performance obligations on a contract), decreased to $1.6 billion from $2.1 billion, or by approximately $500 million, for the year ended December 31, 2019 compared to the same period in 2018. Order backlog generally does not include unexercised contract options and potential orders under indefinite delivery/indefinite quantity contracts. Approximately 61% of the total $1.6 billion backlog as of December 31, 2019 is expected to be converted into revenue in 2020. Backlog in the Space Infrastructure segment is primarily comprised of multi-year awards, such as satellite builds. Fluctuations in the backlog are driven primarily by the timing of large program wins. Most of the Earth Intelligence segment contracts are annual contracts, which renew at various times throughout the year. As a result, the timing of when contracts are awarded and when option years are exercised may cause backlog to fluctuate significantly from period to period. The decrease in backlog within the Earth Intelligence segment is primarily driven by the timing of the exercise of the EnhancedView Contract option year and a decrease due to the termination of a contract related to the loss of WorldView-4. These decreases were partially offset by increases in geospatial services. Unfunded contract options represent estimated amounts of revenue to be earned in the future from negotiated contracts with unexercised contract options and indefinite delivery/indefinite quantity contracts. Unfunded contract options as of December 31, 2019 were primarily comprised of the option years in the EnhancedView Contract (September 1, 2020 through August 31, 2023). We believe it is the U.S. government’s intention to exercise all option years, subject only to annual congressional appropriation of funding and the federal budget process. As each option year is exercised, it will be added to backlog. Although backlog reflects business that is considered to be firm, terminations, amendments or cancellations may occur, which could result in a reduction in our total backlog. LIQUIDITY & CAPITAL RESOURCES Our sources of liquidity include cash provided by operations, collection or securitization of orbital receivables, access to existing credit facilities and, when available and efficient, to the capital markets. We generally maintain limited cash on hand and use available cash to pay down borrowings on our Syndicated Credit Facility. Our primary short-term cash requirements are to fund working capital, including requirements on long-term construction contracts (including our geostationary satellite contracts), fixed overhead costs, and to fund increased capital expenditures, including the construction of our WV-Legion constellation. Working capital requirements can vary significantly from period to period, particularly as a result of the timing of receipts and disbursements related to long-term construction contracts. Our medium-term to long-term cash requirements are to service and repay debt and to invest, including in facilities, equipment, technologies, and research and development for growth initiatives. These capital investments include investments to replace the capability or capacity of satellites which have or will go out of service in the future. Over the near-term to medium-term, it is also possible that our customers may fully or partially fund the construction of additional Legion satellites. We also have call options to purchase the remaining ownership interest in Vricon Inc., a joint venture accounted for under the equity method. The call options are exercisable beginning in the first quarter of either 2020 or 2021 which, if exercised, would require the use of capital. The call option is $150 million to $200 million, including assumed liabilities, but may vary based on future results. Cash is also used to pay dividends and finance other long-term strategic business initiatives. Our first maturity of long-term debt is in the fourth quarter of 2023. Our ability to fund these needs will depend, in part, on our ability to generate cash in the future, which depends on our future financial results. Our future results are subject to general economic, financial, competitive, legislative and regulatory factors that may be outside of our control. Our future access to, and the availability of credit on acceptable terms and conditions is impacted by many factors, including capital market liquidity and overall economic conditions. We intend to use the net cash proceeds from the MDA Transaction to pay down the Company’s long-term debt. The net cash proceeds will be determined under the Company’s Original Syndicated Credit Facility, the 2023 Notes and the MDA Agreement. These proceeds include the netting of certain fees and liabilities, which include the indemnification of the MDA Purchaser for certain liabilities including a dispute with the Ukrainian customer. We believe that our cash from operating activities generated from continuing operations during the year, together with available borrowings under our Revolving Credit Facility, will be adequate for the next twelve months to meet our anticipated uses of cash flow, including working capital, capital expenditure, debt service costs, dividend, and other commitments. While we intend to reduce debt over time using cash provided by operations and net proceeds from the MDA Transaction, we may also seek to meet long-term debt obligations, if necessary, by obtaining capital from a variety of additional sources or by refinancing existing obligations. These sources include public or private capital markets, bank financings, proceeds from dispositions or other third-party sources. Following the sale of MDA, we will continue to evaluate if there are additional assets to be monetized. Summary of cash flows Operating activities Cash provided by operating activities related to continuing operations increased to $258 million from $114 million, or by $144 million, in the year ended December 31, 2019 from the corresponding period in 2018. The increase was primarily due to net income in 2019, compared to a net loss in 2018, adjusted for non-cash items and insurance proceeds of $183 million related to the loss of the WorldView-4 satellite. The insurance proceeds are included in operating cash flows as they are considered business interruption recovery and represent our satellite’s loss of capacity to produce imagery for sale to our customers. Cash provided by operating activities related to discontinued operations increased to $59 million from $25 million, or by $34 million, in the year ended December 31, 2019 from the corresponding period in 2018. The increase was primarily due to favorable changes in working capital in 2019 compared to 2018 and net income in 2019, compared to a loss in 2018, adjusted for non-cash items. Cash provided by operating activities related to continuing operations increased to $114 million from $56 million, or by $58 million, in the year ended December 31, 2018 from the corresponding period in 2017. The increase was primarily due to the inclusion of DigitalGlobe’s operating results, partially offset by a decrease in contract liabilities due to revenue recognized. Cash provided by operating activities related to discontinued operations decreased to $25 million from $49 million, or by $24 million, in the year ended December 31, 2018 from the corresponding period in 2017. The decrease was primarily driven by net losses of $377 million during the period ended December 31, 2018, which included $477 million of impairment losses. Cash flows from operating activities can vary significantly from period to period as a result of our working capital requirements, given our portfolio of large construction programs and the timing of milestone receipts and payments with customers and suppliers in the ordinary course of business. Investment in working capital is also necessary to build our business and manage lead times in construction activities. We expect working capital account balances to continue to vary from period to period. We efficiently fund our working capital requirements with the Revolving Credit Facility (as defined below). Investing activities Cash used in investing activities related to continuing operations decreased to $6 million from $129 million, or by $123 million, in the year ended December 31, 2019 from the corresponding period in 2018. The primary investing activities included expenditures on property, plant and equipment of $257 million and $150 million, for the years ended December 31, 2019 and 2018, respectively, and investments in software of $57 million and $56 million, for the years ended December 31, 2019 and 2018, respectively. Property, plant and equipment expenditures in 2019 and 2018 primarily related to the build of our Legion satellite constellation. In 2019, these expenditures were partially offset by net proceeds of $280 million from the sale and subsequent leaseback of our properties in Palo Alto, California. In 2018, expenditures were partially offset by net proceeds of $68 million from the sale of one of our buildings in Palo Alto, California. Cash used in investing activities in 2019 was also partially offset by a return of capital from discontinued operations of $28 million. Cash used in investing activities related to discontinued operations decreased to $7 million from $21 million, or by $14 million, in the year ended December 31, 2019 from the corresponding period in 2018. The decrease was primarily due to a decrease in cash investments in property, plant and equipment, intangible assets and the acquisition of Neptec Design Group Ltd. (“Neptec”) in 2018. Cash used in investing activities from continuing operations decreased to $129 million from $2,332 million, or by $2,203 million, for the year ended December 31, 2018 from the corresponding period in 2017. Property, plant and equipment expenditures in 2018 of $206 million were primarily related to the build of our Legion satellite constellation and were partially offset by net proceeds of $68 million from the sale of one of our buildings in Palo Alto, California. The primary investing activity in 2017 was the acquisition of DigitalGlobe. Cash used in investing activities related to discontinued operations increased to $21 million from $9 million, or by $12 million, in the year ended December 31, 2018 from the corresponding period in 2017. The primary investing activity in 2018 was the acquisition of Neptec for $6 million. Expenditures for property, plant and equipment were approximately $6 million in each of the years ended December 31, 2018 and 2017. Purchases of intangible assets were $6 million and $7 million, for the years ended December 31, 2018 and 2017, respectively. Financing activities Cash used in financing activities from continuing operations in 2019 increased to $208 million versus cash provided by financing activities of $15 million in 2018, or by $223 million. During the year ended December 31, 2019, cash used in financing activities from continuing operations included net proceeds from bank borrowings of $980 million offset by debt repayments of $1,115 million, debt issuance costs and fees paid to creditors of $24 million, repurchases of orbital receivables of $24 million and settlement of securitization liability of $20 million. During the year ended December 31, 2018, cash provided by financing activities from continuing operations included proceeds from bank borrowings of $104 million, proceeds from securitization of orbital receivables of $18 million and was offset by debt repayments of $27 million, settlement of securitization liability of $15 million and dividend payments of $65 million. Cash used in financing activities related to discontinued operations increased to $30 million from $2 million, or by $28 million, in the year ended December 31, 2019 from the corresponding period in 2018. The increase was primarily due to a return of capital from discontinued operations to continuing operations of $28 million in 2019. Cash provided by financing activities from continuing operations decreased to $15 million from $2,257 million, or by $2,242 million, in the year ended December 31, 2018 from the corresponding period in 2017. During the year ended December 31, 2018, cash provided by financing activities from continuing operations included net proceeds from bank borrowings of $104 million, proceeds from securitization of orbital receivables of $18 million, debt repayment of $27 million, settlement of securitization liability of $15 million, and dividend payments of $65 million. During the year ended December 31, 2017, cash provided by financing activities included proceeds from the Syndicated Credit Facility (as defined below) of $3,160 million, debt repayment of $779 million, payment of debt issuance costs of $63 million, settlement of securitization liability of $15 million and dividend payments of $47 million. Cash used in financing activities related to discontinued operations decreased to $2 million from $22 million, or by $20 million, in the year ended December 31, 2018 from the corresponding period in 2017. The decrease was primarily due to $19 million in overdraft during the year ended December 31, 2017. Long-term debt The following table summarizes our long-term debt: Syndicated Credit Facility As of December 31, 2019, the senior secured syndicated credit facility (the “Original Syndicated Credit Facility”, as amended prior to December 31, 2019, including as described below, the “Syndicated Credit Facility”) is composed of: (i) a senior secured first lien revolving credit facility maturing in December 2023 (the “Revolving Credit Facility”) and (ii) a senior secured first lien term B facility maturing in October 2024 (the “Term Loan B”). Borrowings under the Revolving Credit Facility bear interest at a rate equal to, at our option, either (i) U.S. dollar LIBOR, plus a margin of 120 - 425 basis points per annum, based on our total leverage ratio or (ii) adjusted base rate, plus a margin of 20-325 basis points per annum, based on the Company’s total leverage ratio. The Term Loan B bears interest at our option, either (i) U.S. dollar LIBOR plus 275 basis points per annum, or (ii) adjusted base rate, plus a margin of 175 basis points per annum. In April 2018, we entered into interest rate swaps at a notional value of $1.0 billion maturing in April 2021 or April 2022. As of December 31, 2019, we had hedged approximately 51% of our floating rate exposure on our outstanding debt at an average base rate of 2.56% (excluding the margin specified in the Syndicated Credit Facility). The Revolving Credit Facility is payable at maturity. The Term Loan B will amortize in equal quarterly installments in aggregate annual amounts equal to 1% of the original principal amount of the Term Loan B, with the final balance payable at maturity. The Revolving Credit Facility and the Term Loan B may be repaid by us, in whole or in part, together with accrued interest, without premium or penalty. The Syndicated Credit Facility is guaranteed by us and certain of our designated subsidiaries (the “Subsidiary Guarantors”). The security for the Syndicated Credit Facility, subject to customary exceptions, includes substantially all our tangible and intangible assets and our Subsidiary Guarantors. We are required to make mandatory prepayments of the outstanding principal and accrued interest of the Syndicated Credit Facility (i) upon the occurrence of certain events and (ii) to the extent of a specified percentage of annual excess cash flow that is not reinvested or used for other specified purposes. The Syndicated Credit Facility is subject to customary affirmative and negative covenants, default provisions, representations and warranties and other terms and conditions. As of December 31, 2019 and 2018, we were in compliance with our debt covenants. The Revolving Credit Facility includes an aggregate $200 million sub limit under which letters of credit can be issued. As of December 31, 2019 and December 31, 2018, we had $18 million of issued and undrawn letters of credit outstanding under the Revolving Credit Facility. Senior Secured Notes due 2023 In December 2019, we issued $1.0 billion in principal amount of 9.75% Senior Secured Notes due 2023 (“2023 Notes”) in a private placement to institutional buyers. The 2023 Notes were issued at a price of 98% and are recorded as long-term debt in our consolidated financial statements. The 2023 Notes bear interest at the rate of 9.75% per year, payable semi-annually in cash in arrears, which interest payments will commence in June 2020. The 2023 Notes are guaranteed (“Guarantees”) on a senior secured basis by each of our existing and future subsidiaries that guarantees the Syndicated Credit Facility (“Guarantors”). The 2023 Notes are secured, equally and ratably with the Syndicated Credit Facility and any future first lien debt, by liens on the same assets that secure the Revolving Credit Facility and the Term Loan B. The 2023 Notes and the Guarantees are our general senior secured obligations and rank equally in right of payment with all of our and the Guarantors’ existing and future unsubordinated debt (including the Syndicated Credit Facility). The 2023 Notes and the Guarantees are effectively senior to all of our and the Guarantors’ existing and future unsecured debt as well as to all of any permitted junior lien debt that may be incurred in the future, in each case to the extent of the value of the assets securing the 2023 Notes and the Guarantees. The 2023 Notes and the Guarantees are effectively subordinated to any obligations that are secured by liens on assets that do not constitute a part of the collateral securing the 2023 Notes or the Guarantees, are structurally subordinated to all existing and future liabilities (including trade payables) of our subsidiaries that do not guarantee the 2023 Notes, and are senior in right of payment to all of our and the Guarantors’ existing and future subordinated indebtedness. The indenture governing the 2023 Notes limits, among other things, our and our restricted subsidiaries’ ability to: incur, assume or guarantee additional debt; issue redeemable stock and preferred stock; pay dividends, make distributions or redeem or repurchase capital stock; prepay, redeem or repurchase subordinated debt; make loans and investments; grant or incur liens; restrict dividends, loans or asset transfers from restricted subsidiaries; sell or otherwise dispose of assets; enter into transactions with affiliates; reduce our satellite insurance; and consolidate or merge with, or sell substantially all of our assets to, another person. The 2023 Notes are also subject to compliance with a financial maintenance covenant in respect of our Consolidated Total Debt Ratio which is 7.25x at the end of the fiscal quarter ended December 31, 2019, 7.50x at the end of the fiscal quarter ending March 31, 2020, 7.75x at the end of each fiscal quarter thereafter until the fiscal quarter ending September 30, 2021, 7.50x at the end of each fiscal quarter thereafter until the quarter ending September 30, 2022, 6.50x at the end of each fiscal quarter thereafter until the fiscal quarter ending March 31, 2023, and 5.75x for each fiscal quarter thereafter (subject to a 0.25x reduction in each maximum level upon a disposition of a business line for greater than $500 million). The 2023 Notes may be redeemed, in whole or in part, at any time during the 12 months beginning on December 15, 2021 at a redemption price of 107.313%, during the 12 months beginning on December 15, 2022 at a redemption price of 103.656%, and at any time on or after December 15, 2023 at a redemption price of 100%, in each case plus accrued and unpaid interest, if any, thereon to the redemption date. We may also redeem the 2023 Notes, in whole or in part, at our option at any time prior to December 15, 2021 at a price equal to 100% of the principal amount of such 2023 Notes plus a “make-whole” premium, together with accrued but unpaid interest, if any, to, but excluding, the date of redemption. In addition, we may redeem up to 40% of the aggregate principal amount of the 2023 Notes at any time before December 15, 2021 with the net cash proceeds from certain equity offerings at a specified redemption price, plus accrued and unpaid interest, if any, to, but excluding, the date of redemption. In the event a change of control occurs (as defined in the indenture governing the 2023 Notes), each holder will have the right to require us to repurchase all or any part of such holder’s 2023 Notes at a purchase price in cash equal to 101% of the aggregate principal amount of the 2023 Notes repurchased, plus accrued and unpaid interest, if any, to the date of purchase (subject to the right of holders of record on the relevant record date to receive interest due on the relevant interest payment date). Leaseback Deferred Financing In December 2019, we completed the sale and subsequent leaseback of our owned properties in Palo Alto, California for proceeds of $291 million. We determined that the leaseback terms were off-market. In accordance with ASC 842 - Leases, we accounted for the excess of the leaseback payments over the present value of market rental payments as additional financing, separate from the lease liability. This resulted in recognition of deferred financing liability of $33 million which is repayable over the 10-year leaseback term. Securitization liability We have in place a revolving securitization facility agreement with an international financial institution. Under the terms of the Syndicated Credit Facility, we may offer to sell eligible orbital receivables from time to time with terms of seven years or less, discounted to face value using prevailing market rates. During the year ended December 31, 2019, we did not sell any eligible receivables and repurchased $24 million of specifically identified orbital receivables. The orbital receivables were repurchased as a result of our customer transferring the obligation to another entity which did not meet the credit criteria of our lenders. During the year ended December 31, 2018, the Company sold orbital receivables for net proceeds of $18 million and did not repurchase any receivables. These sold orbital receivables were purchased in tranches that span multiple years and include longer-term maturities. The orbital receivables that were securitized remain on our balance sheet as the accounting criteria for surrendering control of the orbital receivables were not met. The net proceeds received have been recognized as a securitization liability that has been subsequently measured at amortized cost using the effective interest rate method. The securitized orbital receivables and the securitization liabilities are being drawn down as payments are received from customers and passed on to the purchaser of the tranche. We continue to recognize orbital interest revenue on the orbital receivables that are subject to the securitization transactions and recognize interest expense to accrete the securitization liability. Cash requirements related to interest costs, income taxes, and pensions and other postretirement obligations Refer to Consolidated Statements of Cash Flows in Part II, Item 8, “Financial Statements and Supplementary Data” for cash payments for interest costs and income taxes, and Part II, Item 7A, “Quantitative and Qualitative Disclosure about Market Risk” for discussion of potential impacts of fluctuations in interest rates. Funding of pension plans Funding requirements under applicable laws and regulations are a major consideration in making contributions to our U.S. pension plan. Failure to satisfy the minimum funding thresholds with respect to appropriate laws and regulations could result in restrictions on our ability to amend the plans or make benefit payments. With respect to our U.S. qualified pension plan, we intend to contribute annually not less than the required minimum funding thresholds. The total estimated contributions expected to be paid to the plan for the year ended December 31, 2020 is $20 million. CONTRACTUAL OBLIGATIONS, COMMITMENTS AND CONTINGENCIES We enter into contractual obligations in the normal course of business. The following table provides a summary of our payment obligations for continuing operations in each of the next five years and thereafter specifically related to long-term debt, operating leases and other obligations. 1 Deferred financing relates to the sale leaseback. We have significant purchase obligations for goods and services, under agreements with defined terms as to quantity, price and timing of delivery. Most of these conditional purchase obligations are for purchase or construction of property, plant and equipment or intangible assets, operational commitments related to remote ground terminals, or with subcontractors on long-term construction contracts that we have with customers. As of December 31, 2019 and 2018, our banks issued letters of credit for $23 million and $52 million, respectively, in the normal course of business. We are party to various legal proceedings and claims that arise in the ordinary course of business as either a plaintiff or defendant. We analyze all legal proceedings and the allegations therein. The outcome of any of these proceedings, either individually or in the aggregate, is not expected to have a material adverse effect on our financial position, results of operations or liquidity. Refer to Part I, Item 3, “Legal Proceedings” of this Annual Report on Form 10-K for further discussion of legal proceedings. For further information on our contractual obligations, contingencies and commitments, see Note 23, “Commitments and contingencies” to the Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data”. OFF-BALANCE SHEET ARRANGEMENTS As of December 31, 2019, we had foreign exchange sales contracts of $9 million and letters of credit guaranteed by export credit agencies and the Senior Credit Facility, while indemnified by us. Such arrangements are not expected to have a material effect on our liquidity or capital resources, financial position or results of operations. We use derivative financial instruments to manage existing foreign currency exposures. We consider the management of financial risks to be an important part of our overall corporate risk management policy. Foreign exchange forward contracts are used to hedge our exposure to currency risk on sales, purchases, cash, net investments and loans denominated in a currency other than the functional currency of our domestic and foreign operations. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our Consolidated Financial Statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. For a summary of our significant accounting policies, see Note 2, “Summary of significant accounting policies” to the Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data”. We consider the following accounting policies to be critical to an understanding of our financial condition and results of operations because these policies require the most difficult, subjective or complex judgments on the part of management in their application. Actual results could differ from our estimates and assumptions, and any such differences could be material to our consolidated financial statements. Revenue recognition The recognition and measurement of revenue requires the use of judgments and estimates. Specifically, judgment is used in interpreting complex arrangements with nonstandard terms and conditions and determining when all criteria for revenue recognition have been met. Space Infrastructure Revenue in the Space Infrastructure segment is primarily generated from long-term construction contracts. Due to the long-term nature of these contracts, we generally recognize revenue over time using the cost-to-cost method to measure progress. Under the cost-to-cost method, revenue is recognized based on the proportion of total costs incurred to estimated total costs-at-completion ("EAC"). An EAC includes all direct costs and indirect costs directly attributable to a program or allocable based on our program cost pooling arrangements. Estimates regarding the Company’s cost associated with the design, manufacture and delivery of products and services are used in determining the EAC. Changes to an EAC are recorded as a cumulative adjustment to revenue. Our cost estimation process is based on the professional knowledge of our engineering, program management and financial professionals and draws on their significant experience and judgment. We prepare EAC’s for our contracts and calculate estimated revenues and costs over the life of our contracts. Since our contracts typically span a period of several years, estimation of revenue, cost, and progress toward completion requires the use of judgment. Judgements and estimates are re-assessed at least quarterly with most estimates being updated on a monthly basis. Adjustments in estimates could have a material impact on revenue recognition based on the significance of the adjustments. Factors considered in these estimates include our historical performance, the availability, productivity and cost of labor, the nature and complexity of work to be performed, availability and cost of materials, components and subcontracts, the risk and impact of delayed performance and the level of indirect cost allocations. Earth Intelligence Revenue in the Earth Intelligence segment is generated from imagery and geospatial intelligence service contracts. Revenue from imagery service contracts is recognized based on satellite capacity made available to the customer in a particular period, when imagery is delivered to the customer, or ratably over the subscription period. Many of our imagery service contracts relate to the transfer of a series of distinct goods or services over time for which management has determined are a single performance obligation. Revenue from our geospatial intelligence service contracts is recognized from the rendering of services that compensate us at a cost-plus-fixed-fee, firm fixed price, or on a time and materials basis. Some of our contracts contain multiple performance obligations, which requires us to estimate the standalone selling price of each performance obligation in order to allocate consideration transferred from the customer. We have not historically been able to use third-party evidence for determining standalone selling price due to the unique nature of our products and services and lack of visibility into competitor pricing. Standalone selling prices are determined based on management estimates that involve significant judgment. Multiple factors are considered based on the nature of the deliverables included within the contract, which include market conditions, competitive landscape, geographic or regional specific factors, internal costs, profit margin objectives and pricing practices used by us. Pension benefits The determination of projected benefit obligations and the fair value of plan assets for our pension and pension expense requires the use of estimates and actuarial assumptions. We perform an annual review of our estimates and actuarial assumptions in consultation with our actuaries and investment advisors. We believe that the accounting estimates related to our pension plans are critical accounting estimates because they are highly susceptible to change from period to period based on the performance of plan assets, actuarial valuations and market conditions. The selection of assumptions is based on historical trends and known economic and market conditions at the time of valuation, as well as independent studies of trends performed by our actuaries. However, actual results may differ substantially from the estimates that were based on the critical assumptions. The principal estimates and assumptions used in the measurement and recording of our pension benefit plans that have a significant effect on our Consolidated Financial Statements are the discount rate and expected return on plan assets. Discount rates for the U.S. Space Infrastructure pension plans are calculated by actuaries using the Standard FTSE Pension Discount Curve. A singular discount rate is then determined, such that the resulting liability from discounting using the curve matches the liability resulting from discounting the same cash flows using the aforementioned singular discount rate. The expected return on plan assets is based on our best estimate and input from plan investment advisors and actuaries. The rate is representative of a long-term expected return based on asset mix returns utilizing a 30-year annualized geometric return of net fees. For further information regarding our pension benefit plans see Note 2, “Summary of significant accounting policies” and Note 19, “Employee benefit plans” to the Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data”. Goodwill We assess goodwill for impairment at the reporting unit level, which is defined as an operating segment or one level below an operating segment. Goodwill is tested annually for impairment as of October 1, or more frequently if events or circumstances indicate the carrying value may be impaired. We identify potential impairment by comparing the fair value of each of our reporting units with its carrying amount, including goodwill. If the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. Based on the results of our quantitative assessment performed as of October 1, 2019, the estimated fair value of the MDA reporting unit was significantly in excess of its carrying value. This analysis was updated upon announcement of the MDA Transaction for the year ended December 31, 2019. The Company concluded that there were no impairment indicators related to goodwill at either of the dates the impairment analyses were performed. The estimated fair value of the Earth Intelligence reporting unit slightly exceeded its carrying value. We performed a sensitivity analysis over key valuation assumptions. Due to the level of fair value exceeding carrying value and the results of the sensitivity analysis, we may need to record an impairment charge in the future if the operating results of Earth Intelligence are significantly lower than our strategic growth plan assumptions. The Space Infrastructure reporting unit does not have any goodwill. Its estimated fair value was only used in evaluating the aggregate fair value of all reporting units to market data. When evaluating goodwill for impairment, we typically estimate the fair value of each reporting unit using an income approach. To assess the reasonableness of our results, we reconcile the sum of the estimated fair values of the reporting units, including our Corporate balance sheet, to the Company’s market capitalization and market value of invested capital as of the date of our annual impairment test. The income approach utilizes a discounted cash flow approach, which requires the use of significant judgments and estimates, including future cash flows, terminal growth rates, and discount rates. The projections for future cash flows are generated using our strategic growth plan and include assumptions about future revenue growth, operating margins, capital expenditures, income tax rates, and working capital requirements. The terminal growth rate is used to calculate the value of cash flows beyond the last projected period in our discounted cash flow analysis and reflects our best estimates for stable, perpetual growth of our reporting units. The discount rate is an estimate of the overall after-tax rate of return required by a market participant whose weighted average cost of capital includes both debt and equity, including a risk premium. The risk premium is a subjective adjustment that, by its very nature does not include market related data, but instead examines the prospects of the reporting unit relative to the broader industry to determine if there are specific factors, which may make it more “risky” relative to the industry. The discounted cash flow approach requires management to make certain assumptions based upon information available at the time the valuations are performed. Actual results could differ from these assumptions. Management believes the assumptions used are reflective of what a market participant would have used in calculating fair value considering current economic conditions. Additional risks for goodwill across all reporting units include, but are not limited to, the risks discussed in Item 1A, “Risk Factors” contained within this Annual Report on Form 10-K, and: ● a decline in our stock price and resulting market capitalization, if we determine the decline is sustained and is indicative of a reduction in the fair value below the carrying value of our reporting units; ● our failure to reach our internal forecasts could impact our ability to achieve our forecasted levels of cash flows and reduce the estimated discounted value of our reporting units; ● adverse technological events that could impact our performance; ● volatility in equity and debt markets resulting in higher discount rates; and ● significant adverse changes in the regulatory environment or markets in which we operate. It is not possible at this time to determine if an impairment charge would result from these factors. We will continue to monitor our goodwill for potential impairment indicators in future periods. Impairment of Long-Lived Assets We review the carrying amount of long-lived tangible and intangible assets to be held and used in the business for impairment at least annually or whenever events or circumstances warrant such a review. Indicators of impairment include, but are not limited to: a significant change in the extent or manner in which an asset (or asset group) is used; a significant adverse change in the operations of our satellites; a change in government spending or customer demand that could affect the value of the asset group; a significant decline in the observable market value of an asset group; or a significant adverse change in legal factors or in the business climate that could affect the value of the asset group. There were no impairments of long-lived assets during the year ended December 31, 2019. Income Taxes We are subject to income taxes in the United States, Canada, and other foreign jurisdictions. We compute the provision for income taxes using the asset and liability method, under which deferred tax assets and liabilities are determined based on the temporary differences between the financial reporting and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured at the currently enacted tax rates that are expected to apply in years in which they are expected to be paid for or realized. All deferred income taxes are classified as non-current on our Consolidated Balance Sheets. Significant judgments are required in order to determine the realizability of tax assets. In assessing the need for a valuation allowance, we evaluate all significant available positive and negative evidence, including historical operating results, estimates of future sources of taxable income, carry-forward periods available, the existence of prudent and feasible tax planning strategies and other relevant factors. The recognition of uncertain tax positions is evaluated based on whether it is considered more likely than not that position taken, or expected to be taken, on a tax return will be sustained upon examination through litigation or appeal. For those positions that meet the recognition criteria, they are measured as the largest amount that is more than 50 percent likely to be realized upon ultimate settlement. We believe that the reserves for unrecognized tax benefits are adequate to cover all open tax years based on our assessment. If the expected outcome of the matter changes, we will adjust income tax expense accordingly in the period in which the expected outcome has changed. We classify interest and penalties related to income taxes as income tax expense. We earn investment and other tax credits with respect to research and development expenses. The benefit of these tax credits is recorded as a reduction of income tax expense. On December 22, 2017, the 2017 Tax Act was enacted into law, which significantly changed U.S. tax law. The 2017 Tax Act, among other things, lowered the U.S. statutory federal tax rate from 35% to 21%, modified existing interest limitation regulations and created new provisions for the base erosion and anti-abuse tax and global intangible low-taxed income inclusion that taxes certain payments between U.S. corporations and their foreign subsidiaries. During 2019, additional proposed and final regulations were released to clarify the provisions modified or created within the 2017 Tax Act. The effects of the final regulations and any proposed regulations that are anticipated to be enacted substantially in similar form were included in our annual results. RECENT ACCOUNTING PRONOUNCEMENTS See Note 3, “New standards and interpretations not yet adopted” to the Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data” for a discussion of recent accounting pronouncements. NON-GAAP FINANCIAL MEASURES In addition to results reported in accordance with U.S. GAAP, we use certain non-GAAP financial measures as supplemental indicators of our financial and operating performance. These non-GAAP financial measures include EBITDA and Adjusted EBITDA. We define EBITDA as earnings before interest, taxes, depreciation and amortization, and Adjusted EBITDA as EBITDA adjusted for certain items affecting comparability as specified in the calculation. Certain items affecting comparability include restructuring, impairments, satellite insurance recovery, gain on sale of assets, CEO severance and transaction and integration related expense. Transaction and integration related expense includes costs associated with de-leveraging activities, acquisitions and dispositions and the integration of acquisitions. Management believes that exclusion of these items assists in providing a more complete understanding of our underlying results and trends, and management uses these measures along with the corresponding U.S. GAAP financial measures to manage our business, evaluate our performance compared to prior periods and the marketplace, and to establish operational goals. Adjusted EBITDA is a measure being used as a key element of our incentive compensation plan. The Syndicated Credit Facility also uses Adjusted EBITDA in the determination of our debt leverage covenant ratio. The definition of Adjusted EBITDA in the Syndicated Credit Facility includes a more comprehensive set of adjustments. We believe that these non-GAAP measures, when read in conjunction with our U.S. GAAP results, provide useful information to investors by facilitating the comparability of our ongoing operating results over the periods presented, the ability to identify trends in our underlying business, and the comparison of our operating results against analyst financial models and operating results of other public companies. The table below reconciles our net (loss) income to EBITDA and Adjusted EBITDA for the years ended December 31, 2019, 2018 and 2017:

<s>[INST] We are a leading provider of solutions in Earth Intelligence and Space Infrastructure. We help government and commercial customers to monitor, understand and navigate the changing planet; deliver global broadband communications; and explore and advance the use of space. Our approach combines decades of deep mission understanding and a proven commercial and defense foundation to deliver our services with speed, scale and cost effectiveness. Our businesses are organized and managed in three reportable segments: Earth Intelligence, Space Infrastructure and MDA, as described below under “Segment Results.” RECENT DEVELOPMENTS Definitive Agreement to Sell MDA On December 29, 2019, we entered into a Stock Purchase Agreement (“MDA Agreement”), with Neptune Acquisition Inc., a corporation existing under the laws of the Province of British Columbia and an affiliate of Northern Private Capital Ltd. (“MDA Purchaser”) that provides for, among other things, the MDA Purchaser to purchase MDA, our Canadian subsidiary, from us for an aggregate purchase price of approximately C$1.0 billion (“MDA Transaction”). The MDA Transaction is subject to customary purchase price adjustments for working capital, cash and debt, and as otherwise described below. Pursuant to the MDA Agreement, the MDA Purchaser will acquire all of the outstanding shares in the entities that operate our MDA business. The closing of the MDA Transaction is conditioned on customary closing conditions and on specified regulatory approvals, including review by the Committee on Foreign Investment in the United States, HartScottRodino review by the U.S. Department of Justice and the U.S. Federal Trade Commission, and Canadian government reviews under the Radiocommunication Act and the Competition Act. The closing of the MDA Transaction is not subject to a financing condition and is expected to close in the Spring or early Summer of 2020. The MDA Agreement contains specified termination rights for us and the MDA Purchaser, including, among others, if the consummation of the MDA Transaction has not occurred by June 29, 2020, subject to extension to September 29, 2020 for the purpose of obtaining regulatory approvals in the U.S. and Canada and appealing any injunctions preventing the consummation of the MDA Transaction. The MDA Agreement contains a negative purchase price adjustment of up to C$65 million for a complete loss or failure of RADARSAT2, such that it cannot be used for its intended commercial purposes. The MDA Agreement provides that the MDA Purchaser will be required to pay us a reverse termination fee of C$55 million under specified circumstances, including, among others, where the MDA Agreement is terminated because (i) the MDA Purchaser has materially breached its representations and warranties or the MDA Purchaser fails to perform its covenants in all material respects, subject to a cure period, or (ii) all of the conditions to closing of the MDA Transaction (other than those conditions that by their terms are to be satisfied at closing) have been satisfied or waived, we have confirmed in writing to the MDA Purchaser that we stand ready, willing and able to consummate the MDA Transaction and the MDA Purchaser fails to consummate the closing (including for a failure of the MDA Purchaser’s debt financing) within two business days of receipt of the notice from us. Senior Secured 2023 Notes In December 2019, we issued $1.0 billion in principal amount of 9.75% Senior Secured Notes due 2023 (“2023 Notes”) in a private placement to institutional buyers. The 2023 Notes were issued at a price of 98%. The 2023 Notes bear interest at the rate of 9.75% per year, payable semiannually in cash in arrears, which interest payments will commence in June 2020. The 2023 Notes are guaranteed on a senior secured basis by each of our existing and future subsidiaries that guarantee the Syndicated Credit Facility. The proceeds from the 2023 Notes and the sale of our owned properties in Palo Alto, California were used to repay [/INST] Negative. </s>

Berry Petroleum Corp

2019-03-08

2018-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and related notes included elsewhere in this report. The following discussion contains forward-looking statements that reflect our future plans, estimates, beliefs and expected performance. The forward-looking statements are dependent upon events, risks and uncertainties that may be outside our control. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences are described in “Item 1A. Risk Factors” included earlier in this report. Please see “-Cautionary Note Regarding Forward-Looking Statements.” Executive Overview We are a western United States independent upstream energy company with a focus on the conventional, long-lived oil reserves in the San Joaquin basin of California. Our long-lived, high-margin asset base is uniquely positioned to support our objectives of generating top-tier corporate-level returns and positive levered free cash flow through commodity price cycles. We target onshore, low-cost, low-risk, oil-rich reservoirs in the San Joaquin basin of California and, to a lesser extent, our Rockies assets including low-cost, oil-rich reservoirs in the Uinta basin of Utah and low geologic risk natural gas resource plays in the Piceance basin in Colorado. Successful execution of our strategy across our low-declining production base and extensive inventory of identified drilling locations will result in long-term, capital efficient production growth as well as the ability to continue returning capital to our stockholders. How We Plan and Evaluate Operations We use Levered Free Cash Flow to plan our capital allocation for maintenance and internal growth opportunities as well as hedging needs. We define Levered Free Cash Flow as Adjusted EBITDA less interest expense, dividends, and capital expenditures. We use the following metrics to manage and assess the performance of our operations: (a) Adjusted EBITDA; (b) operating expenses; (c) environmental, health & safety (“EH&S”) results; (d) general and administrative expenses; and (e) production. Adjusted EBITDA Adjusted EBITDA is the primary financial and operating measurement that our management uses to analyze and monitor the operating performance of our business. We define Adjusted EBITDA as earnings before interest expense; income taxes; depreciation, depletion, and amortization (“DD&A”); derivative gains or losses net of cash received or paid for scheduled derivative settlements; impairments; stock compensation expense; and other unusual, out-of-period and infrequent items, including gains and losses on sale of assets, restructuring costs and reorganization items. Operating expenses We define operating expenses as lease operating expenses, electricity generation expenses, transportation expenses, and marketing expenses, offset by the third-party revenues generated by electricity, transportation and marketing activities, as well as the effect of derivative settlements (received or paid) for gas purchases. Lease operating expenses include fuel, labor, field office, vehicle, supervision, maintenance, tools and supplies, and workover expenses. Taxes other than income taxes are excluded from operating expenses. The electricity, transportation and marketing activity related revenues are viewed and treated internally as a reduction to operating costs when tracking and analyzing the economics of development projects and the efficiency of our hydrocarbon recovery. Overall, operating expense is used by management as a measure of the efficiency with which operations are performing. Index to Financial Statements and Supplementary Data Environmental, health & safety We are committed to good corporate citizenship in our communities, operating safely and protecting the environment and our employees. We monitor our EH&S performance through various measures, holding our employees and contractors to high standards. Meeting corporate EH&S metrics is a part of our incentive programs for all employees. General and administrative expenses We monitor our cash general and administrative expenses as a measure of the efficiency of our overhead activities. Such expenses are a key component of the appropriate level of support our corporate and professional team provides to the development of our assets and our day-to-day operations. Production Oil and gas production is a key driver of our operating performance, an important factor to the success of our business, and used in forecasting future development economics. We measure and closely monitor production on a continuous basis, adjusting our property development efforts in accordance with the results. We track production by commodity type and compare it to prior periods and expected results. Emergence from Chapter 11 Bankruptcy On February 28, 2017, Berry LLC emerged from bankruptcy as a stand-alone company and wholly-owned subsidiary of Berry Corp. with new management, a new board of directors and new ownership. Through the Chapter 11 Proceedings, the Company significantly improved its financial position from that of Berry LLC while it was owned by the Linn Entities. A final decree closing the Chapter 11 Proceedings were entered September 28, 2018, with the Court retaining jurisdiction as described in the confirmation order and without prejudice to the request of any party-in-interest to reopen the case including with respect to certain, immaterial remaining matters. After the Effective Date we have negotiated with claimants to settle their claims. As a result, in early 2019, we issued 2,770,000 shares to settle these claims for which we had originally reserved 7,080,000 shares. Factors Affecting the Comparability of Our Financial Condition and Results of Operations Basis of Presentation and Fresh-Start Accounting Upon Berry LLC’s emergence from bankruptcy, we adopted fresh-start accounting, which, with the recapitalization upon emergence from bankruptcy, resulted in Berry Corp. becoming the financial reporting entity in our corporate group. Unless otherwise noted or suggested by context, all financial information and data and accompanying financial statements and corresponding notes, as contained in this report, on or prior to the Effective Date, reflect the actual historical results of operations and financial condition of our predecessor company for the periods before and after the Effective Date and do not give effect to the Plan or any of the transactions contemplated thereby or the adoption of fresh-start accounting. Following the Effective Date, they reflect the actual historical results of operations and financial condition of Berry Corp. on a consolidated basis and give effect to the Plan and any of the transactions contemplated thereby and the adoption of fresh-start accounting. Thus, the financial information presented herein on or prior to the Effective Date is not comparable to Berry Corp.’s performance or financial condition after the Effective Date. As a result, “black-line” financial statements are presented to distinguish between Berry LLC as the predecessor and Berry Corp. as the successor. Berry Corp.’s financial statements reflect the application of fresh-start accounting under GAAP. GAAP requires that the financial statements, for periods subsequent to the Chapter 11 Proceedings, distinguish transactions and events that are directly associated with the reorganization from the ongoing operations of the business. Accordingly, certain expenses, gains and losses that are realized or incurred in connection with the bankruptcy proceedings are recorded in “reorganization items, net” on Berry Corp.’s as well as Berry LLC’s statements of operations. In addition, Berry Corp.’s Index to Financial Statements and Supplementary Data balance sheet classifies the cash distributions from a $35 million cash distribution pool (the “Cash Distribution Pool”) as “liabilities subject to compromise.” Pre-petition unsecured and under-secured obligations that were affected by the bankruptcy reorganization process have been classified as “liabilities subject to compromise” on our balance sheet and our predecessor company’s balance sheet. Reorganization and Financing Activities The main actions we took affecting comparability between periods before and after the Effective Date include the reorganization of Berry LLC through bankruptcy and resulting substantial elimination of debt, entry into the RBL Facility, issuance of the 2026 Notes, dividends on and conversion of Series A Preferred Stock and completion of the IPO. These actions are described below in “-Liquidity and Capital Resources.” Capital Expenditures and Capital Budget Immediately following Berry LLC’s emergence from bankruptcy and separation from the Linn Entities in 2017, we increased our pace of development and have continued to do so throughout 2018. For the years ended December 31, 2018 and 2017, our capital expenditures were approximately $148 million and $73 million, respectively, on an accrual basis excluding acquisitions. Our 2019 anticipated capital expenditure budget is approximately $195 to $225 million, which represents an increase of approximately 42% over 2018 capital expenditures. Capital expenditures increased 103% from 2017 to 2018. Based on current commodity prices and a drilling success rate comparable to our historical performance, we believe we will be able to fund our 2019 capital development programs while producing positive Levered Free Cash Flow. Our 2019 capital program is focused on growing our oil production in California. We anticipate oil production will be approximately 86% of total production in 2019, compared to 82% in 2018. This change in product mix also factors in the divestiture of our non-core East Texas gas properties in late 2018. During 2019, we expect to: • employ four drilling rigs in California throughout the year; and • drill approximately 370 to 420 gross development wells, all of which we expect will be in California for oil production. The table below sets forth the expected allocation of our 2019 capital expenditure budget by area as compared to the allocation of our 2018 and 2017 capital expenditures. The amount and timing of these capital expenditures is within our control and subject to our management’s discretion. We retain the flexibility to defer a portion of these planned capital expenditures depending on a variety of factors, including but not limited to the success of our drilling activities, prevailing and anticipated prices for oil, natural gas and NGLs, the availability of necessary equipment, infrastructure and capital, the receipt and timing of required regulatory permits and approvals, seasonal conditions, drilling and acquisition costs and the level of participation by other interest owners. Any postponement or elimination of our development drilling program could result in a reduction of proved reserve volumes and materially affect our business, financial condition and results of operations. Acquisitions and Divestitures Acquisition of Hill Properties Index to Financial Statements and Supplementary Data On July 31, 2017, we acquired the remaining 84% working interest in the South Belridge Hill property located in Kern County, California, in which we previously owned a 16% working interest (the “Hill Acquisition”). We purchased the properties for approximately $249 million. Chevron North Midway-Sunset Acquisition In April 2018, we acquired two leases on an aggregate of 214 acres and a lease option on 490 acres of land owned by Chevron U.S.A. in the north Midway-Sunset field immediately adjacent to assets we currently operate. We assumed a drilling commitment of approximately $34.5 million to drill 115 wells on or before April 1, 2020, which we extended to April 1, 2022. Our drilling commitment will be tolled for a month for each consecutive 30-day period for which the posted price of WTI is less than $45 per barrel. We had not drilled any of these wells as of December 31, 2018. We would assume an additional 40 well drilling commitment if we exercise our option on the 490 acres. We paid no other consideration for the acquisition. Our 2019 anticipated capital expenditure budget currently includes approximately $16 million to drill 33 out of these 115 wells. This transaction is consistent with our business strategy to investigate areas beyond our known productive areas. Disposition of Hugoton Properties On July 31, 2017, we divested our 78% working interest in the Hugoton natural gas field located in Southwest Kansas and the Oklahoma Panhandle (the “Hugoton Disposition”) because we deemed it a non-core asset. This resulted in approximately $234 million of proceeds and a $23 million gain. Disposition of East Texas Properties On November 30, 2018, we sold our non-core gas-producing properties and related assets located in the East Texas basin for approximately $7 million, before purchase price adjustments, which resulted in a gain of approximately $4 million. Production comprised approximately 0.7 MBoe per day of natural gas in the third quarter of 2018. Commodity Derivatives We utilize derivatives, such as swaps, puts and calls, to hedge a portion of our forecasted oil production and gas purchases to reduce exposure to fluctuations in oil and natural gas prices. We target covering our operating expenses and fixed charges, including maintenance capital expenditures, for up to two years out. We have hedged a portion of our exposure to differentials between Brent and WTI as well. We also, from time to time, have entered into agreements to purchase a portion of the natural gas we require for our operations, which we do not record at fair value as derivatives because they qualify for normal purchases and normal sales exclusions. As of February 28, 2019, our hedge position consisted of oil swaps and puts and natural gas swaps. We use oil swaps and puts to protect against decreases in the oil price and natural gas swaps to protect against increases in natural gas prices. We do not enter into derivative contracts for speculative trading purposes and have not accounted for our derivatives as cash-flow or fair-value hedges. For our purchased puts, we would receive settlement payments for prices below the indicated weighted-average price per barrel of Brent. For some of our put positions, we paid the premium at the time the positions were created, and for others, we will pay the premium at the time of settlement. In order to mitigate the exposure to these deferred premiums, we have entered into several offsetting put positions. Swap contracts are designed to provide a fixed price. For fixed-price swaps, we make settlement payments for prices above the indicated weighted-average price per barrel of Brent and receive settlement payments for prices below the indicated weighted-average price per barrel of Brent. For oil basis swaps, we make settlement payments if the difference between Brent and WTI is greater than the indicated weighted-average price per barrel of our contracts and receive settlement payments if the difference between Brent and WTI is below the indicated weighted-average price per barrel. For fixed-price natural gas purchase swaps, we are the buyer so we make settlement payments for prices below the weighted-average price per MMBtu and receive settlement payments for prices above the weighted-average price per MMBtu. Index to Financial Statements and Supplementary Data In January and February 2019, we closed a portion of our deferred premium put positions by selling offsetting put positions and terminating contracts. We also added to our natural gas swap positions we had previously hedged. As of February 28, 2019, we had hedged approximately 15.3 MBbl/d of our 2019 crude oil production at $68 per barrel, as outlined in the following table along with our natural gas derivative contracts: The following table summarizes the historical results of our hedging activities. We expect our operations to generate substantial cash flows at current commodity prices. We have protected a portion of our anticipated cash flows through 2020 as part of our crude oil hedging program. Our low-decline production base, coupled with our stable operating cost environment, affords an ability to hedge a material amount of our future expected production. In May 2018, we elected to terminate outstanding commodity derivative contracts for all WTI oil swaps and certain WTI/Brent basis swaps for July 2018 through December 2019 and all WTI oil sold call options for July 2018 through June 2020. Termination costs totaled approximately $127 million and were calculated in accordance with a bilateral agreement on the cost of elective termination included in these derivative contracts; the present value of the contracts using the forward price curve as of the date termination was elected. No penalties were charged as a result of the elective termination. Concurrently, Berry Corp. entered into commodity derivative contracts consisting of Brent oil swaps for July 2018 through March 2019 and Brent oil purchased put options for January 2019 through March 2020. The Brent oil swaps hedged 1.8 MMBbls in 2018 and 0.9 MMBbls in 2019 at a weighted-average price of $75.66. The Brent oil purchased put options provided a weighted-average price floor of $65.00 for 2.8 MMBbls in 2019 and 0.5 MMBbls in 2020. We effected these transactions to move from a WTI-based position to a Brent-based position as well as bring our hedge pricing more in line with current market pricing. Index to Financial Statements and Supplementary Data Taxes, other than income taxes Taxes, other than income taxes includes severance taxes, ad valorem and property taxes, GHG allowances, and other taxes not based on income. We include these taxes when analyzing the economics of development projects and the efficiency of our hydrocarbon recovery; however, we do not include these taxes in our operating expenses. Income Taxes Prior to the Effective Date, Berry LLC was a limited liability company treated as a disregarded entity for federal and state income tax purposes, with the exception of the state of Texas. Limited liability companies are subject to Texas margin tax. As such, with the exception of the state of Texas, Berry LLC was not a taxable entity, it did not directly pay federal and state income taxes and recognition was not given to federal and state income taxes for the operations of Berry LLC. Upon emergence from bankruptcy, Berry Corp. acquired the assets of Berry LLC in a taxable asset acquisition as part of the restructuring. Consequently, we are now taxed as a corporation and have no net operating loss carryforwards for the periods prior to February 28, 2017. On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the “Act”) made significant changes to the Internal Revenue Code of 1986, including lowering the maximum federal corporate income tax rate from 35% to 21% and imposing limitations on the use of net operating losses arising in taxable years ending after December 31, 2017. The Securities and Exchange Commission (“SEC”) permitted the recognition of provisional amounts based on a reasonable estimate, subject to adjustments in a one-year measurement period. For the year ended December 31, 2017, we recorded provisional estimates for the remeasurement of our net deferred tax asset before valuation allowance of $2.7 million for the reduction in the corporate tax rate and a $1.9 million increase in the valuation allowance as a result of the Act. During 2018, we completed our accounting related to the income tax effects of the Act, resulting in no significant adjustments to the provisional amounts recorded. The key contributor to the change in our effective rate from (15)% in the ten months ended December 31, 2017 to 23% for the year ended December 31, 2018 was the reduction in our valuation allowance. Our earnings for 2018 allowed for the release of our valuation allowance, described below, resulting in an effective tax rate less than the statutory federal and state tax rates. Business Environment and Market Conditions The oil and gas industry is heavily influenced by commodity prices. While oil prices improved in 2018 compared to 2017 and 2016, they did fluctuate during the year. Brent crude oil contract prices ranged during 2018 from $62.59 per Bbl at the beginning, to a high of $86.29 per Bbl and back to $50.47 per Bbl at the end of the year. The Henry Hub spot price for natural gas also fluctuated during 2018 between $2.55 per MMBtu and $3.23 per MMBtu. Our revenue, costs, profitability and future growth are highly dependent on the prices we receive for our oil and natural gas production and the prices we pay for our natural gas purchases which will continue to be affected by a variety of factors. Please see “Item 1A. Risk Factors-Risks Related to Our Business and Industry-Oil, natural gas and NGL prices are volatile and directly affect our results.” The following table presents the average ICE Brent, NYMEX WTI oil and NYMEX Henry Hub natural gas prices for the year ended December 31, 2018, the ten months ended December 31, 2017, the two months ended February 28, 2017, and the year ended December 31, 2016: California oil prices are Brent-influenced as California refiners import more than 50% of the state’s demand from foreign sources, primarily the Middle East and South America. There is a closer correlation of prices in California to Brent pricing than to WTI. Without the higher costs associated with importing crude via rail or supertanker, we believe our in-state production and low-cost crude transportation options, coupled with Brent-influenced pricing, will allow us to continue to realize strong cash margins in California. Utah oil prices have historically traded at a discount to WTI as the local refineries are designed for oil's unique characteristics and the remoteness of the assets makes access to other markets logistically challenging. Prices and differentials for NGLs are related to the supply and demand for the products making up these liquids. Some of them more typically correlate to the price of oil while others are affected by natural gas prices as well as the Index to Financial Statements and Supplementary Data demand for certain chemical products for which they are used as feedstock. In addition, infrastructure constraints magnify pricing volatility. Natural gas prices and differentials are strongly affected by local market fundamentals, as well as availability of transportation capacity from producing areas. We use substantially more natural gas for our steamfloods and power generation, than we produce and sell. Consequently, higher gas prices have a negative impact on our operating costs. However, we mitigate a substantial portion of this exposure by selling excess electricity from our cogeneration operations to third parties. Also, the negative impact of higher gas prices is partially offset by higher gas sales for the gas we produce. Our earnings are also affected by the performance of our cogeneration facilities. These cogeneration facilities generate both electricity and steam for our properties and electricity for off-lease sales. While a portion of the electric output of our cogeneration facilities is utilized within our production facilities to reduce operating expenses, we also sell electricity produced by three of our cogeneration facilities under long-term contracts. The most significant input and cost of the cogeneration facilities is natural gas. The price we receive from selling electricity to third-parties is closely tied to the price of natural gas and thus these operations effectively serve as a partial hedge against gas price increases. Index to Financial Statements and Supplementary Data Certain Operating and Financial Information The following tables set forth information regarding total production, average daily production, average prices and average costs for the year ended December 31, 2018 compared to the year ended December 31, 2017, including the successor and predecessor periods, and the year ended December 31, 2016. The information for the year ended December 31, 2017 is reflected in the tables and narrative discussion that follows in two distinct periods, the ten months ended December 31, 2017 and the two months ended February 28, 2017, as a result of our emergence from bankruptcy on February 28, 2017. References in these results of operations to the year ended December 31, 2017 are used to provide comparable periods. While this combined presentation is a non-GAAP presentation for which there is no comparable GAAP measure, management believes that providing this financial information is the most relevant and useful method for comparing the periods before and after the Effective Date. Index to Financial Statements and Supplementary Data __________ (1) Production represents volumes sold during the period. We also consume a portion of the natural gas we produce on lease to extract oil and gas. (2) Natural gas volumes have been converted to Boe based on energy content of six Mcf of gas to one Bbl of oil. Barrels of oil equivalence does not necessarily result in price equivalence. The price of natural gas on a barrel of oil equivalent basis is currently substantially lower than the corresponding price for oil and has been similarly lower for a number of years. (3) We report electricity, transportation and marketing sales separately in our financial statements as revenues in accordance with GAAP. However, these revenues are viewed and used internally in calculating operating expenses which is used to track and analyze the economics of development projects and the efficiency of our hydrocarbon recovery. We purchase third-party gas to generate electricity through our cogeneration facilities to be used in our field operations activities and view the added benefit of any excess electricity sold externally as a cost reduction/benefit to generating steam for our thermal recovery operations. Marketing expenses mainly relate to natural gas purchased from third parties that moves through our gathering and processing systems and then is sold to third parties. Transportation sales relate to water and other liquids that we transport on our systems on behalf of third parties and have not been significant to-date. Operating expenses also includes the effect of derivative settlements (received or paid) for gas purchases. Index to Financial Statements and Supplementary Data (4) Includes non-recurring restructuring and other costs and non-cash stock compensation expense, in aggregate, of approximately $1.36 per Boe and $3.40 per Boe for the year ended December 31, 2018 and the ten months ended December 31, 2017, respectively, and none for each of the two months ended February 28, 2017 and the year ended December 31, 2016. The following table sets forth average daily production by operating area for the periods indicated: __________ (1) Production represents volumes sold during the period. (2) On July 31, 2017, we purchased the remaining approximately 84% working interest of our South Belridge Hill property, located in Kern County, California. (3) On July 31, 2017, we sold our 78% working interest in the Hugoton natural gas field located in southwest Kansas and the Oklahoma Panhandle. Our Hugoton assets represented approximately 24% of our average net daily production for the year ended December 31, 2016. (4) On November 30, 2018, we sold our non-core gas-producing properties and related assets located in the East Texas basin. We allocated predominantly all of our 2018 capital to develop California’s oil properties which experienced an 11% or 1.9 MBoe/d increase in 2018 production compared to 2017. This included a 1.5 MBoe/d year-over-year increase due to the Hill Acquisition. The 2018 development activities accelerated our California production growth throughout the year, resulting in an 11% increase from 19.5 MBoe/d in the three months ended December 31, 2017 to 21.7 MBoe/d in the three months ended December 31, 2018. The year-over-year Rockies production decline, predominantly gas, was largely due to our decision to allocate most of the 2018 capital to California development. The challenging market conditions in the Uinta basin due to limited local oil demand and takeaway capacity further contributed to this reduction. We also sold our East Texas gas properties in November 2018. Finally, our 2018 production was approximately 5.6 MBoe/d lower than 2017 due to the Hugoton Disposition in July 2017. The impact of our California oil-focused capital program, as well as the Hill Acquisition (100% oil) and Hugoton Disposition (100% natural gas) in 2017, was an increase in oil production to 82% of total production in the year ended December 31, 2018 from 64% of total production in the year ended December 31, 2017. Average daily production volumes decreased in 2017, including the successor ten months ended December 31, 2017 and the predecessor two months ended February 28, 2017, by 7.9 MBoe/d or 20% when compared to the year ended December 31, 2016, primarily due to reduced development capital spending in 2016 and early 2017 and the Hugoton Disposition in July 2017, partially offset by the additional oil volumes from the Hill Acquisition in July 2017. Index to Financial Statements and Supplementary Data Summary by Area The following table shows a summary by area of our selected historical financial information and operating data for the periods indicated. Full year data for 2017 are presented as a single amount for simplicity, but represent two distinct periods, the two months ended February 28, 2017 (our predecessor) and the ten months ended December 31, 2017 (our successor). __________ (1) Operating income includes oil, natural gas and NGL sales, offset by operating expenses, general and administrative expenses, DD&A, and taxes, other than income taxes. (2) PV-10 is a financial measure that is not calculated in accordance with GAAP. For a definition of PV-10 and a reconciliation to the standardized measure of discounted future net cash flows, please see “Items 1 and 2. Business and Properties-Our Reserves and Production Information”. . Results of Operations Results of Operations - Year ended December 31, 2018, Ten Months Ended December 31, 2017, and Two Months Ended February 28, 2017 Our results of operations for the year ended December 31, 2017 are reflected in the tables and narrative discussion that follows in two distinct periods, the two months ended February 28, 2017 and the ten months ended December 31, 2017, as a result of our emergence from bankruptcy on February 28, 2017. References in these results of operations to “the change” and “the percentage change” compare the year ended December 31, 2018 results to the combined results for the comparison period in 2017 in order to provide comparability of such information. While this combined presentation is a non-GAAP presentation for which there is no comparable GAAP measure, management believes that providing this financial information is the most relevant and useful method for comparing the periods before and after the Effective Date. Index to Financial Statements and Supplementary Data Revenues and Other Oil, natural gas and NGL sales increased in 2018 by $121 million or 28% when compared to the year ended December 31, 2017, including the successor and predecessor periods. The increase was primarily due to increased oil production in California and higher realized oil prices, partially offset by lower gas and NGL production. Oil production in the Rockies was adversely impacted as we managed storage to address the extended shutdown of a major refinery in the area which limited sales and negatively impacted production. The net effect of the Hill Acquisition and Hugoton Disposition in 2017 resulted in lower total production on an oil equivalent basis but helped to increase oil volumes and the relative mix of oil production, resulting in a $39 million increase in revenues. Our organic oil production growth from our 2018 capital program also contributed to increased revenues. Electricity sales represents sales to utilities which increased in 2018 by $10 million or 37% when compared to the year ended December 31, 2017, including the successor and predecessor periods, primarily due to higher prices, Index to Financial Statements and Supplementary Data attributed to higher natural gas costs, and higher volumes sold externally because of increased utilization at our cogeneration facilities. Losses on oil derivatives were $4.6 million, a decrease of $49 million or 91% when compared to the year ended December 31, 2017, including the successor and predecessor periods. Our losses in 2018 were due to the mark-to-market losses incurred on oil derivatives prior to being terminated in May 2018 and settled with a $127 million payment. We terminated these derivatives and entered into new hedges to better align our hedge pricing with the then-prevailing market pricing. These early-2018 losses were offset by gains on oil derivatives in the latter portion of the year, primarily due to the decline in oil prices in the fourth quarter compared to the higher hedge pricing. Marketing revenues, which primarily represent sales of natural gas purchased from third-parties, decreased in 2018 compared to the year ended December 31, 2017, including the successor and predecessor periods, due to lower sales volume. Other revenues decreased in 2018 by $5 million or 86% when compared to the year ended December 31, 2017, including the successor and predecessor periods. Other revenues in 2017 primarily consisted of helium sales, all of which were derived from our Hugoton assets prior to their disposition in July 2017. Expenses Operating expenses includes lease operating expenses, electricity generation expenses, transportation expenses, and marketing expenses, offset by the third-party revenues generated by electricity, transportation and marketing activities, as well as the effect of derivative settlements (received or paid) for gas purchases. Operating expenses for 2018 increased to $18.33 per Boe from $16.84 for the year ended December 31, 2017, including the successor and predecessor periods. The increase was primarily driven by an increase in lease operating expenses per Boe, partially offset by an increase in the gross margin for our electricity sales, as discussed below. Lease operating expenses include fuel, labor, field office, vehicle, supervision, maintenance, tools and supplies, and workover expenses. Lease operating expenses per Boe increased by 25% to $19.16 per Boe for the year ended December 31, 2018 from $15.32 per Boe in 2017, including the successor and predecessor periods. The increase was primarily due to the change in the mix of our products from 64% oil in 2017 to 82% in 2018. Our oil production is more costly than gas production, but also generates more margin per barrel. The change in product mix was driven by the Hugoton Disposition (natural gas production) and Hill Acquisition (oil production) in July 2017, as well as the oil production growth from capital expenditures during 2018. Lease operating expenses in absolute dollars increased in 2018 by $11 million or 6% when compared to the year ended December 31, 2017, including the successor and predecessor periods. The increase reflected higher fuel gas costs (mostly due to more volumes purchased), and increased facility maintenance and well servicing activity in 2018 compared to the prior year. Electricity generation expenses per Boe increased by 34% to $2.09 per Boe for the year ended December 31, 2018 from $1.56 per Boe in 2017, including the successor and predecessor periods. Electricity generation expenses in 2018 increased in absolute dollars by $3 million or 14% compared to the year ended December 31, 2017, including the successor and predecessor periods, due to higher fuel costs, mostly due to more volumes purchased for increased steam and electricity cogeneration. The increase on per Boe basis was largely due to the impact of lower volumes in 2018 noted above from the change in production mix resulting from the Hugoton and Hill transactions. In 2018 we began hedging a portion of our internal consumption of natural gas used primarily to fuel our cogeneration units. Gains on natural gas derivatives in 2018 reflected relatively high gas prices in California, compared to the strike price of our derivatives. Transportation expenses per Boe decreased by 54% to $1.00 per Boe for the year ended December 31, 2018 from $2.19 per Boe in 2017, including the successor and predecessor periods, primarily due to the Hugoton Disposition, which required significant transportation expenses. Transportation expenses in absolute dollars decreased in 2018 by $16 million or 61% when compared to the year ended December 31, 2017, including the successor and predecessor periods. Index to Financial Statements and Supplementary Data Marketing expenses, which primarily represent the cost of natural gas purchased from third parties, decreased in 2018 when compared to the year ended December 31, 2017, including the successor and predecessor periods, primarily due to lower sales volumes. General and administrative expenses decreased in 2018 by $10 million or 16% when compared to the year ended December 31, 2017, including the successor and predecessor periods, in absolute dollars. This activity was consistent with our post-emergence efforts to build out our corporate structure in 2017 while reducing restructuring costs going forward. General and administrative expenses mainly consisted of management, support staff, legal and professional services, non-cash stock-based compensation and annual cash incentives, which are largely based upon, and fluctuate with, our financial performance. On a per Boe basis, general and administrative expenses decreased from $5.51 in 2017 to $5.48 in year ended December 31, 2018. In 2018 and 2017, general and administrative expenses included non-recurring restructuring and other costs of approximately $7 million and $30 million, respectively, and non-cash stock compensation costs of approximately $7 million and $2 million, respectively. Adjusted general and administrative expenses were $4.13 per Boe for 2018 compared to $2.74 per Boe for 2017. The increase in adjusted general and administrative expenses per Boe reflected increased costs associated with supporting the company's growth and public company status, as well as the impact of lower volumes noted above from the change in production mix resulting from the Hugoton and Hill transactions. Adjusted general and administrative expenses is a non-GAAP financial measure defined as general and administrative expenses adjusted for non-recurring restructuring and other costs and non-cash stock compensation expense. Please see “-Non-GAAP Financial Measure” for a reconciliation to the GAAP financial measure of general and administrative expenses. Depreciation, depletion and amortization decreased in 2018 by $10 million or 11% when compared to the year ended December 31, 2017, including the successor and predecessor periods. This decrease was largely driven by the decreased year-over-year production, partially offset by higher depreciation and depletion rates for 2018 due to the impact of the July 2017 Hugoton Disposition (lower rates) and Hill Acquisition (higher rates). Taxes, Other Than Income Taxes Taxes, other than income taxes per BOE decreased by 1% to $3.36 per BOE for the year ended December 31, 2018 from $3.40 per BOE in 2017, including the successor and predecessor periods. These costs decreased in 2018 by $6 million or 16% compared to 2017. The $1 million or 11% lower severance taxes in 2018 compared to 2017, including successor and predecessor periods, was largely a result of lower production, the basis for severance taxes. Ad valorem taxes, which are based on the value of reserves and production equipment and vary by location, were comparable year-over-year. Greenhouse gas allowances decreased in 2018 by $5 million or 33% when compared to the year ended December 31, 2017, including the successor and predecessor periods. This was a result of additional free allowances in 2018, which reduced the average unit cost of the incurred emissions compared to 2017. Gains on Sale of Assets and Other, Net Gains on sales of assets and other, net decreased in 2018 by $20 million or 88% compared to the year ended December 31, 2017, including the successor and predecessor periods. The gains in 2018 included a $4 million gain Index to Financial Statements and Supplementary Data from the sale of our East Texas property, offset by a $1 million loss on settlement of asset retirement obligations, largely due to a change in timing of the retirements. The 2017 gains included a $23 million gain on the sale of our Hugoton assets. Other Income (Expenses) Interest expense increased in 2018 by $9 million or 34% compared to the year ended December 31, 2017, including the successor and predecessor periods, due to the interest expense on the 7% 2026 Notes issued in February 2018, partially offset by lower interest expense on the RBL Facility which had reduced borrowings in 2018 compared to 2017. Other income, net, for the year ended December 31, 2017 primarily consisted of a refund of a federal income tax overpayment from a prior year. Reorganization Items, Net Reorganization items, net, reflected a gain of approximately $25 million for the year ended December 31, 2018 compared to an expense of $509 million for the year ended December 31, 2017, including the successor and predecessor periods. The gains for 2018 were primarily due to a return of $23 million from the funds reserved for the claims of the general unsecured creditors, coupled with a third-party bankruptcy claim receipt and the resolution of pre-emergence liabilities, partially offset by remaining bankruptcy-related legal and professional fees. Reorganization items represent costs and income directly associated with the Chapter 11 Proceedings since May 11, 2016, and also include adjustments to reflect the carrying value of certain liabilities subject to compromise at their estimated allowed claim amounts, as such adjustments are determined. Index to Financial Statements and Supplementary Data The following table summarizes the components of reorganization items included on the statement of operations: Income Tax Expense (Benefit) Income tax expense increased in 2018 compared to 2017, including the successor and predecessor periods, by approximately $40 million due to the significant increase in pretax income in 2018 compared to the pre-tax loss in 2017 and the change in the effective tax rates. The key contributor to the change in our effective rate from (15)% in the ten months ended December 31, 2017 to 23% for the year ended December 31, 2018 was the reduction in the valuation allowance. Our earnings for 2018 allowed for the release of our valuation allowance, resulting in an effective tax rate less than the statutory federal and state tax rates. Series A Preferred Stock dividends and conversion to common stock The increase in Series A Preferred Stock dividends and conversion to common stock in 2018 compared to the ten months ended December 31, 2017 was due to a $60 million payment made to preferred stockholders in the Series A Preferred Stock Conversion in conjunction with our IPO, and the $27 million conversion value assigned to the additional 1.9 million shares of common stock received by the preferred stockholders. Results of Operations - Ten Months Ended December 31, 2017, Two Months Ended February 28, 2017 and Year ended December 31, 2016 Our results of operations for the year ended December 31, 2017 are reflected in the tables and narrative discussion that follows in two distinct periods, the two months ended February 28, 2017 and the ten months ended December 31, 2017, as a result of our emergence from bankruptcy on February 28, 2017. References in these results of operations to “the change” and “the percentage change” compare the year ended December 31, 2016 results to the combined results for the comparison period in 2017 in order to provide comparability of such information. While this combined presentation is a non-GAAP presentation for which there is no comparable GAAP measure, management believes that providing this financial information is the most relevant and useful method for comparing the periods before and after the Effective Date. Index to Financial Statements and Supplementary Data Revenues and Other Oil, natural gas and NGL sales increased in 2017, including the successor and predecessor periods, by $40 million or 10% when compared to the year ended December 31, 2016 due to an increase in realized oil and NGL prices and an increased mix of oil production compared to gas production as a result of the Hill Acquisition and Hugoton Disposition, partially offset by decreased natural gas and NGL production. Electricity sales increased in 2017, including the successor and predecessor periods, by $2 million or 10% when compared to the year ended December 31, 2016 primarily due to higher volumes sold externally because of lower internal utilization as well as higher prices. Index to Financial Statements and Supplementary Data Losses on oil and natural gas derivatives increased in 2017, including the successor and predecessor periods, by $38 million or 242% when compared to the year ended December 31, 2016 primarily due to increased hedging activity, a portion of which was required by the RBL Facility, and improved commodity prices relative to the fixed prices of our derivative contracts. Marketing revenues in 2017, including the successor and predecessor periods, were comparable to the year ended December 31, 2016. Other revenues decreased in 2017, including the successor and predecessor periods, by $2 million or 29% when compared to the year ended December 31, 2016 due to a decrease in helium gas sales as a result of the Hugoton Disposition. Expenses Lease operating expenses include fuel, labor, field office, vehicle, supervision, maintenance, tools and supplies, and workover expenses. Lease operating expenses in absolute dollars decreased in 2017, including the successor and predecessor periods, by $7 million or 4% when compared to the year ended December 31, 2016 primarily due to our production decline as a result of decreased development activity and a reduction of steamflooding. Lease operating expenses per Boe increased to $15.32 per Boe in 2017, including the successor and predecessor periods, from $12.73 per Boe for the year ended December 31, 2016. The increase in lease operating expenses per Boe was primarily due to the effect of the Hugoton Disposition (natural gas production) and the Hill Acquisition (oil production), both of which occurred in July 2017, reflecting higher operating expenses associated with oil production compared to natural gas production. While production volumes decreased as a result of the Hugoton Disposition and Hill Acquisition, which decrease adversely impacted costs per Boe, our oil, natural gas and NGL revenues remained constant due to a product mix more heavily weighted towards oil. Electricity generation expenses increased in 2017, including the successor and predecessor periods, by $1 million or 6% when compared to the year ended December 31, 2016, primarily due to the increase in the price of natural gas used in steam generation, for which electricity generation is a by-product. Transportation expenses decreased in 2017, including the successor and predecessor periods, by $16 million or 39% when compared to the year ended December 31, 2016, primarily due to the cancellation of uneconomic contracts in the Chapter 11 Proceedings and the Hugoton Disposition, which required significant transportation expenses. Marketing expenses in 2017, including the successor and predecessor periods, were comparable to the year ended December 31, 2016. General and administrative expenses decreased in 2017, including the successor and predecessor periods, by $15 million or 19% when compared to the year ended December 31, 2016 primarily due to the management change in conjunction with our emergence from bankruptcy. The reduction in absolute dollars offset by lower production resulted in higher general and administrative expenses per Boe for the year ended December 31, 2017 when compared to the same period in 2016. General and administrative expenses include non-recurring restructuring and other costs of approximately $30 million and non-cash stock compensation costs of approximately $2 million for the ten months ended December 31, 2017. General and administrative expenses in 2016 mainly consisted of allocations from our parent company at the time. Depreciation, depletion and amortization decreased in 2017, including the successor and predecessor periods, by $82 million or 46% when compared to the year ended December 31, 2016, primarily due to the fair market revaluation of our assets in fresh-start accounting resulting in a lower depreciable asset base and lower depreciation and depletion rates. Lower production in 2017 also contributed to the reduction in absolute dollars of depreciation, depletion and amortization for the year ended December 31, 2017, including successor and predecessor periods, when compared to 2016. Index to Financial Statements and Supplementary Data Impairment of Long-Lived Assets We recorded the following non-cash impairment charges associated with proved oil and natural gas properties: __________ (1) On November 30, 2018, we sold our non-core gas-producing properties and related assets located in the East Texas basin. The impairment charge of $1.0 billion for the year ended December 31, 2016 was primarily due to a decline in commodity prices and changes in expected capital development resulting in a decline of our proved reserves. Taxes, Other Than Income Taxes Taxes, other than income taxes, increased in 2017, including the successor and predecessor periods, by $14 million or 57% compared to the year ended December 31, 2016. Severance taxes, which are a function of production in certain jurisdictions, increased in 2017, including successor and predecessor periods, by $2.5 million or 32% primarily because of increased production in those areas. Ad valorem taxes, which are based on the value of reserves and production equipment, and vary by location, increased in 2017, including the successor and predecessor periods, by $3 million or 25% compared to the year ended December 31, 2016, as a result of higher estimated valuations by various tax authorities based on increased commodity prices. Greenhouse gas allowances increased in 2017, including the successor and predecessor periods, by $9 million or 150% when compared to the year ended December 31, 2016, primarily due to increased development activity in the second half of 2017 and an increase in the price of allowances. Gains on Sale of Assets and Other, Net Gains on sales of assets and other, net increased in 2017, including the successor and predecessor periods, by $23 million, compared to the year ended December 31, 2016, primarily due to the Hugoton Disposition. Index to Financial Statements and Supplementary Data Other Income (Expenses) Interest expense decreased in 2017, including the successor and predecessor periods, by $35 million or 56% compared to the year ended December 31, 2016, due to reduced debt resulting from the bankruptcy. Other income, net, for the year ended December 31, 2017, primarily consists of a refund of a federal income tax overpayment from a prior year. Reorganization Items, Net Reorganization items, net, contributed a larger loss in 2017, including the successor and predecessor periods by $437 million or 600% compared to the year ended December 31, 2016, primarily due to the impact from the application of fresh-start accounting in conjunction with our emergence from bankruptcy during the two months ended February 28, 2017, partially offset by the gains on settlement of liabilities subject to compromise. Reorganization items represent costs and income directly associated with the Chapter 11 Proceedings since May 11, 2016, and also include adjustments to reflect the carrying value of certain liabilities subject to compromise at their estimated allowed claim amounts, as such adjustments are determined. The following table summarizes the components of reorganization items included on the statement of operations: Income Tax Expense (Benefit) On the Effective Date, upon consummation of the Plan, we became subject to federal and state income taxes as a C corporation. Prior to the consummation of the Plan, we were treated as a disregarded entity for federal and state income tax purposes as a limited liability company, with the exception of the State of Texas. Limited liability companies are subject to Texas margin tax. As such, with the exception of the State of Texas, we did not directly pay federal and Index to Financial Statements and Supplementary Data state income taxes and recognition was not given to federal and state income taxes for our operations prior to the Effective Date. Income tax expense increased in 2017, including the successor and predecessor periods, by $3 million when compared to the year ended December 31, 2016 as a result of federal and state alternative minimum tax current taxes and a valuation allowance in excess of net deferred tax assets of $1.9 million due to the impact of applying the Tax Act legislation at the end of 2017. Liquidity and Capital Resources Currently, we expect our primary sources of liquidity and capital resources will be Levered Free Cash Flow, and as needed, borrowings under the RBL Facility. Depending upon market conditions and other factors, we have issued and may issue additional equity and debt securities; however, we expect our operations to continue to generate positive Levered Free Cash Flow at current commodity prices allowing us to fund maintenance operations, organic growth and, opportunistic repurchases of our common stock or debt. We believe our liquidity and capital resources will be sufficient to conduct our business and operations for the next 12 months. IPO and Preferred Stock Conversion In July 2018, we completed the IPO and as a result, on July 26, 2018, our common stock began trading on the NASDAQ under the ticker symbol BRY. We received approximately $110 million of net proceeds, after deducting underwriting discounts and offering expenses payable by us, for the 8,695,653 shares of common stock issued for our benefit in the IPO, net of the shares sold for the benefit of certain selling stockholders. The price to the public for the shares sold in our IPO was $14.00 per share. Of the approximately $110 million of net proceeds we received in the IPO, we used approximately $105 million to repay borrowings under our RBL Facility, which included $60 million we borrowed to make the payment due to the holders of our Series A Preferred Stock in connection with the conversion of preferred stock to common stock. We used the remainder for general corporate purposes. In connection with the IPO, on July 17, 2018, we entered into stock purchase agreements with certain funds affiliated with Oaktree Capital Management and Benefit Street Partners, pursuant to which we purchased an aggregate of 410,229 and 1,391,967 shares of our common stock, respectively, or 1,802,196 in total. In addition to the 8,695,653 shares of common stock issued and sold for our benefit in the IPO, we simultaneously received $24 million for issuing and selling 1,802,196 shares to the public and paid $24 million to purchase 1,802,196 shares under the stock purchase agreements. We purchased the shares immediately following the closing of the IPO and retired and returned them to the status of authorized but unissued shares. The selling stockholders sold an additional 2,545,630 shares at a price to the public of $14.00 per share, for which we did not receive any proceeds. In connection with the IPO, each of the 37.7 million shares of our Series A Preferred Stock outstanding was automatically converted to common stock in the Series A Preferred Stock Conversion. The cash payment was to be reduced in respect of any cash dividend paid by the Company on such share of Series A Preferred Stock for any period commencing on or after April 1, 2018. Because we paid the second quarter preferred dividend of $0.15 per share in June, the cash payment for the conversion was reduced to $1.60 per share, or approximately $60 million in aggregate. In connection with the IPO, we assigned the additional 1.9 million shares of common stock issued in the Series A Preferred Stock Conversion a value of $14.00 per share, which was equal to the value of shares sold in the IPO. The approximate $27 million value assigned to the 1.9 million shares and the $60 million cash payment for the Series A Preferred Stock Conversion reduced the income available to common stockholders by approximately $87 million. On August 21, 2018, our board of directors approved a $0.12 per share quarterly cash dividend on our common stock on a pro-rated basis from the date of our IPO through September 30, 2018, which resulted in a payment of $0.09 per share in October 2018. On November 7, 2018, our board of directors approved a $0.12 per share quarterly cash Index to Financial Statements and Supplementary Data dividend on our common stock for the fourth quarter of 2018, which was paid in January 2019. On February 28, 2019, our board of directors approved a $0.12 per share quarterly cash dividend on our common stock for the first quarter of 2019. Preferred Stock Dividends In March 2018, our board of directors approved a cumulative paid-in-kind dividend on the Series A Preferred Stock for the periods through December 31, 2017. The cumulative dividend was 0.050907 new shares per outstanding share or approximately 1,825,000 shares in total. Also in March 2018, the board approved a $0.158 per share, or approximately $5.6 million, cash dividend on the Series A Preferred Stock for the quarter ended March 31, 2018. In both cases, the payments were to stockholders of record as of March 15, 2018. In May 2018, the board of directors approved a $0.15 per share, or approximately $5.6 million, cash dividend on the Series A Preferred Stock for the quarter ended June 30, 2018. The payment was made to stockholders of record as of June 7, 2018. 2026 Notes Offering In February 2018, we issued our 7.0% 2026 Notes through our operating subsidiary, Berry LLC, which resulted in net proceeds to us of approximately $391 million after deducting expenses and the initial purchasers’ discount. We used the net proceeds from the issuance to repay the $379 million outstanding balance on the RBL Facility and used the remainder for general corporate purposes. We may, at our option, redeem all or a portion of the 2026 Notes at any time on or after February 15, 2021. We are also entitled to redeem up to 35% of the aggregate principal amount of the 2026 Notes before February 15, 2021, with an amount of cash not greater than the net proceeds that we raise in certain equity offerings at a redemption price equal to 107% of the principal amount of the 2026 Notes being redeemed, plus accrued and unpaid interest, if any. In addition, prior to February 15, 2021, we may redeem some or all of the 2026 Notes at a price equal to 100% of the principal amount thereof, plus a “make-whole” premium, plus any accrued and unpaid interest. If we experience certain kinds of changes of control, holders of the 2026 Notes may have the right to require us to repurchase their notes at 101% of the principal amount of the 2026 Notes, plus accrued and unpaid interest, if any. The 2026 Notes are our senior unsecured obligations and rank equally in right of payment with all of our other senior indebtedness and senior to any of our subordinated indebtedness. The notes are fully and unconditionally guaranteed on a senior unsecured basis by us and will also be guaranteed by certain of our future subsidiaries (other than Berry LLC). The 2026 Notes and related guarantees are effectively subordinated to all of our secured indebtedness (including all borrowings and other obligations under the RBL Facility) to the extent of the value of the collateral securing such indebtedness, and structurally subordinated in right of payment to all existing and future indebtedness and other liabilities (including trade payables) of any future subsidiaries that do not guarantee the 2026 Notes. The indenture governing the 2026 Notes contains restrictive covenants and customary events of default, including, among others, (a) non-payment; (b) non-compliance with covenants (in some cases, subject to grace periods); (c) payment default under, or acceleration events affecting, material indebtedness and (d) bankruptcy or insolvency events involving us or certain of our subsidiaries. The RBL Facility On July 31, 2017, we entered into the RBL Facility. The RBL Facility provides for a revolving loan with up to $1.5 billion of commitments, subject to a reserve borrowing base. The RBL Facility also provides a letter of credit subfacility for the issuance of letters of credit in an aggregate amount not to exceed $25 million. Issuances of letters of credit reduce the borrowing availability for revolving loans under the RBL Facility on a dollar for dollar basis. Borrowing base redeterminations become effective on or about each May 1 and November 1, although each of the administrative agent and Berry LLC may make one interim redetermination between scheduled redeterminations. The RBL Facility has an elected commitment feature that allows us to increase commitments to the amount of our borrowing base with lender approval. In November 2018, we completed a borrowing Index to Financial Statements and Supplementary Data base redetermination under our RBL Facility that increased our borrowing base from $400 million to $850 million and reaffirmed our elected commitment amount at $400 million. The RBL Facility matures on July 29, 2022, unless terminated earlier in accordance with the RBL Facility terms. As of December 31, 2018, we had approximately $7 million in letters of credit outstanding and borrowing availability of $393 million under the RBL Facility. The outstanding borrowings under the RBL Facility bear interest at a rate equal to either (i) a customary London interbank offered rate plus an applicable margin ranging from 2.50% to 3.50% per annum, and (ii) a customary base rate plus an applicable margin ranging from 1.50% to 2.50% per annum, in each case depending on levels of borrowing base utilization. In addition, we must pay the lenders a quarterly commitment fee of 0.50% on the average daily unused amount of the borrowing availability under the RBL Facility. We have the right to prepay any borrowings under the RBL Facility with prior notice at any time without a prepayment penalty, other than customary “breakage” costs with respect to eurodollar loans. The RBL Facility contains events of default and remedies customary for this type of credit facility. If we do not comply with the financial and other covenants in the RBL Facility, the lenders may, subject to customary cure rights, require immediate payment of all amounts outstanding under the RBL Facility and exercise all of their other rights and remedies, including foreclosure on all of the collateral. The RBL Facility requires us to maintain on a consolidated basis as of each quarter-end (i) a Leverage Ratio of no more than 4.00 to 1.00 and (ii) a Current Ratio of at least 1.00 to 1.00. The RBL Facility also contains customary restrictions. As of December 31, 2018, our Leverage Ratio and Current Ratio were 1.63:1.00 and 3.73:1.00, respectively. As of December 31, 2018, we had $393 million available for borrowing under the RBL Facility and were in compliance with the financial covenants under the RBL Facility. Berry Corp. guarantees, and each future subsidiary of Berry Corp. (other than Berry LLC), with certain exceptions, is required to guarantee, our obligations and obligations of the other guarantors under the RBL Facility and under certain hedging transactions and banking services arrangements (the “Guaranteed Obligations”). In addition, pursuant to a Guaranty Agreement dated as of July 31, 2017, Berry LLC guarantees the Guaranteed Obligations. The lenders under the RBL Facility hold a mortgage on at least 85% of the present value of our proven oil and gas reserves. The obligations of Berry LLC and the guarantors are also secured by liens on substantially all of our personal property, subject to customary exceptions. The RBL Facility, with certain exceptions, also requires that any future subsidiaries of Berry LLC are required to grant mortgages, security interests and equity pledges. Hedging We have protected a significant portion of our anticipated cash flows through our commodity hedging program, including through fixed-price derivative contracts. For information regarding risks related to our hedging program, see “Item 1A. Risk Factors-Risks Related to Our Business and Industry”. In January and February 2019, we closed a portion of our deferred premium put positions by selling offsetting put positions and terminating contracts. We also added to our natural gas swap positions we had previously hedged. As of February 28, 2019, we had hedged approximately 15.3 MBbl/d of our 2019 crude oil production at $68 per barrel. In May 2018, we elected to terminate outstanding commodity derivative contracts for all WTI oil swaps and certain WTI/Brent basis swaps for July 2018 through December 2019 and all WTI oil sold call options for July 2018 through June 2020. Termination costs totaled approximately $127 million and were calculated in accordance with a bilateral agreement on the cost of elective termination included in these derivative contracts; the present value of the contracts using the forward price curve as of the date termination was elected. No penalties were charged as a result of the elective termination. See “-Factors Affecting the Comparability of Our Financial Condition and Results of Operations-Capital Expenditures and Capital Budget” for a description of our 2018 capital expenditure budget and expected 2019 capital expenditure budget. Index to Financial Statements and Supplementary Data Statements of Cash Flows The following is a comparative cash flow summary: __________ (1) The amounts provided by operating activities in 2018 were negatively impacted by a one-time $127 million payment in May 2018 for early termination on derivatives. Operating Activities Cash provided by operating activities was approximately $103 million for the year ended December 31, 2018 compared to cash provided by operating activities of approximately $130 million for the year ended December 31, 2017, including the successor and predecessor periods. The amounts provided by operating activities in 2018 were negatively impacted by a one-time $127 million payment made in May 2018 for early termination on derivatives in order to better align our hedge pricing with the then-prevailing market pricing. Excluding the impact of these early hedge termination payments, the increase in cash provided by operating activities in 2018 compared to 2017 reflected higher oil prices and lower operating costs slightly offset by negative working capital effects, lower oil and gas volumes and scheduled derivative cash settlements. Cash provided by operating activities increased for the year ended December 31, 2017, including successor and predecessor periods, by approximately $117 million when compared to the same period in 2016, primarily due to the increases in the price of oil and natural gas, and decreases in operating expenses, interest expense and costs incurred in conjunction with our emergence from bankruptcy. Investing Activities The following provides a comparative summary of cash flow from investing activities: __________ (1) Based on actual cash payments rather than accrual. Index to Financial Statements and Supplementary Data Cash used in investing activities was approximately $119 million for the year ended December 31, 2018. The increase in cash used for investing activities for the year ended December 31, 2018 when compared to the year ended December 31, 2017 including the successor and predecessor periods, was due to the expansion of our drilling program in accordance with the 2018 capital budget. Investing activities in 2017 included the Hill Acquisition and the Hugoton Disposition. Cash used in investing activities increased in 2017, including the successor and predecessor periods, by $49 million compared to the year ended December 31, 2016, due to the Hill Acquisition, partially offset by the Hugoton Disposition and the increase in capital expenditures. Capital expenditures increased in 2017, including the successor and predecessor periods, by $34 million or 97% compared to the year ended December 31, 2016, primarily due to development of oil and gas properties as a result of increased liquidity. Our liquidity improved significantly in 2017 due to our emergence from bankruptcy, improved commodity prices, decreased costs and entry into the RBL Facility. Financing Activities Cash provided by financing activities was approximately $16 million for the year ended December 31, 2018 and was due to the net proceeds of $391 million from the issuance of our 2026 Notes and $110 million from our IPO in July, offset by $379 million in payments on our RBL Facility, a $60 million payment to preferred stockholders in connection with the Series A Preferred Conversion, $20 million payments to repurchase the rights to our common stock from certain claimholders originating from the bankruptcy process, $11 million in cash dividends declared on our Series A Preferred Stock, $7 million in dividends paid on our common stock and $3 million to acquire treasury shares under our stock repurchase program. Cash used in financing activities was approximately $43 million for the ten months ended December 31, 2017 and was primarily related to repayments of the Emergence Credit Facility (as defined below) of $400 million and payments of debt issuance costs for the RBL Facility of $22 million, partially offset by borrowings under the new RBL Facility of $379 million. Cash used in financing activities was approximately $163 million for the two months ended February 28, 2017 and was primarily related to the repayments on the Pre-Emergence Credit Facility (as defined below) of $498 million, partially offset by the receipt of proceeds from the issuance of our Series A Preferred Stock of $335 million. Cash used in financing activities was approximately $2 million for the year ended December 31, 2016 and was primarily related to repayments on the Pre-Emergence Credit Facility. Pre-Emergence Credit Facility and Emergence Credit Facility All outstanding obligations under the Second Amended and Restated Credit Agreement, dated November 15, 2010, by and among Berry LLC, as borrower, Wells Fargo Bank, N.A., as administrative agent, and certain lenders, (as amended, the “Pre-Emergence Credit Facility”) were canceled and the agreements governing these obligations were terminated on the Effective Date. Also on the Effective Date, Berry LLC entered into a new credit facility with the holders of claims under the Pre-Emergence Credit Facility, as lenders, and Wells Fargo Bank, N.A, as administrative agent, providing for a new reserves-based revolving loan with up to $550 million in borrowing commitments (the “Emergence Credit Facility”). Initial borrowings under the RBL Facility were primarily incurred to repay borrowings made under the Emergence Credit Facility. All outstanding obligations under the Emergence Credit Facility were canceled, and the agreements governing these obligations were terminated on July 31, 2017. Lawsuits, Claims, Commitments, and Contingencies In the normal course of business, we, or our subsidiary, are subject to lawsuits, environmental and other claims and other contingencies that seek, or may seek, among other things, compensation for alleged personal injury, breach of contract, property damage or other losses, punitive damages, civil penalties, or injunctive or declaratory relief. On May 11, 2016 our predecessor company filed the Chapter 11 Proceeding. Our bankruptcy case was jointly administered with that of Linn Energy and its affiliates under the caption In re Linn Energy, LLC, et al., Case No. 16-60040. On January 27, 2017, the Bankruptcy Court approved and confirmed our plan of reorganization in the Chapter 11 Proceeding. On February 28, 2017, the Effective Date occurred and the Plan became effective and was implemented. A final decree closing the Chapter 11 Proceeding was entered September 28, 2018, with the Court retaining jurisdiction Index to Financial Statements and Supplementary Data as described in the confirmation order and without prejudice to the request of any party-in-interest to reopen the case including with respect to certain, immaterial remaining matters. We accrue reserves for currently outstanding lawsuits, claims and proceedings when it is probable that a liability has been incurred and the liability can be reasonably estimated. We have not recorded any reserve balances at December 31, 2018 and December 31, 2017. We also evaluate the amount of reasonably possible losses that we could incur as a result of these matters. We believe that reasonably possible losses that we could incur in excess of reserves accrued on our balance sheet would not be material to our consolidated financial position or results of operations. We, or our subsidiary, or both, have indemnified various parties against specific liabilities those parties might incur in the future in connection with transactions that they have entered into with us. As of December 31, 2018, we are not aware of material indemnity claims pending or threatened against us. Contractual Obligations The following is a summary of our commitments and contractual obligations as of December 31, 2018: __________ (1) Represents interest on the 2026 Notes computed at 7.0% through contractual maturity in 2026. (2) Amounts include payments which will become due under long-term agreements to purchase goods and services used in the normal course of business to secure transportation of our natural gas production to market as well as pipeline and processing capacity. (3) Included are obligations of approximately $6 million, which could be higher if we elect to construct, or begin construction of, the road in which case we are obligated to cover 100% of the first $9 million of construction costs plus 50% of the all construction costs above $9 million. Alternatively, we can provide long-term access to an existing road. Index to Financial Statements and Supplementary Data Balance Sheet Analysis The changes in our balance sheet from December 31, 2017 to December 31, 2018 are discussed below. See “-Liquidity and Capital Resources” for discussions about the changes in cash and cash equivalents and long-term debt. The $3 million increase in accounts receivable was primarily driven by an increase in receivables for derivative settlements. The increase in the derivative asset reflected the early termination and replacement of certain hedge contracts during 2018 to align our hedging program with higher commodity prices and the impact of mark-to-market values on our derivatives at the end of 2018 compared to the end of 2017. Restricted cash at December 31, 2017 represented funds set aside to settle the general unsecured creditors' claims resulting from our bankruptcy process. The decrease in restricted cash, and the corresponding decrease in liabilities subject to compromise, represented the settlement of these claims, the return of undistributed funds of approximately $23 million and professional fees related to the settlement of these claims. The $56 million increase in property, plant and equipment was largely the result of increased capital expenditures in oil and gas properties, partially offset by increased accumulated depreciation associated with such properties. The $4 million decrease in other non-current assets was primarily driven by amortization of debt issuance costs. The increase in accounts payable and accrued liabilities included a $19 million increase in the accruals for the increased capital spending in 2018, an $11 million increase from the new interest payment obligations on our 2026 Notes, issued in February of 2018, a $10 million increase in dividends payable, a $3 million increase in the current portion of the asset retirement obligation, and other items, partially offset by a $10 million decrease in the current portion of our greenhouse gas liability and other items. Index to Financial Statements and Supplementary Data The decrease in the derivative liability reflected the early termination and replacement of certain hedge contracts during 2018 to align our hedging program with higher commodity prices and the impact of mark-to-market values on our derivatives at the end of 2018 compared to the end of 2017. The increase in long-term debt resulted from the issuance of our 2026 Notes in February 2018 in the principal amount of $400 million, net of deferred financing costs, which was used to pay down the $379 million balance on our RBL Facility. The decrease in the long-term portion of the asset retirement obligation reflected a reduction in the estimated obligation for 2018 of $5 million, a reduction due to property sales of $4 million, liabilities settled during the period of $4 million and an increase to the current portion of the asset retirement obligation of $3 million. These decreases were offset by accretion expenses of $6 million and new liabilities incurred of $5 million. The increase in other non-current liabilities primarily represented an additional greenhouse gas liability of $12 million for production during the 2018, which is due for payment more than one year from December 31, 2018. The increase in equity reflected the receipt of IPO net proceeds of $110 million, net income of $147 million, and stock-based incentive awards of $7 million; offset by approximately $60 million of distributions to the former preferred stockholders in connection with the Series A Preferred Stock Conversion, $20 million repurchase from certain general unsecured creditors of the right to receive shares of our common stock in settlement of their claims, $17 million in common stock dividends, and $11 million in preferred stock dividends, treasury stock purchases of $4 million and shares withheld for payment of taxes on equity awards of $4 million. Non-GAAP Financial Measures Adjusted EBITDA, Levered Free Cash Flow, Adjusted Net Income (Loss) and Adjusted General and Administrative Expenses Adjusted EBITDA and Adjusted Net Income (Loss) are not measures of net income (loss) and Levered Free Cash Flow is not a measure of cash flow, in all cases, as determined by GAAP. Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow are supplemental non-GAAP financial measures used by management and external users of our financial statements, such as industry analysts, investors, lenders and rating agencies. We define Adjusted EBITDA as earnings before interest expense; income taxes; depreciation, depletion, and amortization; derivative gains or losses net of cash received or paid for scheduled derivative settlements; impairments; stock compensation expense; and other unusual, out-of-period and infrequent items, including restructuring costs and reorganization items. We define Levered Free Cash Flow as Adjusted EBITDA less capital expenditures, interest expense and dividends. Our management believes Adjusted EBITDA provides useful information in assessing our financial condition, results of operations and cash flows and is widely used by the industry and the investment community. The measure also allows our management to more effectively evaluate our operating performance and compare the results between periods without regard to our financing methods or capital structure. Levered Free Cash Flow is used by management as a primary metric to plan capital allocation for maintenance and internal growth opportunities, as well as hedging needs. It also serves as a measure for assessing our financial performance and our ability to generate excess cash from operations to service debt and pay dividends. Adjusted Net Income (Loss) excludes the impact of unusual, out-of-period and infrequent items affecting earnings that vary widely and unpredictably, including non-cash items such as derivative gains and losses. This measure is used by management when comparing results period over period. We define Adjusted Net Income (Loss) as net income (loss) adjusted for derivative gains or losses net of cash received or paid for scheduled derivative settlements, other unusual, out-of-period and infrequent items, including restructuring costs and reorganization items and the income tax expense or benefit of these adjustments using our effective tax rate. Index to Financial Statements and Supplementary Data While Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow are non-GAAP measures, the amounts included in the calculation of Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow were computed in accordance with GAAP. These measures are provided in addition to, and not as an alternative for, income and liquidity measures calculated in accordance with GAAP. Certain items excluded from Adjusted EBITDA are significant components in understanding and assessing our financial performance, such as our cost of capital and tax structure, as well as the historic cost of depreciable and depletable assets. Our computations of Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow may not be comparable to other similarly titled measures used by other companies. Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow should be read in conjunction with the information contained in our financial statements prepared in accordance with GAAP. Adjusted General and Administrative Expenses is a supplemental non-GAAP financial measure that is used by management. We define Adjusted General and Administrative Expenses as general and administrative expenses adjusted for non-recurring restructuring and other costs and non-cash stock compensation expense. Management believes Adjusted General and Administrative Expenses is useful because it allows us to more effectively compare our performance from period to period. We exclude the items listed above from general and administrative expenses in arriving at Adjusted General and Administrative Expenses because these amounts can vary widely and unpredictably in nature, timing, amount and frequency and stock compensation expense is non-cash in nature. Adjusted General and Administrative Expenses should not be considered as an alternative to, or more meaningful than, general and administrative expenses as determined in accordance with GAAP. Our computations of Adjusted General and Administrative Expenses may not be comparable to other similarly titled measures of other companies. The following tables present reconciliations of the non-GAAP financial measures Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow to the GAAP financial measures of net income (loss) and net cash provided or used by operating activities, as applicable, for each of the periods indicated. __________ (1) Net cash received (paid) for scheduled derivative settlements does not include the $127 million in cash paid for early terminated derivatives. Index to Financial Statements and Supplementary Data __________ (1) Cash dividends declared in 2018 include $11 million of dividends for Series A Preferred Stock for the first two quarters of 2018 and $17 million of dividends for common stock. In connection with our IPO in July 2018, all of our outstanding Series A Preferred Stock was automatically converted into common stock. Common stock dividends were $0.09 per share for the third quarter of 2018, which was pro-rated from the date of our IPO through September 30, 2018, and $0.12 per share for the fourth quarter of 2018. (2) Levered Free Cash Flow includes cash paid for scheduled derivative settlements of $38 million for the year ended December 31, 2018 and cash received for scheduled derivative settlements of $3 million for the ten months ended December 31, 2017, $1 million for the two months ended February 28, 2017, and $10 million for the year ended December 31, 2016. Index to Financial Statements and Supplementary Data The following table presents a reconciliation of the non-GAAP financial measure Adjusted Net Income (Loss) to the GAAP financial measure of Net income (loss). __________ (1) For the ten months ended December 31, 2017, our effective tax rate was (15%) due to a net loss and valuation allowances. For purposes of this calculation, we used the statutory rate for this period, which was 28%. The following table presents a reconciliation of the non-GAAP financial measure Adjusted General and Administrative Expenses to the GAAP financial measure of general and administrative expenses for each of the periods indicated. Off-Balance Sheet Arrangements See “-Liquidity and Capital Resources-Lawsuits, Claims, Commitments, and Contingencies” and “-Contractual Obligations” for information regarding our off-balance sheet arrangements. Index to Financial Statements and Supplementary Data Critical Accounting Policies and Estimates The process of preparing financial statements in accordance with generally accepted accounting principles requires management to select appropriate accounting policies and to make informed estimates and judgments regarding certain items and transactions. Changes in facts and circumstances or discovery of new information may result in revised estimates and judgments, and actual results may differ from these estimates upon settlement. We consider the following to be our most critical accounting policies and estimates that involve management’s judgment and that could result in a material impact on the financial statements due to the levels of subjectivity and judgment. Fresh-Start Accounting Upon our emergence from Chapter 11 bankruptcy, we adopted fresh-start accounting which resulted in our becoming a new entity for financial reporting purposes. We were required to adopt fresh-start accounting upon our emergence from Chapter 11 bankruptcy because (i) the holders of existing voting ownership interests of Berry LLC received less than 50% of the voting shares of Berry Corp. and (ii) the reorganization value of our assets immediately prior to confirmation of the Plan was less than the total of all post-petition liabilities and allowed claims, as shown below: Upon adoption of fresh-start accounting, the reorganization value derived from the enterprise value was allocated to our assets and liabilities based on their fair values in accordance with GAAP. The Effective Date fair values of our assets and liabilities differed materially from their recorded values as reflected on the historical balance sheet. The effects of the Plan and the application of fresh-start accounting were reflected in the financial statements as of February 28, 2017, and the related adjustments thereto were recorded on the statement of operations for the two months ended February 28, 2017. As a result of the adoption of fresh-start accounting and the effects of the implementation of the Plan, our consolidated financial statements subsequent to February 28, 2017 are not comparable to our financial statements prior to February 28, 2017. Our consolidated financial statements and related footnotes are presented with a black line division, which delineates the lack of comparability between amounts presented after February 28, 2017, and amounts presented on or prior to February 28, 2017. Our financial results for future periods following the application of fresh-start accounting will be different from historical trends and the differences may be material. Index to Financial Statements and Supplementary Data Reorganization Value Under GAAP, Berry Corp. determined a value to be assigned to the equity of the emerging entity as of the date of adoption of fresh-start accounting. The Plan and disclosure statement approved by the Bankruptcy Court did not include an enterprise value or reorganization value, nor did the Bankruptcy Court approve a value as part of its confirmation of the Plan. Our reorganization value was derived from an estimate of enterprise value, or the fair value of our long-term debt, stockholders’ equity and working capital. Reorganization value approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring. Based on the various estimates and assumptions necessary for fresh-start accounting, we estimated our enterprise value as of the Effective Date to be approximately $1.3 billion. The enterprise value was estimated using a sum of parts approach. The sum of parts approach represents the summation of the indicated fair value of the component assets of the Company. The fair value of our assets was estimated by relying on a combination of the income, market and cost approaches. The estimated enterprise value, reorganization value and equity value are highly dependent on the achievement of the financial results contemplated in our underlying projections. While we believe the assumptions and estimates used to develop enterprise value and reorganization value are reasonable and appropriate, different assumptions and estimates could materially impact the analysis and resulting conclusions. Additionally, the assumptions used in estimating these values are inherently uncertain and require judgment. The primary assumptions for which there is a reasonable possibility of the occurrence of a variation that would have significantly affected the reorganization value include those regarding pricing, discount rates and the amount and timing of capital expenditures. Our principal assets are our oil and natural gas properties. The fair values of oil and natural gas properties were estimated using a valuation technique consistent with the income approach, specifically the discounted cash flows method. We also used the market approach to corroborate the valuation results from the income approach. We used a market-based weighted-average cost of capital discount rate of 10% for proved and unproved reserves, with further risk adjustment factors applied to the discounted values. The underlying commodity prices embedded in our estimated cash flows are based on the ICE (Brent) and NYMEX (Henry Hub) forward curve pricing, adjusted for estimated location and quality differentials, as well as other factors that we believe will impact realizable prices. Forward curve pricing was used for years 2017 through 2019 and then was escalated at approximately 2.0%. The following table reconciles the enterprise value to the estimated reorganization value as of the Effective Date: The fair value of non-debt liabilities consists of liabilities assumed by Berry Corp. on the Effective Date and excludes the fair value of long-term debt. Consolidated Balance Sheet The adjustments included in the fresh-start consolidated balance sheet in the accompanying financial statements reflect the effects of the transactions contemplated by the Plan and executed on the Effective Date as well as fair value and other required accounting adjustments resulting from the adoption of fresh-start accounting. The explanatory notes provide additional information with regard to the adjustments recorded, methods used to determine the fair values and significant assumptions. Index to Financial Statements and Supplementary Data Oil and Natural Gas Properties Proved Properties We account for oil and natural gas properties in accordance with the successful efforts method. Under this method, all acquisition and development costs of proved properties are capitalized and amortized on a unit-of-production basis over the remaining life of the proved reserves and proved developed reserves, respectively. Costs of retired, sold or abandoned properties that constitute a part of an amortization base are charged or credited, net of proceeds, to accumulated depreciation, depletion and amortization unless doing so significantly affects the unit-of-production amortization rate, in which case a gain or loss is recognized in the current period. Gains or losses from the disposal of other properties are recognized in the current period. For assets acquired, we base the capitalized cost on fair value at the acquisition date. We expense expenditures for maintenance and repairs necessary to maintain properties in operating condition, as well as annual lease rentals, as they are incurred. Estimated dismantlement and abandonment costs are capitalized, net of salvage, at their estimated net present value and amortized over the remaining lives of the related assets. Interest is capitalized only during the periods in which these assets are brought to their intended use. The amount of capitalized interest and exploratory well costs in 2018, 2017 and 2016 was not significant. We only capitalize the interest on borrowed funds related to our share of costs associated with qualifying capital expenditures. We evaluate the impairment of our proved oil and natural gas properties generally on a field by field basis or at the lowest level for which cash flows are identifiable, whenever events or changes in circumstance indicate that the carrying value may not be recoverable. We reduce the carrying values of proved properties to fair value when the expected undiscounted future cash flows are less than net book value. We measure the fair values of proved properties using valuation techniques consistent with the income approach, converting future cash flows to a single discounted amount. Significant inputs used to determine the fair values of proved properties include estimates of: (i) reserves; (ii) future operating and development costs; (iii) future commodity prices; and (iv) a risk-adjusted discount rate. These inputs require significant judgments and estimates by our management at the time of the valuation and are the most sensitive estimates that we make and the most likely to change. The underlying commodity prices are embedded in our estimated cash flows and are the product of a process that begins with the relevant forward curve pricing, adjusted for estimated location and quality differentials, as well as other factors our management believes will impact realizable prices. Impairment of Proved Properties Based on the analysis described above, for the year ended December 31, 2016, we recorded non-cash impairment charges of approximately $1.0 billion associated with proved oil and natural gas properties. The 2016 impairment charges were due to a decline in commodity prices, changes in expected capital development and a decline in our estimates of proved reserves. The carrying values of the impaired proved properties were reduced to fair value, estimated using inputs characteristic of a Level 3 fair value measurement (see Note 1 for definition). The impairment charges were included in “impairment of long-lived assets” on our statements of operations. Unproved Properties A portion of the carrying value of our oil and gas properties was attributable to unproved properties. At December 31, 2018 and 2017, the net capitalized costs attributable to unproved properties were approximately $388 million and $517 million, respectively. The unproved amounts were not subject to depreciation, depletion and amortization until they were classified as proved properties and amortized on a unit-of-production basis. We evaluate the impairment of our unproved oil and gas properties whenever events or changes in circumstances indicate the carrying value may not be recoverable. If the exploration and development work were to be unsuccessful, or management decided not to pursue development of these properties as a result of lower commodity prices, higher development and operating costs, contractual conditions or other factors, the capitalized costs of such properties would be expensed. The timing of any write-downs of unproved properties, if warranted, depends upon management’s plans, the nature, timing and extent of future exploration and development activities and their results. We believe our current plans and exploration and development efforts will allow us to realize the carrying value of our unproved property balance at December 31, 2018. Index to Financial Statements and Supplementary Data Based on the analysis described above, for the year ended December 31, 2016, we recorded non-cash impairment charges of approximately $13 million associated with unproved oil and natural gas properties. The impairment charges in 2016 were primarily due to a decline in commodity prices and changes in expected capital development. The carrying values of the impaired unproved properties were reduced to fair value, estimated using inputs characteristic of a Level 3 fair value measurement. The impairment charges are included in “impairment of long-lived assets” on our statements of operations. Asset Retirement Obligation We recognize the fair value of asset retirement obligations (“AROs”) in the period in which a determination is made that a legal obligation exists to dismantle an asset and remediate the property at the end of its useful life and the cost of the obligation can be reasonably estimated. The liability amounts are based on future retirement cost estimates and incorporate many assumptions such as time to abandonment, technological changes, future inflation rates and the risk-adjusted discount rate. When the liability is initially recorded, we capitalize the cost by increasing the related property, plant and equipment (“PP&E”) balances. If the estimated future cost of the AROs changes, we record an adjustment to both the ARO and PP&E. Over time, the liability is increased, and expense is recognized through accretion, and the capitalized cost is depreciated over the useful life of the asset. In certain cases, we do not know or cannot estimate when we may settle these obligations and therefore we cannot reasonably estimate the fair value of the liabilities. We will recognize these AROs in the periods in which sufficient information becomes available to reasonably estimate their fair values. Fair Value Measurements We have categorized our assets and liabilities that are measured at fair value in a three-level fair value hierarchy, based on the inputs to the valuation techniques: Level 1-using quoted prices in active markets for the assets or liabilities; Level 2-using observable inputs other than quoted prices for the assets or liabilities; and Level 3-using unobservable inputs. Transfers between levels, if any, are recognized at the end of each reporting period. We primarily apply the market approach for recurring fair value measurement, maximize our use of observable inputs and minimize use of unobservable inputs. We generally use an income approach to measure fair value when observable inputs are unavailable. This approach utilizes management’s judgments regarding expectations of projected cash flows and discounts those cash flows using a risk-adjusted discount rate. The most significant items on our balance sheet that would be affected by recurring fair value measurements are derivatives. We determine the fair value of our oil and natural gas derivatives using valuation techniques which utilize market quotes and pricing analysis. Inputs include publicly available prices and forward price curves generated from a compilation of data gathered from third parties. We validate data provided by third parties by understanding the valuation inputs used, obtaining market values from other pricing sources, analyzing pricing data in certain situations and confirming that those instruments trade in active markets. We classify these measurements as Level 2. Stock-based Compensation Subsequent to February 28, 2017, we issued restricted stock units (“RSUs”) that vest over time and performance-based restricted stock units (“PSUs”) that vest based on our achievement of certain average prices per share, to certain employees and non-employee directors. The fair value of the stock-based awards is determined at the date of grant and is not remeasured. Prior to our IPO in July 2018, we determined the fair value of the RSUs based on an estimate of the fair value of our equity using an income approach. We used a discounted cash flow method to value the estimated future cash flows at an appropriate discount rate. Subsequent to our IPO, since the underlying shares are now trading in the public markets, these estimates are no longer necessary. For PSUs, compensation value is measured on the grant date using payout values derived from a Monte-Carlo valuation model. Estimates used in the Monte Carlo valuation model are considered highly complex and subjective. Compensation expense, net of actual forfeitures, for the RSUs and PSUs Index to Financial Statements and Supplementary Data is recognized on a straight-line basis over the requisite service periods, which is over the awards’ respective vesting or performance periods which range from one to three years. Other Loss Contingencies In the normal course of business, we are involved in lawsuits, claims and other environmental and legal proceedings and audits. We accrue reserves for these matters when it is probable that a liability has been incurred and the liability can be reasonably estimated. In addition, we disclose, if material, in aggregate, our exposure to loss in excess of the amount recorded on the balance sheet for these matters if it is reasonably possible that an additional material loss may be incurred. We review our loss contingencies on an ongoing basis. Loss contingencies are based on judgments made by management with respect to the likely outcome of these matters and are adjusted as appropriate. Management’s judgments could change based on new information, changes in, or interpretations of, laws or regulations, changes in management’s plans or intentions, opinions regarding the outcome of legal proceedings, or other factors. Significant Accounting and Disclosure Changes See Note 1 in the Notes to Consolidated Financial Statements in Part II-Item 8. Financial Statements and Supplementary Data of this report for a discussion of new accounting matters. Inflation Inflation in the United States has been relatively low in recent years and did not have a material impact on our results of operations for the periods discussed. Although the impact of inflation has been insignificant in recent years, it is still a factor in the United States economy and we may experience inflationary pressure on the cost of oilfield services and equipment as increasing oil, natural gas and NGL prices increase drilling activity in our areas of operations. An increase in oil, natural gas and NGL prices may cause the costs of materials and services to rise. CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS The information in this document includes forward-looking statements that involve risks and uncertainties that could materially affect our expected results of operations, liquidity, cash flows and business prospects. Such statements specifically include our expectations as to our future financial position, liquidity, cash flows, results of operations and business strategy, potential acquisition opportunities, other plans and objectives for operations, maintenance capital requirements, expected production and costs, reserves, hedging activities, capital expenditures, return of capital, improvement of recovery factors and other guidance. Actual results may differ from anticipated results, sometimes materially, and reported results should not be considered an indication of future performance. You can typically identify forward-looking statements by words such as aim, anticipate, achievable, believe, budget, continue, could, effort, estimate, expect, forecast, goal, guidance, intend, likely, may, might, objective, outlook, plan, potential, predict, project, seek, should, target, will or would and other similar words that reflect the prospective nature of events or outcomes. For any such forward-looking statement that includes a statement of the assumptions or bases underlying such forward-looking statement, we caution that, while we believe such assumptions or bases to be reasonable and make them in good faith, assumed facts or bases almost always vary from actual results, sometimes materially. Material risks that may affect us are discussed above in “Item 1A. Risk Factors”. Factors (but not necessarily all the factors) that could cause results to differ include among others: • volatility of oil, natural gas and NGL prices; • inability to generate sufficient cash flow from operations or to obtain adequate financing to fund capital expenditures and meet working capital requirements; • price and availability of natural gas; Index to Financial Statements and Supplementary Data • our ability to use derivative instruments to manage commodity price risk; • impact of environmental, health and safety, and other governmental regulations, and of current, pending, or future legislation; • uncertainties associated with estimating proved reserves and related future cash flows; • our inability to replace our reserves through exploration and development activities; • our ability to obtain permits and otherwise to meet our proposed drilling schedule and to successfully drill wells that produce oil and natural gas in commercially viable quantities; • changes in tax laws; • effects of competition; • our ability to make acquisitions and successfully integrate any acquired businesses; • market fluctuations in electricity prices and the cost of steam; • asset impairments from commodity price declines; • large or multiple customer defaults on contractual obligations, including defaults resulting from actual or potential insolvencies; • geographical concentration of our operations; • our ability to improve our financial results and profitability following our emergence from bankruptcy and other risks and uncertainties related to our emergence from bankruptcy; • impact of derivatives legislation affecting our ability to hedge; • ineffectiveness of internal controls; • concerns about climate change and other air quality issues; • catastrophic events; • litigation; • our ability to retain key members of our senior management and key technical employees; and • information technology failures or cyber attacks. Except as required by law, we undertake no responsibility to publicly release the result of any revision of our forward-looking statements after the date they are made. All forward-looking statements, expressed or implied, included in this report are expressly qualified in their entirety by this cautionary statement. This cautionary statement should also be considered in connection with any subsequent written or oral forward-looking statements that we or persons acting on our behalf may issue. Index to Financial Statements and Supplementary Data

<s>[INST] Executive Overview We are a western United States independent upstream energy company with a focus on the conventional, longlived oil reserves in the San Joaquin basin of California. Our longlived, highmargin asset base is uniquely positioned to support our objectives of generating toptier corporatelevel returns and positive levered free cash flow through commodity price cycles. We target onshore, lowcost, lowrisk, oilrich reservoirs in the San Joaquin basin of California and, to a lesser extent, our Rockies assets including lowcost, oilrich reservoirs in the Uinta basin of Utah and low geologic risk natural gas resource plays in the Piceance basin in Colorado. Successful execution of our strategy across our lowdeclining production base and extensive inventory of identified drilling locations will result in longterm, capital efficient production growth as well as the ability to continue returning capital to our stockholders. How We Plan and Evaluate Operations We use Levered Free Cash Flow to plan our capital allocation for maintenance and internal growth opportunities as well as hedging needs. We define Levered Free Cash Flow as Adjusted EBITDA less interest expense, dividends, and capital expenditures. We use the following metrics to manage and assess the performance of our operations: (a) Adjusted EBITDA; (b) operating expenses; (c) environmental, health & safety (“EH&S”) results; (d) general and administrative expenses; and (e) production. Adjusted EBITDA Adjusted EBITDA is the primary financial and operating measurement that our management uses to analyze and monitor the operating performance of our business. We define Adjusted EBITDA as earnings before interest expense; income taxes; depreciation, depletion, and amortization (“DD&A”); derivative gains or losses net of cash received or paid for scheduled derivative settlements; impairments; stock compensation expense; and other unusual, outofperiod and infrequent items, including gains and losses on sale of assets, restructuring costs and reorganization items. Operating expenses We define operating expenses as lease operating expenses, electricity generation expenses, transportation expenses, and marketing expenses, offset by the thirdparty revenues generated by electricity, transportation and marketing activities, as well as the effect of derivative settlements (received or paid) for gas purchases. Lease operating expenses include fuel, labor, field office, vehicle, supervision, maintenance, tools and supplies, and workover expenses. Taxes other than income taxes are excluded from operating expenses. The electricity, transportation and marketing activity related revenues are viewed and treated internally as a reduction to operating costs when tracking and analyzing the economics of development projects and the efficiency of our hydrocarbon recovery. Overall, operating expense is used by management as a measure of the efficiency with which operations are performing. Index to Financial Statements and Supplementary Data Environmental, health & safety We are committed to good corporate citizenship in our communities, operating safely and protecting the environment and our employees. We monitor our EH&S performance through various measures, holding our employees and contractors to high standards. Meeting corporate EH&S metrics is a part of our incentive programs for all employees. General and administrative expenses We monitor our cash general and administrative expenses as a measure of the efficiency of our overhead activities. Such expenses are a key component of the appropriate level of support our corporate and professional team provides to the development of our assets and our daytoday operations. Production Oil and gas production is a key driver of our operating performance, an important factor to the success of our business, and used in forecasting future development economics. We measure and closely monitor production on a continuous basis, adjusting our property development efforts in accordance with the results. We track production by commodity type and compare it to prior periods and expected results. Emergence from Chapter 11 Bankruptcy On February 28, 2017, Berry LLC emerged from bankruptcy as a standalone company and whollyowned subsidiary of Berry Corp. with new management, a new board of directors and new ownership. Through the Chapter 11 Proceedings, the Company significantly improved its financial position from that of Berry LLC while it was owned by the Linn Entities. A final decree closing the Chapter 1 [/INST] Negative. </s>

Berry Corp (bry)

2020-02-27

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and related notes included elsewhere in this report. The following discussion contains forward-looking statements that reflect our future plans, estimates, beliefs and expected performance. The forward-looking statements are dependent upon events, risks and uncertainties that may be outside our control. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences are described in “Item 1A. Risk Factors” included earlier in this report. Please see “-Cautionary Note Regarding Forward-Looking Statements.” This section of the Form 10-K generally discusses 2019 and 2018 items and year-to-year comparisons between those years. For discussion of our ten months ended December 31, 2017 and two months ended February 28, 2017, as well as the year ended 2018 compared to ten months ended December 31, 2017 and two months ended February 28, 2017, refer to Part II, Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our 2018 Annual Report on Form 10-K. Executive Overview We are a western United States independent upstream energy company with a focus on onshore, low geologic risk, long-lived, oil reserves in conventional reservoirs. Most of our assets are located in the oil-rich reservoirs in the San Joaquin basin of California, which has more than 100 years of production history and substantial remaining oil in place. As a result of the substantial data produced over the basin's long history, its reservoir characteristics are well understood, leading to predictable, repeatable, low geological risk and low-c and, to a lesser extent, in our Rockies assets which include low-cost, oil-rich reservoirs in the Uinta basin of Utah and low geologic risk natural gas resource plays in the Piceance basin in Colorado. Successful execution of our strategy across our low-declining production base and extensive inventory of identified drilling locations will result in our ability to continue returning capital to our stockholders and demonstrate long-term, capital efficient, consistent, and predictable production growth while living within levered free cash flow. Effective February 18, 2020, Berry Petroleum Corporation changed its name to Berry Corporation (bry) and introduced a new logo. We believe that the name Berry Corporation (bry) is a name that better represents our progressive approach to evolving and growing the business in today’s dynamic oil and gas industry. We are proactively engaging the many forces driving our industry to maximize our assets, create value for shareholders, and support environmental goals that align with a more positive future. One of the more visible elements of our business is our publicly traded stock, and our new logo echoes the public value of the company by using our ticker symbol as an identifiable element of our brand. How We Plan and Evaluate Operations We use Levered Free Cash Flow in planning our capital allocation to sustain production levels and fund internal growth opportunities, as well as determine hedging needs. We define Levered Free Cash Flow as Adjusted EBITDA less capital expenditures, interest expense, and dividends. We use the following metrics to manage and assess the performance of our operations and are part of our incentive program for all employees: (a) Adjusted EBITDA; (b) operating expenses; (c) environmental, health & safety (“EH&S”) results; (d) general and administrative expenses; and (e) production. Adjusted EBITDA Adjusted EBITDA is the primary financial and operating measurement that our management uses to analyze and monitor the operating performance of our business. We define Adjusted EBITDA as earnings before interest expense; income taxes; depreciation, depletion, and amortization (“DD&A”); derivative gains or losses net of cash received or Index to Financial Statements and Supplementary Data paid for scheduled derivative settlements; impairments; stock compensation expense; and other unusual, out-of-period and infrequent items, including restructuring costs and reorganization items. Operating expenses We define operating expenses as lease operating expenses, electricity generation expenses, transportation expenses, and marketing expenses, offset by the third-party revenues generated by electricity, transportation and marketing activities, as well as the effect of derivative settlements (received or paid) for gas purchases. Lease operating expenses include fuel, labor, field office, vehicle, supervision, maintenance, tools and supplies, and workover expenses. Taxes other than income taxes are excluded from operating expenses. The electricity, transportation and marketing activity related revenues are viewed and treated internally as a reduction to operating costs when tracking and analyzing the economics of development projects and the efficiency of our hydrocarbon recovery. Additionally, we strive to minimize the variability of our fuel gas costs for our steam operations with gas hedges. Overall, operating expense is used by management as a measure of the efficiency with which operations are performing. Environmental, health & safety Like other companies in the oil and gas industry, our operations are subject to stringent federal, state and local laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. Current and future laws and regulations can materially impact our exploration, development and production plans. We are committed to good corporate citizenship in our communities, operating safely and protecting the environment and our employees. We monitor our EH&S performance through various measures, holding our employees and contractors to high standards. General and administrative expenses We monitor our cash general and administrative expenses as a measure of the efficiency of our overhead activities. Such expenses are a key component of the appropriate level of support our corporate and professional team provides to the development of our assets and our day-to-day operations. Production Oil and gas production is a key driver of our operating performance, an important factor to the success of our business, and used in forecasting future development economics. We measure and closely monitor production on a continuous basis, adjusting our property development efforts in accordance with the results. We track production by commodity type and compare it to prior periods and expected results. Business Environment and Market Conditions The oil and gas industry is heavily influenced by commodity prices. Average oil prices were lower for 2019 compared to 2018 . Brent crude oil contract prices ranged during 2019 from $54.91 per Bbl at the beginning, to a high of $74.57 per Bbl and back to $56.23 per Bbl. In California, the price we pay for fuel gas purchases is generally based on the Kern, Delivered Index, as well as the SoCal Index which were as low as $0.99 per MMBtu and as high as $22.38 per MMBtu for a short time in 2019 due to market disruptions, while we paid an average of $3.14 for the year. The Henry Hub spot price for natural gas fluctuated between $1.75 per MMBtu and $4.25 per MMBtu, with an average of $2.56 during 2019. Our revenue, costs, profitability and future growth are highly dependent on the prices we receive for our oil and natural gas production and the prices we pay for our natural gas purchases which will continue to be affected by a variety of factors. Please see “Item 1A. Risk Factors-Risks Related to Our Business and Industry-Oil, natural gas and NGL prices are volatile and directly affect our results.” Index to Financial Statements and Supplementary Data The following table presents the average Brent, WTI, Kern, and Henry Hub prices for the years ended December 31, 2019 and 2018: California oil prices are Brent-influenced as California refiners import approximately 73% of the state’s demand from OPEC countries and other waterborne sources, primarily the Middle East and South America. There is a closer correlation of prices in California to Brent pricing than to WTI. Without the higher costs associated with importing crude via rail or supertanker, we believe our in-state production and low-cost crude transportation options, coupled with Brent-influenced pricing, will allow us to continue to realize strong cash margins in California. Utah oil prices have historically traded at a discount to WTI as the local refineries are designed for oil's unique characteristics and the remoteness of the assets makes access to other markets logistically challenging. Prices and differentials for NGLs are related to the supply and demand for the products making up these liquids. Some of them more typically correlate to the price of oil while others are affected by natural gas prices as well as the demand for certain chemical products for which they are used as feedstock. In addition, infrastructure constraints magnify pricing volatility. Natural gas prices and differentials are strongly affected by local market fundamentals, availability of transportation capacity from producing areas and seasonal impacts. We purchase substantially more natural gas for our steamfloods and cogeneration facilities, than we produce and sell. Consequently, higher gas prices have a negative impact on our operating costs. However, we mitigate a portion of this exposure by selling excess electricity from our cogeneration operations to third parties at prices linked to the price of natural gas. Additionally, we strive to minimize the variability of our fuel gas costs for our steam operations by hedging a significant portion of such gas purchases. Also, the negative impact of higher gas prices is partially offset by higher gas sales for the gas we produce. Our earnings are also affected by the performance of our cogeneration facilities. These cogeneration facilities generate both electricity and steam for our properties and electricity for off-lease sales. We have negotiated terms of a new power purchase agreement for our 18 MW cogeneration facility which began in December 2019 for a period of seven years. While a portion of the electric output of our cogeneration facilities is utilized within our production facilities to reduce operating expenses, we also sell electricity produced by three of our cogeneration facilities under long-term contracts with terms ending in July 1, 2021 through December 1, 2026. The most significant input and cost of the cogeneration facilities is natural gas. We generally receive significantly more revenue from these cogeneration facilities in the summer months, June through September, due to negotiated capacity payments we receive. Natural gas prices can fluctuate based on seasonal and other market-related impacts. We purchase significantly more gas than we sell to generate steam and electricity in our cogeneration facilities for our producing activities. As a result, our key exposure to gas prices is in our costs. We mitigate a substantial portion of this exposure by selling excess electricity from our cogeneration operations to third parties. The pricing of these electricity sales is closely tied to the purchase price of natural gas. We also hedge a significant portion of the gas we expect to consume. Seasonal weather conditions can impact our drilling and production activities. These seasonal conditions can occasionally pose challenges in our operations for meeting well-drilling objectives and increase competition for equipment, supplies and personnel, which could lead to shortages and increase costs or delay operations. For example, our operations may have been and in the future may be impacted by ice and snow in the winter and by electrical storms and high temperatures in the spring and summer, as well as by wild fires and rain. Index to Financial Statements and Supplementary Data Additionally, like other companies in the oil and gas industry, our operations are subject to stringent federal, state and local laws and regulations relating to drilling, completion, well stimulation, operation, maintenance or abandonment of wells or facilities, managing energy, water, land, greenhouse gases or other emissions, protection of health, safety and the environment, or transportation, marketing, and sale of our products. Federal, state and local agencies may assert overlapping authority to regulate in these areas. See “Items 1 and 2. Business and Properties-Regulation of Health, Safety and Environmental Matters” for a description of laws and regulations that affect our business. For more information related to regulatory risks, see “Item 1A. Risk Factors-Risks Related to Our Business and Industry” Index to Financial Statements and Supplementary Data Certain Operating and Financial Information The following tables set forth information regarding average daily production, total production, and average prices for the years ended December 31, 2019 and 2018. __________ (1) Production represents volumes sold during the period. We also consume a portion of the natural gas we produce on lease to extract oil and gas. (2) Natural gas volumes have been converted to Boe based on energy content of six Mcf of gas to one Bbl of oil. Barrels of oil equivalence does not necessarily result in price equivalence. The price of natural gas on a barrel of oil equivalent basis is currently substantially lower than the corresponding price for oil and has been similarly lower for a number of years. For example, in the year ended December 31, 2019, the average prices of Brent oil and Henry Hub natural gas were $64.16 per Bbl and $2.56 per MMBtu respectively, resulting in an oil-to-gas ratio of approximately 4 to 1 on an energy equivalent basis. (3) On November 30, 2018, we sold our non-core gas-producing properties and related assets located in the East Texas basin. (4) Kern, Delivered Index is the relevant index used for gas purchases in California. (5) Henry Hub is the relevant index used for gas sales in the Rockies. The following table sets forth average daily production by operating area for the periods indicated: Index to Financial Statements and Supplementary Data __________ (1) Production represents volumes sold during the period. (2) On November 30, 2018, we sold our non-core gas-producing properties and related assets located in the East Texas basin. Average daily oil production increased 15% for the year ended December 31, 2019 compared to the year ended December 31, 2018. Year-over-year daily overall production increased 7% due to production response from the development capital spending throughout 2019 and 2018, which more than offset the natural decline of our properties and the sale of our East Texas properties in November 2018 California production increased 15% year-over-year in response to the deployment of the substantial majority of our development capital. This increase strongly demonstrated the ability of our California properties to respond to capital investment. The 2019 development activities accelerated our California production growth during the year, resulting in a 17% increase from 21.7 MBoe/d in the three months ended December 31, 2018 to 25.5 MBoe/d in the three months ended December 31, 2019. Additionally, our 2019 capital program contributed to the increase in our California proved reserves of 24.5 MMBoe, or 23% before production, resulting in a 299% replacement ratio. We also replaced 159% of our total company proved undeveloped drilling location inventory. The production in Utah and Colorado declined 3% year-over-year. The overall decline is primarily due to no capital allocated to Colorado, while there was a slight increase in Utah due to the deployed capital there. Additionally, we sold our East Texas gas properties in November 2018. Index to Financial Statements and Supplementary Data Summary by Area The following table shows a summary by area of our selected historical financial information and operating data for the periods indicated. __________ (1) Operating income includes oil, natural gas and NGL sales, marketing revenues, other revenues, and scheduled oil derivative settlements, offset by operating expenses, general and administrative expenses, DD&A, impairment of oil and gas properties, and taxes, other than income taxes. (2) Excludes corporate capital expenditures. Results of Operations Revenues and Other Oil, natural gas and NGL sales increased $13 million to $566 million for the year ended December 31, 2019 from $553 million for the year ended December 31, 2018. The increase was driven by $76 million of higher oil volumes that was partially offset by $54 million of lower oil prices and $8 million of lower gas and natural gas liquid sales, mainly volume-related. Index to Financial Statements and Supplementary Data Electricity sales represent sales to utilities which decreased by $6 million or 17%, to approximately $29 million for the year ended December 31, 2019 when compared to the year ended December 31, 2018. The decrease was due to lower unit sales that were affected by unexpected downtime at our largest cogen during the summer when we receive peak pricing, and lower year-over-year gas pricing. Included in the results of our oil derivatives for the year ended December 31, 2019 were $43 million of settlement gains reflecting the positions that expired during the year with hedge prices below the respective Brent index prices. During 2019, the change in Brent prices relative to our remaining positions at year end resulted in reduced value, resulting in mark-to-market losses in 2019. Losses on oil derivatives were $4.6 million for the year ended December 31, 2018. Our losses in 2018 were due to the mark-to-market losses incurred on oil derivatives prior to being terminated in May 2018 and settled with a $127 million payment. We terminated these derivatives and entered into new hedges to better align our hedge pricing with the then prevailing market pricing. These early-2018 losses were offset by gains on oil derivatives in the latter portion of the year, primarily due to the decline in oil prices in the fourth quarter compared to the higher hedge pricing. Marketing and other revenues were comparable for the year ended December 31, 2019 and the year ended December 31, 2018. Marketing revenues in these periods represented sales of natural gas purchased from third-parties. Index to Financial Statements and Supplementary Data __________ (1) We report electricity, transportation and marketing sales separately in our financial statements as revenues in accordance with GAAP. However, these revenues are viewed and used internally in calculating operating expenses which is used to track and analyze the economics of development projects and the efficiency of our hydrocarbon recovery. We purchase third-party gas to generate electricity through our cogeneration facilities to be used in our field operations activities and view the added benefit of any excess electricity sold externally as a cost reduction/benefit to generating steam for our thermal recovery operations. Marketing revenues and expenses mainly relate to natural gas purchased from third parties that moves through our gathering and processing systems and then is sold to third parties. Transportation sales relate to water and other liquids that we transport on our systems on behalf of third parties and have not been significant to date. Operating expenses also include the effect of derivative settlements (received or paid) for gas purchases. (2) Total unhedged operating expenses equals total operating expenses less the derivatives settlements paid for gas purchases. (3) Total non-energy operating expenses equals total operating expenses, excluding fuel, electricity sales and gas purchase derivatives settlement (gains) losses. (4) Total energy operating expenses equals fuel and gas purchase derivative settlement (gains) losses less electricity sales. (5) Includes restructuring and other non-recurring costs and non-cash stock compensation expense, in aggregate, of approximately $1.08 per Boe and $1.36 per Boe for the year ended December 31, 2019 and December 31, 2018, respectively. (6) For the year ended December 31, 2019, we recorded an impairment charge of $51 million for the Piceance gas properties in Colorado. (7) Adjusted EBITDA and Adjusted Net Income (Loss) are financial measures that are not calculated in accordance with GAAP. For definitions and a reconciliation to the Net Cash Provided by Operating Activities and Net Income (Loss), please see “Item 7 - Non-GAAP Financial Measures” Expenses Operating expenses increased to $20.32 per Boe for the year ended December 31, 2019 from $18.33 for the year ended December 31, 2018. This increase included approximately $1.26 per Boe of increased repair and maintenance expenses, $0.80 decreased electricity sales, and $0.18 increased hedged fuel cost. This was partially offset by $0.24 lower transportation expense. On an unhedged basis, operating expenses increased $1.65 per Boe to $20.22 for the year ended December 31, 2019 from $18.57 for the year ended December 31, 2018. Operating expenses are defined above in "How We Plan And Evaluate Operations". Lease operating expenses increased $1.26 per Boe to $20.42 for the year ended December 31, 2019 from $19.16 for the year ended December 31, 2018. The increase included repair and maintenance costs of $0.66 per Boe for facility tanks and vessels, and $0.61 for well servicing maintenance. These increases in maintenance costs for facilities and wells during 2019 resulted from our continuing efforts to aggressively manage repair and maintenance activities, in Index to Financial Statements and Supplementary Data particular, long-term delayed maintenance on some equipment. Lease operating expenses include fuel, maintenance, labor including supervision, vehicles, workover expenses, field office, and tools and supplies. Electricity generation expenses decreased $0.25 to $1.84 per Boe for the year ended December 31, 2019 from $2.09 for the year ended December 31, 2018 mostly due to higher downtime and lower natural gas costs. These fuel costs exclude the effects of natural gas derivative settlements mentioned elsewhere. Losses on natural gas derivatives of $7 million for the year ended December 31, 2019 included $6 million of mark-to-market valuation losses and $1 million, or $0.10 per Boe of gas hedge settlements. For the year ended December 31, 2018, gains on natural gas derivatives were $6 million including $4 million of mark-to-market valuation gains and $2 million, or $0.24 per Boe of gas hedge settlements. In late 2018 we began hedging a portion of our internal consumption of natural gas used primarily to fuel our cogeneration units. Early in 2019 we increased the volume of natural gas volume hedged given the increase in natural gas prices at that time. Gains on natural gas derivatives in 2018 and in early 2019 reflected relatively high gas prices in California, compared to the strike price of our derivatives. However, the price decrease towards the end of the year resulted in mark-to-market hedging losses in 2019. Transportation expenses decreased $0.24 per Boe to $0.76 for the year ended December 31, 2019 from $1.00 for the year ended December 31, 2018, mainly due to the impact from selling our East Texas asset during the fourth quarter of 2018 and lower volumes shipped from our Rockies assets. Marketing expenses were comparable for the year ended December 31, 2019 and the year ended December 31, 2018. Marketing expenses in these periods, which exclude the effects of hedging, represented the cost of natural gas purchased from third-parties. General and administrative expenses increased by $9 million or 16%, to approximately $63 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. General and administrative expenses included restructuring and other non-recurring costs that decreased year over year to approximately $3.1 million from $6.8 million due to the completion of those activities in early 2019. For the same periods non-cash stock compensation costs increased to approximately $8.4 million from $6.6 million due to increased headcount. Adjusted general and administrative expenses, which exclude restructuring and other non-recurring costs and non-cash stock compensation costs, were approximately $51 million or $4.84 per Boe for the year ended December 31, 2019 compared to $41 million or $4.13 per Boe for the year ended December 31, 2018. The increases in both general and administrative expenses and adjusted general and administrative expenses were primarily due to increased costs associated with our growth and public company status, and the continuing development and growth of our corporate affairs department and activities whose purpose is to support our efforts and participation in the regulatory, political and legislative process primarily in California. DD&A increased by approximately $20 million or 23%, to approximately $106 million, for the year ended December 31, 2019 compared to the year ended December 31, 2018. On a per Boe basis, DD&A increased $1.26 to $10.01 year over year primarily due to higher 2019 depreciation and depletion rates caused by increasing capital development programs in 2018 and 2019. Impairment of Oil and Gas Properties At year end 2019, we evaluated our proved and unproved natural gas properties in regards to the decline in our expectations of future gas prices. As a result, we recorded a non-cash pre-tax asset impairment charge of $51 million for our Piceance gas properties in Colorado, of which $23 million was for proved properties and $28 million for unproved properties. Index to Financial Statements and Supplementary Data Taxes, Other Than Income Taxes Taxes, other than income taxes, increased to $3.84 per Boe for the year ended December 31, 2019 from $3.36 for the year ended December 31, 2018 due to higher greenhouse gas allowance costs, partially offset by lower severance taxes than in the year ended December 31, 2018. Greenhouse gas allowance costs increased as a result of fewer free allowances from the state of California and higher spot prices for those allowances purchased, both of which increased the average unit cost of emissions incurred. The lower severance taxes in the year ended December 31, 2019 were the result of increased exemptions. Other Operating Expense (Income) Other operating expenses were $5 million in the year ended December 31, 2019 and mainly consisted of excess abandonment costs. The gains in 2018 included a $4 million gain from the sale of our East Texas property, offset by a $1 million loss on settlement of asset retirement obligations, largely due to a change in timing of the retirements. Interest Expense Interest expense decreased slightly due to less borrowings throughout 2019 compared to 2018. Reorganization Items, Net Reorganization items, net, consisted of less than $1 million expense for the year ended December 31, 2019, compared to $25 million of income primarily from the return of undistributed funds reserved for settlement of claims of general unsecured creditors for the year ended December 31, 2018. Income Tax Expense (Benefit) For the year ended December 31, 2019 we had an income tax benefit of approximately $37 million and for the year ended December 31, 2018 we had an income tax provision of approximately $43 million. The key contributor to the year-over-year change in income taxes and our effective rate from 23% for the year ended December 31, 2018 to (523)% for the year ended December 31, 2019 is due to the recognition of US federal general business credits in 2019 and are related to the 2017 and 2018 tax periods. These credits are available to offset future federal income tax liabilities. Refer to Note 8 of the consolidated financial statements for more information about our income taxes. Series A Preferred Stock dividends and conversion to common stock There were no Series A Preferred Stock dividends in 2019. Series A Preferred Stock (the "Series A Preferred Stock") was converted to common stock (the "Series A Preferred Stock Conversion") in 2018 when a $60 million payment was made to preferred stockholders in the Series A Preferred Stock Conversion in conjunction with our IPO, and the $27 million conversion value assigned to the additional 1.9 million shares of common stock received by the preferred stockholders, and $11 million of dividends paid prior to the conversion. Index to Financial Statements and Supplementary Data Liquidity and Capital Resources Currently, we expect our primary sources of liquidity and capital resources will be Levered Free Cash Flow, and as needed, borrowings under the RBL Facility. Depending upon market conditions and other factors, we have issued and may issue additional equity and debt securities; however, we expect our operations to continue to generate positive Levered Free Cash Flow at current commodity prices allowing us to fund operations at sustained production levels and organic growth. Remaining excess cash flow could be used in various ways, including additional return of capital to shareholders, debt repurchases, bolt-on acquisitions and maintained as cash. As of December 31, 2019, we have available liquidity of $391 million under our RBL Facility. We believe our liquidity and capital resources will be sufficient to conduct our business and operations for the next 12 months. Cash Dividends Our Board of Directors approved a $0.12 per share quarterly cash dividend on our common stock each quarter in 2019. We paid the fourth quarter dividend in January 2020 and declared the first quarter 2020 dividend of $0.12 per share in February 2020, which is payable in April 2020. Since our IPO in July 2018 through February 2020, we have returned $65 million in regular quarterly dividends. 2026 Notes Offering In February 2018, we issued our 7.0% 2026 Notes through our operating subsidiary, Berry LLC, which resulted in net proceeds to us of approximately $391 million after deducting expenses and the initial purchasers’ discount. We used the net proceeds from the issuance to repay the $379 million outstanding balance on the RBL Facility and used the remainder for general corporate purposes. We may, at our option, redeem all or a portion of the 2026 Notes at any time on or after February 15, 2021. We are also entitled to redeem up to 35% of the aggregate principal amount of the 2026 Notes before February 15, 2021, with an amount of cash not greater than the net proceeds that we raise in certain equity offerings at a redemption price equal to 107% of the principal amount of the 2026 Notes being redeemed, plus accrued and unpaid interest, if any. In addition, prior to February 15, 2021, we may redeem some or all of the 2026 Notes at a price equal to 100% of the principal amount thereof, plus a “make-whole” premium, plus any accrued and unpaid interest. If we experience certain kinds of changes of control, holders of the 2026 Notes may have the right to require us to repurchase their notes at 101% of the principal amount of the 2026 Notes, plus accrued and unpaid interest, if any. The 2026 Notes are our senior unsecured obligations and rank equally in right of payment with all of our other senior indebtedness and senior to any of our subordinated indebtedness. The notes are fully and unconditionally guaranteed on a senior unsecured basis by us and will also be guaranteed by certain of our future subsidiaries (other than Berry LLC). The 2026 Notes and related guarantees are effectively subordinated to all of our secured indebtedness (including all borrowings and other obligations under the RBL Facility) to the extent of the value of the collateral securing such indebtedness, and structurally subordinated in right of payment to all existing and future indebtedness and other liabilities (including trade payables) of any future subsidiaries that do not guarantee the 2026 Notes. The indenture governing the 2026 Notes contains restrictive covenants and customary events of default, including, among others, (a) non-payment; (b) non-compliance with covenants (in some cases, subject to grace periods); (c) payment default under, or acceleration events affecting, material indebtedness and (d) bankruptcy or insolvency events involving us or certain of our subsidiaries. The 2026 Notes do not restrict us from making open market and other purchases of such notes. Bond Repurchase Program Index to Financial Statements and Supplementary Data In February 2020, our Board of Directors adopted a program for the opportunistic repurchase of up to $75 million of our 2026 Notes. The manner, timing and amount of any purchases will be determined based on our evaluation of market conditions, compliance with outstanding agreements and other factors, may be commenced or suspended at any time without notice and does not obligate Berry Corp. to purchase the 2026 Notes during any period or at all. The RBL Facility On July 31, 2017, we entered into the RBL Facility. The RBL Facility provides for a revolving loan with up to $1.5 billion of commitments, subject to a reserve borrowing base. The RBL Facility also provides a letter of credit subfacility for the issuance of letters of credit in an aggregate amount not to exceed $25 million. Issuances of letters of credit reduce the borrowing availability for revolving loans under the RBL Facility on a dollar for dollar basis. Borrowing base redeterminations become effective each May and November, although each of the administrative agent and Berry LLC may make one interim redetermination between scheduled redeterminations. The RBL Facility has an elected commitment feature that allows us to increase commitments to the amount of our borrowing base with lender approval. In late 2019, we completed a borrowing base redetermination under our RBL Facility that set our borrowing base to $500 million and reaffirmed our elected commitment amount at $400 million. The RBL Facility matures on July 29, 2022, unless terminated earlier in accordance with the RBL Facility terms. As of December 31, 2019, we had approximately $7 million in letters of credit outstanding, $2 million borrowed and borrowing availability of $391 million under the RBL Facility. As of January 31, 2020, we had no borrowings outstanding, $7 million in letters of credit outstanding, and approximately $393 million of available borrowings capacity under the RBL Facility. The outstanding borrowings under the RBL Facility bear interest at a rate equal to either (i) a customary London interbank offered rate plus an applicable margin ranging from 2.50% to 3.50% per annum, and (ii) a customary base rate plus an applicable margin ranging from 1.50% to 2.50% per annum, in each case depending on levels of borrowing base utilization. In addition, we must pay the lenders a quarterly commitment fee of 0.50% on the average daily unused amount of the borrowing availability under the RBL Facility. We have the right to prepay any borrowings under the RBL Facility with prior notice at any time without a prepayment penalty, other than customary “breakage” costs with respect to eurodollar loans. The RBL Facility contains events of default and remedies customary for this type of credit facility. If we do not comply with the financial and other covenants in the RBL Facility, the lenders may, subject to customary cure rights, require immediate payment of all amounts outstanding under the RBL Facility and exercise all of their other rights and remedies, including foreclosure on all of the collateral. The RBL Facility requires us to maintain on a consolidated basis as of each quarter-end (i) a Leverage Ratio of no more than 4.00 to 1.00 and (ii) a Current Ratio of at least 1.00 to 1.00. The RBL Facility also contains customary restrictions. As of December 31, 2019, our Leverage Ratio and Current Ratio were 1.4:1.00 and 3.2:1.00, respectively. As of December 31, 2019, we were in compliance with the financial covenants under the RBL Facility. The RBL Facility permits us to repurchase equity and indebtedness, among other things, if availability is equal to or greater than 15% of the elected commitments or borrowing base, whichever is in effect, and our pro forma leverage ratio is less than or equal to 2.75 to 1.00. Berry Corp. guarantees, and each future subsidiary of Berry Corp. (other than Berry LLC), with certain exceptions, is required to guarantee, our obligations and obligations of the other guarantors under the RBL Facility and under certain hedging transactions and banking services arrangements (the “Guaranteed Obligations”). In addition, pursuant to a Guaranty Agreement dated as of July 31, 2017, Berry LLC guarantees the Guaranteed Obligations. The lenders under the RBL Facility hold a mortgage on at least 85% of the present value of our proven oil and gas reserves. The obligations of Berry LLC and the guarantors are also secured by liens on substantially all of our personal property, subject to customary exceptions. The RBL Facility, with certain exceptions, also requires that any future subsidiaries of Berry LLC are required to grant mortgages, security interests and equity pledges. Index to Financial Statements and Supplementary Data Corporate Organization Berry Corp., as Berry LLC's parent company, has no independent assets or operations. Any guarantees of potential future registered debt securities by Berry Corp. or Berry LLC would be full and unconditional. Berry Corp. and Berry LLC currently do not have any other subsidiaries. In addition, there are no significant restrictions upon the ability of Berry LLC to distribute funds to Berry Corp. by distribution or loan other than under the RBL Facility. None of the assets of Berry Corp. or Berry LLC represent restricted net assets. The RBL permits Berry LLC to make distributions to Berry Corp. so long as both before and after giving pro forma effect to such distribution no default or borrowing base deficiency exists, availability equals or exceeds 15% of the then effective borrowing base, and Berry Corp. demonstrates a pro forma leverage ratio less than or equal to 2.75 to 1.00. The conditions are currently met with significant margin. Hedging We have protected a significant portion of our anticipated cash flows through our commodity hedging program, including through fixed-price derivative contracts for oil production and gas purchases. For information regarding risks related to our hedging program, see “Item 1A. Risk Factors-Risks Related to Our Business and Industry”. We currently have hedged a significant portion of our crude oil production through 2020 and into 2021. Our generally low-decline production base, coupled with our stable operating cost environment, affords an ability to hedge a material amount of our future expected production. Oil derivative settlements increased for the year ended December 31, 2019 when compared to the year ended December 31, 2018, as a result of an increase in realized oil prices with hedges, as well as, an increase in oil volumes hedged. As of December 31, 2019, we had the following crude oil production and gas purchases hedges. After December 31, 2019 we added fixed price gas purchase swaps (Kern, Delivered) of 5,000 MMBtu/d at $2.55 beginning November 2020 through October 2021. Index to Financial Statements and Supplementary Data The following table summarizes the historical results of our hedging activities. In 2019, our gas purchase derivative settlements resulted in payments as the strike price of our hedges were higher than the index price. In 2018, our gas purchase derivative settlements resulted in receipts as the strike price of our hedges were lower than the index price. In May 2018, we elected to terminate outstanding commodity derivative contracts for all WTI oil swaps and certain WTI/Brent basis swaps for July 2018 through December 2019 and all WTI oil sold call options for July 2018 through June 2020. Termination costs totaled approximately $127 million and were calculated in accordance with a bilateral agreement on the cost of elective termination included in these derivative contracts; the present value of the contracts using the forward price curve as of the date termination was elected. No penalties were charged as a result of the elective termination. Capital Program For the years ended December 31, 2019 and 2018 our capital expenditures were approximately $211 million and $148 million, respectively, on an accrual basis excluding acquisitions. California production increased 15% year-over-year in response to the deployment of the substantial majority of our development capital. This increase strongly demonstrated the ability of our California properties to respond to capital and perform as expected. Additionally, our 2019 capital program contributed to the increase in our California proved reserves of 24.5 MMBoe, or 23% before production, resulting in a 299% replacement ratio. We also replaced 159% of our total company proved undeveloped drilling location inventory. Our 2020 anticipated capital expenditure budget is approximately $125 to $145 million. Using the mid-point of this range, we expect to have a decrease of approximately 36% over 2019 capital expenditures. Our 2020 capital program is focused on generating strong year-over-year oil production growth in California, while holding overall production close to flat throughout the year, and continue returning capital to our shareholders. Based on current commodity prices and our drilling success rate, we expect to be able to fund our 2020 capital development programs while producing positive Levered Free Cash Flow and continue to pay quarterly dividends. We anticipate oil production will be approximately 90% of total production in 2020, compared to 87% in 2019 and 82% in 2018. During 2020, we expect to employ up to three drilling rigs in California throughout the last three quarters of the year, and averaging up to one rig in the first quarter. For the year, we expect to drill 195 to 225 gross development wells, almost all of which will be in California for oil production. However, the execution of these plans requires certain regulatory review and approvals, and current and future laws and regulations could impact our ability to successfully execute our plans. Please see “Regulation of Health, Safety and Environmental Matters” for additional discussion. In addition to capital expenditures, we also incur costs associated with retiring assets and remediating property at the end of its useful life, both due to regulatory obligations and our focus on EH&S as we develop existing fields. Most of these obligations and activities are regulated by governmental agencies. During 2019, we spent approximately $27 million in fulfilling these obligations and in 2020 we expect to spend approximately $20 million. A significant portion of these costs is a result of California's new idle well regulations which became effective in 2019 and accelerated the timing of abandonment of certain existing idle wells. In accordance with these regulations, we expect to plug and abandon a majority of our existing idle wells over the next eight years. Index to Financial Statements and Supplementary Data The amount and timing of capital expenditures is within our control and subject to our management’s discretion, and may be adjusted during the year depending on commodity prices and other factors. We retain the flexibility to defer planned capital expenditures depending on a variety of factors, including but not limited to the success of our drilling activities, prevailing and anticipated prices for oil, natural gas and NGLs, the receipt and timing of required regulatory permits and approvals, the availability of necessary equipment, infrastructure and capital, seasonal conditions, drilling and acquisition costs and the level of participation by other interest owners, as well as general market conditions. IPO and Preferred Stock Conversion In July 2018, we completed the IPO and as a result, on July 26, 2018, our common stock began trading on the NASDAQ under the ticker symbol BRY. We received approximately $110 million of net proceeds, after deducting underwriting discounts and offering expenses payable by us, for the 8,695,653 shares of common stock issued for our benefit in the IPO, net of the shares sold for the benefit of certain selling stockholders. The price to the public for the shares sold in our IPO was $14.00 per share. Of the approximately $110 million of net proceeds we received in the IPO, we used approximately $105 million to repay borrowings under our RBL Facility, which included $60 million we borrowed to make the payment due to the holders of our Series A Preferred Stock in connection with the conversion of preferred stock to common stock. We used the remainder for general corporate purposes. In connection with the IPO, on July 17, 2018, we entered into stock purchase agreements with certain funds affiliated with Oaktree Capital Management and Benefit Street Partners, pursuant to which we purchased an aggregate of 410,229 and 1,391,967 shares of our common stock, respectively, or 1,802,196 in total. In addition to the 8,695,653 shares of common stock issued and sold for our benefit in the IPO, we simultaneously received $24 million for issuing and selling 1,802,196 shares to the public and paid $24 million to purchase 1,802,196 shares under the stock purchase agreements. We purchased the shares immediately following the closing of the IPO and retired and returned them to the status of authorized but unissued shares. The selling stockholders sold an additional 2,545,630 shares at a price to the public of $14.00 per share, for which we did not receive any proceeds. In connection with the IPO, each of the 37.7 million shares of our Series A Preferred Stock outstanding was automatically converted to common stock in the Series A Preferred Stock Conversion. The cash payment was to be reduced in respect of any cash dividend paid by the Company on such share of Series A Preferred Stock for any period commencing on or after April 1, 2018. Because we paid the second quarter preferred dividend of $0.15 per share in June, the cash payment for the conversion was reduced to $1.60 per share, or approximately $60 million in aggregate. In connection with the IPO, we assigned the additional 1.9 million shares of common stock issued in the Series A Preferred Stock Conversion a value of $14.00 per share, which was equal to the value of shares sold in the IPO. The approximate $27 million value assigned to the 1.9 million shares and the $60 million cash payment for the Series A Preferred Stock Conversion reduced the income available to common stockholders by approximately $87 million. Stock Repurchase Program In December 2018, our Board of Directors adopted a program for the opportunistic repurchase of up to $100 million of our common stock. Based on the Board’s evaluation of current market conditions for our common stock they authorized current repurchases of up to $50 million under the program. Purchases may be made from time to time in the open market, in privately negotiated transactions or otherwise. The manner, timing and amount of any purchases will be determined based on our evaluation of market conditions, stock price, compliance with outstanding agreements and other factors, may be commenced or suspended at any time without notice and does not obligate Berry Corp. to purchase shares during any period or at all. Any shares acquired will be available for general corporate purposes. In 2019 the Company repurchased 4,609,021 shares at an average price of $9.99. Since 2018 the Company has repurchased a total of 5,057,682 shares at an average price of $9.88 per share under the Stock Repurchase Program, Index to Financial Statements and Supplementary Data which is reflected as treasury stock. In February 2020, the Board of Directors authorized the remaining $50 million of our $100 million repurchase program. Preferred Stock Dividends In March 2018, our board of directors approved a cumulative paid-in-kind dividend on the Series A Preferred Stock for the periods through December 31, 2017. The cumulative dividend was 0.050907 new shares per outstanding share or approximately 1,825,000 shares in total. Also in the first and second quarter of 2018 the board of directors approved a $0.158 per share and a $0.15 per share cash dividend on the Series A Preferred Stock, respectively, for a total of $11.3 million. Statements of Cash Flows The following is a comparative cash flow summary: __________ (1) The amounts provided by operating activities in 2018 were negatively impacted by a one-time $127 million payment in May 2018 for early termination on derivatives. Operating Activities Cash provided by operating activities increased for the year ended December 31, 2019 by approximately $136 million when compared to the year ended December 31, 2018, due to the early termination of certain hedge contracts paid during the second quarter of 2018 of $127 million, the year-over-year increase in oil derivative cash settlements received of $84 million, and the increase in oil, natural gas and natural gas liquids sales of approximately $13 million, offset by increased operating expenses of $35 million, increased taxes, other than income of approximately $8 million, increased general and administrative expenses of $9 million and working capital changes of approximately $39 million. Index to Financial Statements and Supplementary Data Investing Activities The following provides a comparative summary of cash flow from investing activities: __________ (1) Based on actual cash payments rather than accrual. Cash used in investing activities increased $104 million for the year ended December 31, 2019 when compared to the year ended December 31, 2018, primarily due to an increase in capital spending in accordance with the 2019 capital program. Financing Activities Cash used in financing activities was approximately $85 million for the year ended December 31, 2019 and was primarily used to purchase treasury stock of $47 million and pay dividends on common stock of approximately $39 million, offset by approximately $2 million of net borrowings under the RBL Facility for monthly working capital fluctuations. Cash provided by financing activities was approximately $16 million for the year ended December 31, 2018 and was due to the net proceeds of $391 million from the issuance of our 2026 Notes and $110 million from our IPO in July 2018, offset by $379 million in payments on our RBL Facility, a $60 million payment to preferred stockholders in connection with the Series A Preferred Stock Conversion, $20 million payments to repurchase the rights to our common stock from certain claimholders originating from the bankruptcy process, $11 million in cash dividends declared on our Series A Preferred Stock, $7 million in dividends paid on our common stock and $3 million to acquire treasury shares under our stock repurchase program. Commitments, and Contingencies In the normal course of business, we, or our subsidiary, are subject to lawsuits, environmental and other claims and other contingencies that seek, or may seek, among other things, compensation for alleged personal injury, breach of contract, property damage or other losses, punitive damages, civil penalties, or injunctive or declaratory relief. On May 11, 2016 our predecessor company filed the Chapter 11 Proceeding. Our bankruptcy case was jointly administered with that of Linn Energy and its affiliates under the caption In re Linn Energy, LLC, et al., Case No. 16-60040. On January 27, 2017, the Bankruptcy Court approved and confirmed our plan of reorganization in the Chapter 11 Proceeding. On February 28, 2017, the Effective Date occurred and the Plan became effective and was implemented. A final decree closing the Chapter 11 Proceeding was entered September 28, 2018, with the Court retaining jurisdiction as described in the confirmation order and without prejudice to the request of any party-in-interest to reopen the case including with respect to certain, immaterial remaining matters. We accrue reserves for currently outstanding lawsuits, claims and proceedings when it is probable that a liability has been incurred and the liability can be reasonably estimated. We have not recorded any reserve balances at Index to Financial Statements and Supplementary Data December 31, 2019 and December 31, 2018. We also evaluate the amount of reasonably possible losses that we could incur as a result of these matters. We believe that reasonably possible losses that we could incur in excess of reserves accrued on our balance sheet would not be material to our consolidated financial position or results of operations. We have certain commitments under contracts, including purchase commitments for goods and services. We previously had an obligation to a counterparty in connection with our Piceance assets to either build a road or secure a license for alternative access, in lieu of paying a $6 million penalty. As of December 31, 2019, we fulfilled the obligation by delivering the access license pursuant to the agreement. The counterparty has since filed a claim challenging the sufficiency of such access. We, or our subsidiary, or both, have indemnified various parties against specific liabilities those parties might incur in the future in connection with transactions that they have entered into with us. As of December 31, 2019, we are not aware of material indemnity claims pending or threatened against us. Contractual Obligations The following is a summary of our commitments and contractual obligations as of December 31, 2019: __________ (1) Represents interest on the 2026 Notes computed at 7.0% through contractual maturity in 2026. (2) Represents the estimated future asset retirement obligations on a discounted basis. We do not show the long-term asset retirement obligations by year as we are not able to precisely predict the timing of these amounts. Because these costs typically extend many years into the future, estimating these future costs requires management to make estimates and judgments that are subject to revisions based on numerous factors, including the rate of inflation, changing technology, and changes to federal, state and local laws and regulations. See Note 1 in the Notes to Consolidated Financial Statements in Part II-Item 8. Financial Statements and Supplementary Data for more information. (3) Amounts include payments which will become due under long-term agreements to purchase goods and services used in the normal course of business to secure transportation of our natural gas production to market as well as pipeline and processing capacity. (4) We have certain commitments under contracts, including purchase commitments for goods and services. We previously had an obligation to a counterparty in connection with our Piceance assets to either build a road or secure a license for alternative access, in lieu of paying a $6 million penalty. As of December 31, 2019, we fulfilled the obligation by delivering the access license pursuant to the agreement. The counterparty has since filed a claim challenging the sufficiency of such access. Index to Financial Statements and Supplementary Data Balance Sheet Analysis The changes in our balance sheet from December 31, 2018 to December 31, 2019 are discussed below. See “-Liquidity and Capital Resources” for discussions about the changes in cash and cash equivalents. The $14 million increase in accounts receivable was driven mostly by higher sales period-over-period, partially offset by lower hedge settlements outstanding at each period-end. The $77 million decrease in derivative assets and liabilities reflected the reduction in the mark-to-market values relative to the strike price of the derivatives at the end of each period presented, as well as the change in positions held at the end of each period and the settlements received throughout the period. The $5 million increase in other current assets was mainly due to purchases of materials inventory related to our capital development program. The $134 million increase in property, plant and equipment was largely the result of increased capital investments in oil and gas properties, as well as revisions to timing and cost estimates in our asset retirement obligations noted below, partially offset by increased accumulated depreciation of all properties and the Piceance property impairment. The $4 million decrease in other non-current assets was primarily due to amortization of debt issuance costs. The $8 million increase in accounts payable and accrued liabilities included approximately $19 million for the increased current portion of the asset retirement obligation partially offset by decreased accruals for various capital and operating costs of $10 million due to the level of these costs at the end of each year. The $3 million increase in long-term debt primarily represented borrowing and repayment activity from our RBL Facility for monthly working capital fluctuations. The $35 million increase in the long-term portion of the asset retirement obligation reflected revisions to timing and cost estimates of $57 million, $12 million for new wells, and $8 million of accretion expense. A significant portion of the change in estimate was a result of California's new idle well regulations which became effective in 2019. These regulations accelerated the abandonment timing of certain long existing idle wells. These increases were partially offset by increased liability settlements of $22 million and a $19 million change from long to short-term asset retirement obligation. Index to Financial Statements and Supplementary Data The $19 million increase in other non-current liabilities primarily represented increases to the greenhouse gas liability, which is due for payment more than one year from December 31, 2019. The $34 million decrease in equity was due to the purchase of treasury stock for $46 million and common stock dividends declared of $39 million. These decreases were offset by $44 million of net income and $8 million related to our stock-based incentive awards. Non-GAAP Financial Measures Adjusted EBITDA, Levered Free Cash Flow, Adjusted Net Income (Loss) and Adjusted General and Administrative Expenses Adjusted Net Income (Loss) is not a measure of net income (loss), Levered Free Cash Flow is not a measure of cash flow, and Adjusted EBITDA is not a measure of either, in all cases, as determined by GAAP. Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow are supplemental non-GAAP financial measures used by management and external users of our financial statements, such as industry analysts, investors, lenders and rating agencies. We define Adjusted EBITDA as earnings before interest expense; income taxes; depreciation, depletion, and amortization; derivative gains or losses net of cash received or paid for scheduled derivative settlements; impairments; stock compensation expense; and other unusual, out-of-period and infrequent items, including restructuring costs and reorganization items. We define Levered Free Cash Flow as Adjusted EBITDA less capital expenditures, interest expense and dividends. Our management believes Adjusted EBITDA provides useful information in assessing our financial condition, results of operations and cash flows and is widely used by the industry and the investment community. The measure also allows our management to more effectively evaluate our operating performance and compare the results between periods without regard to our financing methods or capital structure. Levered Free Cash Flow is used by management as a primary metric to plan capital allocation to sustain production levels and for internal growth opportunities, as well as hedging needs. It also serves as a measure for assessing our financial performance and our ability to generate excess cash from operations to service debt and pay dividends. Adjusted Net Income (Loss) excludes the impact of unusual, out-of-period and infrequent items affecting earnings that vary widely and unpredictably, including non-cash items such as derivative gains and losses. This measure is used by management when comparing results period over period. We define Adjusted Net Income (Loss) as net income (loss) adjusted for derivative gains or losses net of cash received or paid for scheduled derivative settlements, other unusual, out-of-period and infrequent items, including restructuring costs and reorganization items and the income tax expense or benefit of these adjustments using our effective tax rate. While Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow are non-GAAP measures, the amounts included in the calculation of Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow were computed in accordance with GAAP. These measures are provided in addition to, and not as an alternative for, income and liquidity measures calculated in accordance with GAAP. Certain items excluded from Adjusted EBITDA are significant components in understanding and assessing our financial performance, such as our cost of capital and tax structure, as well as the historic cost of depreciable and depletable assets. Our computations of Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow may not be comparable to other similarly titled measures used by other companies. Adjusted EBITDA, Adjusted Net Income (Loss) and Levered Free Cash Flow should be read in conjunction with the information contained in our financial statements prepared in accordance with GAAP. Adjusted General and Administrative Expenses is a supplemental non-GAAP financial measure that is used by management and external users of our financial statements, such as industry analysts, investors, lenders and rating agencies. We define Adjusted General and Administrative Expenses as general and administrative expenses adjusted for restructuring and other non-recurring costs and non-cash stock compensation expense. Management believes Index to Financial Statements and Supplementary Data Adjusted General and Administrative Expenses is useful because it allows us to more effectively compare our performance from period to period. We exclude the items listed above from general and administrative expenses in arriving at Adjusted General and Administrative Expenses because these amounts can vary widely and unpredictably in nature, timing, amount and frequency and stock compensation expense is non-cash in nature. Adjusted General and Administrative Expenses should not be considered as an alternative to, or more meaningful than, general and administrative expenses as determined in accordance with GAAP. Our computations of Adjusted General and Administrative Expenses may not be comparable to other similarly titled measures of other companies. The following tables present reconciliations of the non-GAAP financial measures Adjusted EBITDA, Levered Free Cash Flow, and Adjusted Net Income (Loss) to the GAAP financial measures of net income (loss) and net cash provided or used by operating activities, as applicable, for each of the periods indicated. __________ (1) Net cash received (paid) for scheduled derivative settlements does not include the $127 million in cash paid for early terminated derivatives in 2018. Index to Financial Statements and Supplementary Data __________ (1) Cash dividends declared in 2018 include $11 million of dividends for Series A Preferred Stock for the first two quarters of 2018 and $17 million of dividends for common stock. In connection with our IPO in July 2018, all of our outstanding Series A Preferred Stock was automatically converted into common stock. Common stock dividends were $0.09 per share for the third quarter of 2018, which was pro-rated from the date of our IPO through September 30, 2018, and $0.12 per share for the fourth quarter of 2018 and each quarter in 2019. (2) Levered Free Cash Flow includes cash received for scheduled derivative settlements of $42 million for the year ended December 31, 2019, and cash paid for scheduled derivative settlements $38 million for the year ended December 31, 2018. The following table presents a reconciliation of the non-GAAP financial measure Adjusted Net Income (Loss) to the GAAP financial measure of Net income (loss). Index to Financial Statements and Supplementary Data __________ (1) Excludes prior year income tax credits from the total additions (subtractions), net line item and the tax effect the prior tax credits have on the current year effective tax rate. The following table presents a reconciliation of the non-GAAP financial measure Adjusted General and Administrative Expenses to the GAAP financial measure of general and administrative expenses for each of the periods indicated. Off-Balance Sheet Arrangements See “-Liquidity and Capital Resources-Commitments, and Contingencies” and “-Contractual Obligations ” for information regarding our off-balance sheet arrangements. Critical Accounting Policies and Estimates The process of preparing financial statements in accordance with generally accepted accounting principles requires management to select appropriate accounting policies and to make informed estimates and judgments regarding certain items and transactions. Changes in facts and circumstances or discovery of new information may result in revised estimates and judgments, and actual results may differ from these estimates upon settlement. We consider the following to be our most critical accounting policies and estimates that involve management’s judgment and that could result in a material impact on the financial statements due to the levels of subjectivity and judgment. Oil and Natural Gas Properties Proved Properties We account for oil and natural gas properties in accordance with the successful efforts method. Under this method, all acquisition costs of proved properties are capitalized and amortized on a unit-of-production basis over the remaining life of the proved reserves. All development costs of proved properties are capitalized and amortized on a unit-of-production basis over the remaining life of the proved developed reserves. Costs of retired, sold or abandoned properties that constitute a part of an amortization base are charged or credited, net of proceeds, to accumulated depreciation, depletion and amortization unless doing so significantly affects the unit-of-production amortization rate, in which case a gain or loss is recognized in the current period. Gains or losses from the disposal of other properties are recognized in the current period. For assets acquired, we base the capitalized cost on fair value at the acquisition date. We expense expenditures for maintenance and repairs necessary to maintain properties in operating condition, as well as annual lease rentals, as they are incurred. Estimated dismantlement and abandonment costs are capitalized, net of salvage, at their estimated net present value and amortized over the remaining lives of the related assets. Interest is capitalized only during the periods in which these assets are brought to their intended use. We only capitalize the interest on borrowed funds related to our share of costs associated with qualifying capital expenditures. Index to Financial Statements and Supplementary Data We evaluate the impairment of our proved oil and natural gas properties generally on a field by field basis or at the lowest level for which cash flows are identifiable, whenever events or changes in circumstance indicate that the carrying value may not be recoverable. We reduce the carrying values of proved properties to fair value when the expected undiscounted future cash flows are less than net book value. We measure the fair values of proved properties using valuation techniques consistent with the income approach, converting future cash flows to a single discounted amount. Significant inputs used to determine the fair values of proved properties include estimates of: (i) reserves; (ii) future operating and development costs; (iii) future commodity prices; and (iv) a risk-adjusted discount rate. These inputs require significant judgments and estimates by our management at the time of the valuation and are the most sensitive estimates that we make and the most likely to change. The underlying commodity prices are embedded in our estimated cash flows and are the product of a process that begins with the relevant forward curve pricing, adjusted for estimated location and quality differentials, as well as other factors our management believes will impact realizable prices. The fair value was estimated using inputs characteristic of a Level 3 fair value measurement. Unproved Properties A portion of the carrying value of our oil and gas properties was attributable to unproved properties. At December 31, 2019 and 2018, the net capitalized costs attributable to unproved properties were approximately $314 million and $388 million, respectively. The unproved amounts were not subject to depreciation, depletion and amortization until they were classified as proved properties and amortized on a unit-of-production basis. We evaluate the impairment of our unproved oil and gas properties whenever events or changes in circumstances indicate the carrying value may not be recoverable. If the exploration and development work were to be unsuccessful, or management decided not to pursue development of these properties as a result of lower commodity prices, higher development and operating costs, contractual conditions or other factors, the capitalized costs of such properties would be expensed. The timing of any write-downs of unproved properties, if warranted, depends upon management’s plans, the nature, timing and extent of future exploration and development activities and their results. We believe our current plans and exploration and development efforts will allow us to realize the carrying value of our unproved property balance at December 31, 2019. At year end 2019, we evaluated our proved and unproved natural gas properties in regards to the decline in our expectations of future gas prices. As a result, we recorded a non-cash pre-tax asset impairment charge of $51 million for our Piceance gas properties in Colorado, of which $23 million was for proved properties and $28 million for unproved properties. Asset Retirement Obligation We recognize the fair value of asset retirement obligations (“AROs”) in the period in which a determination is made that a legal obligation exists to dismantle an asset and remediate the property at the end of its useful life and the cost of the obligation can be reasonably estimated. The liability amounts are based on future retirement cost estimates and incorporate many assumptions such as time to abandonment, technological changes, future inflation rates and the risk-adjusted discount rate. When the liability is initially recorded, we capitalize the cost by increasing the related property, plant and equipment (“PP&E”) balances. If the estimated future cost of the AROs changes, we record an adjustment to both the ARO and PP&E. Over time, the liability is increased, and expense is recognized through accretion, and the capitalized cost is depreciated over the useful life of the asset. In certain cases, we do not know or cannot estimate when we may settle these obligations and therefore we cannot reasonably estimate the fair value of the liabilities. We will recognize these AROs in the periods in which sufficient information becomes available to reasonably estimate their fair values. Fair Value Measurements We have categorized our assets and liabilities that are measured at fair value in a three-level fair value hierarchy, based on the inputs to the valuation techniques: Level 1-using quoted prices in active markets for the assets or liabilities; Level 2-using observable inputs other than quoted prices for the assets or liabilities; and Level 3-using unobservable Index to Financial Statements and Supplementary Data inputs. Transfers between levels, if any, are recognized at the end of each reporting period. We primarily apply the market approach for recurring fair value measurement, maximize our use of observable inputs and minimize use of unobservable inputs. We generally use an income approach to measure fair value when observable inputs are unavailable. This approach utilizes management’s judgments regarding expectations of projected cash flows and discounts those cash flows using a risk-adjusted discount rate. The most significant items on our balance sheet that would be affected by recurring fair value measurements are derivatives. We determine the fair value of our oil and natural gas derivatives using valuation techniques which utilize market quotes and pricing analysis. Inputs include publicly available prices and forward price curves generated from a compilation of data gathered from third parties. We classify these measurements as Level 2. Stock-based Compensation We have issued restricted stock units (“RSUs”) that vest over time and performance-based restricted stock units (“PSUs”) that vest based on our achievement of certain average prices per share or total shareholder return, to certain employees and non-employee directors. The fair value of the stock-based awards is determined at the date of grant and is not remeasured. Prior to our IPO in July 2018, we determined the fair value of the RSUs based on an estimate of the fair value of our equity using an income approach. We used a discounted cash flow method to value the estimated future cash flows at an appropriate discount rate. Subsequent to our IPO, since the underlying shares are now trading in the public markets, these estimates are no longer necessary. For PSUs, compensation value is measured on the grant date using payout values derived from a Monte-Carlo valuation model. Estimates used in the Monte Carlo valuation model are considered highly complex and subjective. Compensation expense, net of actual forfeitures, for the RSUs and PSUs is recognized on a straight-line basis over the requisite service periods, which is over the awards’ respective vesting or performance periods which range from one to three years. Other Loss Contingencies In the normal course of business, we are involved in lawsuits, claims and other environmental and legal proceedings and audits. We accrue reserves for these matters when it is probable that a liability has been incurred and the liability can be reasonably estimated. In addition, we disclose, if material, in aggregate, our exposure to loss in excess of the amount recorded on the balance sheet for these matters if it is reasonably possible that an additional material loss may be incurred. We review our loss contingencies on an ongoing basis. Loss contingencies are based on judgments made by management with respect to the likely outcome of these matters and are adjusted as appropriate. Management’s judgments could change based on new information, changes in, or interpretations of, laws or regulations, changes in management’s plans or intentions, opinions regarding the outcome of legal proceedings, or other factors. Index to Financial Statements and Supplementary Data Fresh-Start Accounting Upon our emergence from Chapter 11 bankruptcy, we adopted fresh-start accounting which resulted in our becoming a new entity for financial reporting purposes. We were required to adopt fresh-start accounting upon our emergence from Chapter 11 bankruptcy because (i) the holders of existing voting ownership interests of Berry LLC received less than 50% of the voting shares of Berry Corp. and (ii) the reorganization value of our assets immediately prior to confirmation of the Plan was less than the total of all post-petition liabilities and allowed claims, as shown below: Upon adoption of fresh-start accounting, the reorganization value derived from the enterprise value was allocated to our assets and liabilities based on their fair values in accordance with GAAP. The Effective Date fair values of our assets and liabilities differed materially from their recorded values as reflected on the historical balance sheet. The effects of the Plan and the application of fresh-start accounting were reflected in the financial statements as of February 28, 2017, and the related adjustments thereto were recorded on the statement of operations for the two months ended February 28, 2017. As a result of the adoption of fresh-start accounting and the effects of the implementation of the Plan, our consolidated financial statements subsequent to February 28, 2017 are not comparable to our financial statements prior to February 28, 2017. Our consolidated financial statements and related footnotes are presented with a black line division, which delineates the lack of comparability between amounts presented after February 28, 2017, and amounts presented on or prior to February 28, 2017. Our financial results for future periods following the application of fresh-start accounting will be different from historical trends and the differences may be material. Reorganization Value Under GAAP, Berry Corp. determined a value to be assigned to the equity of the emerging entity as of the date of adoption of fresh-start accounting. The Plan and disclosure statement approved by the Bankruptcy Court did not include an enterprise value or reorganization value, nor did the Bankruptcy Court approve a value as part of its confirmation of the Plan. Our reorganization value was derived from an estimate of enterprise value, or the fair value of our long-term debt, stockholders’ equity and working capital. Reorganization value approximates the fair value of the entity before considering liabilities and approximates the amount a willing buyer would pay for the assets of the entity immediately after the restructuring. Based on the various estimates and assumptions necessary for fresh-start accounting, we estimated our enterprise value as of the Effective Date to be approximately $1.3 billion. The enterprise value was estimated using a sum of parts approach. The sum of parts approach represents the summation of the indicated fair value of the component assets of the Company. The fair value of our assets was estimated by relying on a combination of the income, market and cost approaches. The estimated enterprise value, reorganization value and equity value are highly dependent on the achievement of the financial results contemplated in our underlying projections. While we believe the assumptions and estimates used to develop enterprise value and reorganization value are reasonable and appropriate, different assumptions and estimates could materially impact the analysis and resulting conclusions. Additionally, the assumptions used in estimating these values are inherently uncertain and require judgment. The primary assumptions for which there is a reasonable possibility Index to Financial Statements and Supplementary Data of the occurrence of a variation that would have significantly affected the reorganization value include those regarding pricing, discount rates and the amount and timing of capital expenditures. Our principal assets are our oil and natural gas properties. The fair values of oil and natural gas properties were estimated using a valuation technique consistent with the income approach, specifically the discounted cash flows method. We also used the market approach to corroborate the valuation results from the income approach. We used a market-based weighted-average cost of capital discount rate of 10% for proved and unproved reserves, with further risk adjustment factors applied to the discounted values. The underlying commodity prices embedded in our estimated cash flows are based on the Brent and Henry Hub forward curve pricing, adjusted for estimated location and quality differentials, as well as other factors that we believe will impact realizable prices. Forward curve pricing was used for years 2017 through 2019 and then was escalated at approximately 2.0%. The following table reconciles the enterprise value to the estimated reorganization value as of the Effective Date: The fair value of non-debt liabilities consists of liabilities assumed by Berry Corp. on the Effective Date and excludes the fair value of long-term debt. Consolidated Balance Sheet The adjustments included in the fresh-start consolidated balance sheet in the accompanying financial statements reflect the effects of the transactions contemplated by the Plan and executed on the Effective Date as well as fair value and other required accounting adjustments resulting from the adoption of fresh-start accounting. The explanatory notes provide additional information with regard to the adjustments recorded, methods used to determine the fair values and significant assumptions. Significant Accounting and Disclosure Changes See Note 1 in the Notes to Consolidated Financial Statements in Part II-Item 8. Financial Statements and Supplementary Data of this report for a discussion of new accounting matters. Inflation Inflation in the United States has been relatively low in recent years and did not have a material impact on our results of operations for the periods discussed. Although the impact of inflation has been insignificant in recent years, it is still a factor in the United States economy and we may experience inflationary pressure on the cost of oilfield services and equipment as increasing oil, natural gas and NGL prices increase drilling activity in our areas of operations. An increase in oil, natural gas and NGL prices may cause the costs of materials and services to rise. Index to Financial Statements and Supplementary Data CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS The information included or incorporated by reference in this report includes forward-looking statements that involve risks and uncertainties that could materially affect our expected results of operations, liquidity, cash flows and business prospects. Such statements specifically include our expectations as to our future financial position, liquidity, cash flows, results of operations and business strategy, potential acquisition opportunities, other plans and objectives for operations, capital for sustained production levels, expected production and costs, reserves, hedging activities, capital expenditures, return of capital, improvement of recovery factors and other guidance. Actual results may differ from anticipated results, sometimes materially, and reported results should not be considered an indication of future performance. You can typically identify forward-looking statements by words such as aim, anticipate, achievable, believe, budget, continue, could, effort, estimate, expect, forecast, goal, guidance, intend, likely, may, might, objective, outlook, plan, potential, predict, project, seek, should, target, will or would and other similar words that reflect the prospective nature of events or outcomes. For any such forward-looking statement that includes a statement of the assumptions or bases underlying such forward-looking statement, we caution that, while we believe such assumptions or bases to be reasonable and make them in good faith, assumed facts or bases almost always vary from actual results, sometimes materially. Material risks that may affect us are discussed above in “Item 1A. Risk Factors” in this prospectus, in any applicable prospectus supplement and in the documents incorporated by reference. Factors (but not necessarily all the factors) that could cause results to differ include among others: • volatility of oil, natural gas and NGL prices; • inability to generate sufficient cash flow from operations or to obtain adequate financing to fund capital expenditures, meet our working capital requirements or fund planned investments; • price and availability of natural gas; • our ability to use derivative instruments to manage commodity price risk; • availability or timing of, or conditions imposed on, permits and approvals; • our ability to meet our planned drilling schedule, including due to our ability to obtain permits, and to successfully drill wells that produce oil and natural gas in commercially viable quantities; • the impact of current laws and regulations, and of pending or future legislative and regulatory changes and other government activities, including those related to drilling, completion, well stimulation, operation, maintenance or abandonment of wells or facilities, managing energy, water, land, greenhouse gases or other emissions, protection of health, safety and the environment, or transportation, marketing and sale of our products; • concerns about climate change and other air quality issues; • uncertainties associated with estimating proved reserves and related future cash flows; • our ability to replace our reserves through exploration and development activities; • lower-than-expected production, reserves or resources from development projects or higher-than-expected decline rates; • our ability to obtain timely and available drilling and completion equipment and crew availability and access to necessary resources for drilling, completing and operating wells • changes in tax laws; • effects of competition; • our ability to make acquisitions and successfully integrate any acquired businesses; • market fluctuations in electricity prices and the cost of steam; • asset impairments from commodity price declines; Index to Financial Statements and Supplementary Data • large or multiple customer defaults on contractual obligations, including defaults resulting from actual or potential insolvencies; • geographical concentration of our operations; • our ability to improve our financial results and profitability following our emergence from bankruptcy and other risks and uncertainties related to our emergence from bankruptcy; • impact of derivatives legislation affecting our ability to hedge; • ineffectiveness of internal controls; • catastrophic events; • litigation; • our ability to retain key members of our senior management and key technical employees; and • information technology failures or cyber attacks. Except as required by law, we undertake no responsibility to publicly release the result of any revision of our forward-looking statements after the date they are made. All forward-looking statements, expressed or implied, included in this report are expressly qualified in their entirety by this cautionary statement. This cautionary statement should also be considered in connection with any subsequent written or oral forward-looking statements that we or persons acting on our behalf may issue. Index to Financial Statements and Supplementary Data

<s>[INST] This section of the Form 10K generally discusses 2019 and 2018 items and yeartoyear comparisons between those years. For discussion of our ten months ended December 31, 2017 and two months ended February 28, 2017, as well as the year ended 2018 compared to ten months ended December 31, 2017 and two months ended February 28, 2017, refer to Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of our 2018 Annual Report on Form 10K. Executive Overview We are a western United States independent upstream energy company with a focus on onshore, low geologic risk, longlived, oil reserves in conventional reservoirs. Most of our assets are located in the oilrich reservoirs in the San Joaquin basin of California, which has more than 100 years of production history and substantial remaining oil in place. As a result of the substantial data produced over the basin's long history, its reservoir characteristics are well understood, leading to predictable, repeatable, low geological risk and lowc and, to a lesser extent, in our Rockies assets which include lowcost, oilrich reservoirs in the Uinta basin of Utah and low geologic risk natural gas resource plays in the Piceance basin in Colorado. Successful execution of our strategy across our lowdeclining production base and extensive inventory of identified drilling locations will result in our ability to continue returning capital to our stockholders and demonstrate longterm, capital efficient, consistent, and predictable production growth while living within levered free cash flow. Effective February 18, 2020, Berry Petroleum Corporation changed its name to Berry Corporation (bry) and introduced a new logo. We believe that the name Berry Corporation (bry) is a name that better represents our progressive approach to evolving and growing the business in today’s dynamic oil and gas industry. We are proactively engaging the many forces driving our industry to maximize our assets, create value for shareholders, and support environmental goals that align with a more positive future. One of the more visible elements of our business is our publicly traded stock, and our new logo echoes the public value of the company by using our ticker symbol as an identifiable element of our brand. How We Plan and Evaluate Operations We use Levered Free Cash Flow in planning our capital allocation to sustain production levels and fund internal growth opportunities, as well as determine hedging needs. We define Levered Free Cash Flow as Adjusted EBITDA less capital expenditures, interest expense, and dividends. We use the following metrics to manage and assess the performance of our operations and are part of our incentive program for all employees: (a) Adjusted EBITDA; (b) operating expenses; (c) environmental, health & safety (“EH&S”) results; (d) general and administrative expenses; and (e) production. Adjusted EBITDA Adjusted EBITDA is the primary financial and operating measurement that our management uses to analyze and monitor the operating performance of our business. We define Adjusted EBITDA as earnings before interest expense; income taxes; depreciation, depletion, and amortization (“DD&A”); derivative gains or losses net of cash received or Index to Financial Statements and Supplementary Data paid for scheduled derivative settlements; impairments; stock compensation expense; and other unusual, outofperiod and infrequent items, including restructuring costs and reorganization items. Operating expenses We define operating expenses as lease operating expenses, electricity generation expenses, transportation expenses, and marketing expenses, offset by the thirdparty revenues generated by electricity, transportation and marketing activities, as well as the effect of derivative settlements (received or paid) for gas purchases. Lease operating expenses include fuel, labor, field office, vehicle, supervision, maintenance, tools and supplies, and workover expenses. Taxes other than income taxes are excluded from operating expenses. The electricity, transportation and marketing activity related revenues are viewed and treated internally as a reduction to operating costs when tracking and analyzing the economics of development projects [/INST] Positive. </s>

Tottenham Acquisition I Ltd

2019-03-15

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We were formed on November 13, 2017 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more target businesses. Our efforts to identify a prospective target business will not be limited to any particular industry or geographic region, although the Company intends to focus on operating businesses in the TMT (Technology, Media, Telecom), education, e-commerce, health-care and consumer goods industries with primary operations in Asia (with an emphasis in China). We have not selected any target business for our initial business combination. We presently have no revenue, have had losses since inception from incurring formation costs and have had no operations other than the active solicitation of a target business with which to complete a business combination. We have relied upon the sale of our securities and loans from our officers and directors to fund our operations. On August 6, 2018, the Company consummated its IPO of 4,600,000 Units, which includes the full exercise of the over-allotment option. Each Unit consists of one ordinary share, one redeemable warrant, and one right to receive one-tenth (1/10) of an ordinary share upon the consummation of a business combination. Each redeemable warrant entitles the holder thereof to purchase one-half (1/2) of one ordinary share, and each ten rights entitle the holder thereof to receive one ordinary share at the closing of a business combination. The Units were sold at an offering price of $10.00 per Unit, generating gross proceeds of $46,000,000. Simultaneously with the closing of the IPO, the Company consummated a Private Placement of 215,000 units at a price of $10.00 per Private Unit, generating total proceeds of $2,150,000. A total of $46,000,000 of the net proceeds from the sale of Units in the IPO (including the over-allotment option units) and the Private Placements were placed in a trust account established for the benefit of the Company’s public shareholders. As of December 31, 2018, a total of $46,370,520 was held in a trust account established for the benefit of the Company’s public shareholders, which included $46,000,000 of the net proceeds from the IPO (including the exercise of the over-allotment option) and the Private Placements and subsequent interest income. Our management has broad discretion with respect to the specific application of the net proceeds of the IPO and the Private Placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. Results of Operations Our entire activity from inception up to August 6, 2018 was in preparation for the IPO. Since the IPO, our activity has been limited to the evaluation of business combination candidates, and we will not be generating any operating revenues until the closing and completion of our business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. We expect our expenses to increase substantially after this period. For the year ended December 31, 2018, we had a net income of $19,429, which consisted of operating expenses offset by interest income from our trust account. Operating expenses generally consist of the $10,000 monthly payment to our Sponsor for office and administrative support, monthly professional fees owed to our service providers, travel expenses, Nasdaq market listing fees and amortization of our directors and officers insurance policy. Operating expenses after our initial public offering increased dramatically due to our having commenced operations, and certain professional expenses no longer being charged directly against paid-in-capital on our balance sheet, but now being expensed in the statement of operations. Liquidity and Capital Resources As of December 31, 2018, we had cash outside our trust account of $743,783 available for working capital needs. All remaining cash was held in the trust account and is generally unavailable for our use, prior to the business combination. Our management is of the opinion that we have sufficient funds to meet our working capital requirements and debt obligations as they become due for at least one year from the date of this report. On August 6, 2018, we consummated the IPO of 4,600,000 Units (which includes the full exercise of the underwriter’s over-allotment option), at a price of $10.00 per Unit, generating gross proceeds of $46,000,000. Simultaneously with the closing of the IPO, we consummated the sale of 215,000 Private Units, at a price of $10.00 per Unit, generating gross proceeds of $2,150,000. Following the IPO and the exercise of the over-allotment option, a total of $46,000,000 was placed in the Trust Account. We incurred approximately $1,590,000 in IPO related costs, including $1,150,000 of underwriting fees and approximately $440,000 of IPO Costs. Our liquidity needs have been satisfied to date through receipt of $25,000 from the sale of the insider shares, advances from our Sponsor and an affiliate of our Sponsor in an aggregate amount of $189,929, which were repaid upon our IPO and not outstanding as of December 31, 2018, and the remaining net proceeds from our IPO and Private Placement. We intend to use substantially all of the net proceeds of the IPO, including the funds held in the Trust Account, to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our capital stock is used in whole or in part as consideration to effect our business combination, the remaining proceeds held in the Trust Account, as well as any other net proceeds not expended, will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our business combination if the funds available to us outside of the Trust Account were insufficient to cover such expenses. We anticipate that the funds held outside of our trust account will be sufficient to allow us to operate 12 months from the filing date of this Form 10-K, assuming that a business combination is not consummated during that time. Over this time period, we will be using these funds for identifying and evaluating prospective business combination candidates, performing business due diligence on prospective target businesses, traveling to and from the offices, plants or similar locations of prospective target businesses, reviewing corporate documents and material agreements of prospective target businesses, selecting the target business to consummate our initial business combination with and structuring, negotiating and consummating the business combination. If our estimates of the costs of undertaking in-depth due diligence and negotiating our initial business combination is less than the actual amount necessary to do so, or the amount of interest available to us from the trust account is less than we expect as a result of the current interest rate environment, we may have insufficient funds available to operate our business prior to our initial business combination. Moreover, we may need to obtain additional financing either to consummate our initial business combination or because we become obligated to redeem a significant number of our public shares upon consummation of our initial business combination, in which case we may issue additional securities or incur debt in connection with such business combination. Subject to compliance with applicable securities laws, we would only consummate such financing simultaneously with the consummation of our initial business combination. Following our initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. Off-Balance Sheet Financing Arrangements As of December 31, 2018, we did not have any off-balance sheet arrangements. We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or entered into any non-financial assets. Contractual Obligations At December 31, 2018, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. Critical Accounting Policies Basis of presentation These accompanying financial statements have been prepared in U.S. Dollars in conformity with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, all adjustments (consisting of normal recurring adjustments) have been made that are necessary to present fairly the financial position, and the results of its operations and its cash flows. Use of Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. Cash The Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. There were no cash equivalents as of December 31, 2018. Cash and Investments Held in Trust Account At December 31, 2018, the assets held in the Trust Account are held in cash and US Treasury securities. The Company classifies marketable securities as available-for-sale at the time of purchase and reevaluates such classification as of each balance sheet date. All marketable securities are recorded at their estimated fair value. Unrealized gains and losses for available-for-sale securities are recorded in other comprehensive loss. The Company evaluates its investments to assess whether those with unrealized loss positions are other than temporarily impaired. Impairments are considered other than temporary if they are related to deterioration in credit risk or if it is likely the Company will sell the securities before the recovery of the cost basis. Realized gains and losses and declines in value determined to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the statements of operations. Ordinary Shares Subject To Possible Redemption The Company accounts for its ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Ordinary share subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable ordinary shares (including ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, at December 31, 2018, 3,977,835 ordinary shares subject to possible redemption are presented as temporary equity, outside of the shareholders’ equity section of the Company’s balance sheet. Offering Costs The Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the Public Offering and that were charged to shareholders’ equity upon the completion of the Public Offering. Fair Value of Financial Instruments FASB ASC Topic 820 “Fair Value Measurements and Disclosures” defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. FASB ASC Topic 820 establishes a fair value hierarchy for inputs, which represent the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances. The fair value hierarchy is categorized into three levels based on the inputs as follows: Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment. Level 2 - Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by market through correlation or other means. Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash and cash equivalents, and other current assets, accrued expenses, due to sponsor are estimated to approximate the carrying values as of December 31, 2018 due to the short maturities of such instruments. The following table presents information about the Company’s assets and liabilities that were measured at fair value on a recurring basis as of December 31, 2018, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. *included in cash and investments held in trust account on the Company’s balance sheet. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentration of credit risk consist of cash and trust accounts in a financial institution which, at times may exceed the Federal depository insurance coverage of $250,000. The Company has not experienced losses on these accounts and management believes the Company is not exposed to significant risks on such accounts. Net Income (Loss) Per Share The Company calculates net loss per share in accordance with ASC Topic 260, “Earnings per Share.” Basic loss per share is computed by dividing the net loss by the weighted-average number of ordinary shares outstanding during the period, excluding ordinary shares subject to possible conversion. Diluted loss per share is computed by dividing net loss by the weighted average number of ordinary shares outstanding, plus to the extent dilutive, the incremental number of ordinary shares to settle rights and other ordinary share equivalents (currently none outstanding), as calculated using the treasury stock method. Ordinary shares subject to possible conversion at December 31, 2018, which are not currently redeemable and are not redeemable at fair value, have been excluded from the calculation of basic and diluted loss per share since such shares, if redeemed, only participate in their pro rata share of the Trust Account earnings. The Company has not considered the effect of rights that convert into 220,000 ordinary shares in the unit purchase option sold to the underwriter, in the calculation of diluted loss per share, since the conversion of the rights into ordinary is contingent upon the occurrence of future events. Related Parties Parties, which can be a corporation or individual, are considered to be related if the Company has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operational decisions. Companies are also considered to be related if they are subject to common control or common significant influence. Recent Accounting Pronouncements The Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on the results of operations, financial condition, or cash flows, based on the current information.

<s>[INST] Overview We were formed on November 13, 2017 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more target businesses. Our efforts to identify a prospective target business will not be limited to any particular industry or geographic region, although the Company intends to focus on operating businesses in the TMT (Technology, Media, Telecom), education, ecommerce, healthcare and consumer goods industries with primary operations in Asia (with an emphasis in China). We have not selected any target business for our initial business combination. We presently have no revenue, have had losses since inception from incurring formation costs and have had no operations other than the active solicitation of a target business with which to complete a business combination. We have relied upon the sale of our securities and loans from our officers and directors to fund our operations. On August 6, 2018, the Company consummated its IPO of 4,600,000 Units, which includes the full exercise of the overallotment option. Each Unit consists of one ordinary share, one redeemable warrant, and one right to receive onetenth (1/10) of an ordinary share upon the consummation of a business combination. Each redeemable warrant entitles the holder thereof to purchase onehalf (1/2) of one ordinary share, and each ten rights entitle the holder thereof to receive one ordinary share at the closing of a business combination. The Units were sold at an offering price of $10.00 per Unit, generating gross proceeds of $46,000,000. Simultaneously with the closing of the IPO, the Company consummated a Private Placement of 215,000 units at a price of $10.00 per Private Unit, generating total proceeds of $2,150,000. A total of $46,000,000 of the net proceeds from the sale of Units in the IPO (including the overallotment option units) and the Private Placements were placed in a trust account established for the benefit of the Company’s public shareholders. As of December 31, 2018, a total of $46,370,520 was held in a trust account established for the benefit of the Company’s public shareholders, which included $46,000,000 of the net proceeds from the IPO (including the exercise of the overallotment option) and the Private Placements and subsequent interest income. Our management has broad discretion with respect to the specific application of the net proceeds of the IPO and the Private Placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. Results of Operations Our entire activity from inception up to August 6, 2018 was in preparation for the IPO. Since the IPO, our activity has been limited to the evaluation of business combination candidates, and we will not be generating any operating revenues until the closing and completion of our business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. We expect our expenses to increase substantially after this period. For the year ended December 31, 2018, we had a net income of $19,429, which consisted of operating expenses offset by interest income from our trust account. Operating expenses generally consist of the $10,000 monthly payment to our Sponsor for office and administrative support, monthly professional fees owed to our service providers, travel expenses, Nasdaq market listing fees and amortization of our directors and officers insurance policy. Operating expenses after our initial public offering increased dramatically due to our having commenced operations, and certain professional expenses no longer being charged directly against paidincapital on our balance sheet, but now being expensed in the statement of operations. Liquidity and Capital Resources As of December 31, 2018, we had cash outside our trust account of $743,783 available for working capital needs. All remaining cash was held in the trust account and is generally unavailable for our use, [/INST] Negative. </s>

Tottenham Acquisition I Ltd

2020-03-24

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Overview We were formed on November 13, 2017 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more target businesses. Our efforts to identify a prospective target business will not be limited to any particular industry or geographic region, although the Company intends to focus on operating businesses in the TMT (Technology, Media, Telecom), education, e-commerce, health-care and consumer goods industries with primary operations in Asia (with an emphasis in China). We have not selected any target business for our initial business combination. We presently have no revenue, have had losses since inception from incurring formation costs and have had no operations other than the active solicitation of a target business with which to complete a business combination. We have relied upon the sale of our securities and loans from our officers and directors to fund our operations. On August 6, 2018, the Company consummated its IPO of 4,600,000 Units, which includes the full exercise of the over-allotment option. Each Unit consists of one ordinary share, one redeemable warrant, and one right to receive one-tenth (1/10) of an ordinary share upon the consummation of a business combination. Each redeemable warrant entitles the holder thereof to purchase one-half (1/2) of one ordinary share, and each ten rights entitle the holder thereof to receive one ordinary share at the closing of a business combination. The Units were sold at an offering price of $10.00 per Unit, generating gross proceeds of $46,000,000. Simultaneously with the closing of the IPO, the Company consummated a Private Placement of 215,000 units at a price of $10.00 per Private Unit, generating total proceeds of $2,150,000. A total of $46,000,000 of the net proceeds from the sale of Units in the IPO (including the over-allotment option units) and the Private Placements were placed in a trust account established for the benefit of the Company’s public shareholders. As of December 31, 2019, a total of $48,300,233 was held in a trust account established for the benefit of the Company’s public shareholders, which included $46,000,000 of the net proceeds from the IPO (including the exercise of the over-allotment option) and the Private Placements and subsequent interest income. On July 23, 2019, the Company issued unsecured promissory note in the aggregate principal amount of $460,000 to Norwich in exchange for Norwich depositing such amount into the Company’s trust account in order to extend the amount of time it has available to complete a business combination. On October 25, 2019, the Company issued unsecured promissory note in the aggregate principal amount of $460,000 to Norwich in exchange for Norwich depositing such amount into the Company’s trust account in order to extend the amount of time it has available to complete a business combination. On January 21, 2020, the Company issued the third unsecured promissory note in the aggregate principal amount of $460,000 to Norwich in exchange for Norwich depositing such amount into the Company’s trust account in order to extend the amount of time it has available to complete a business combination. As the date of this Report, we have extended three times the period of time to consummate a business combination until May 6, 2020. Our management has broad discretion with respect to the specific application of the net proceeds of the IPO and the Private Placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. The outbreak of the COVID-19 coronavirus has resulted in a widespread health crisis that has adversely affected the economies and financial markets worldwide, and potential target companies may defer or end discussions for a potential business combination with us whether or not COVID-19 affects their business operations. The extent to which COVID-19 impacts our search for a business combination will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of COVID-19 and the actions to contain COVID-19 or treat its impact, among others. We may be unable to complete a business combination if continued concerns relating to COVID-19 restrict travel, limit the ability to have meetings with potential investors or the target company’s personnel, vendors and services providers are unavailable to negotiate and consummate a transaction in a timely manner. Results of Operations Our entire activity from inception up to August 6, 2018 was in preparation for the IPO. Since the IPO, our activity has been limited to the evaluation of business combination candidates, and we will not be generating any operating revenues until the closing and completion of our business combination. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. We expect our expenses to increase substantially after this period. For the year ended December 31, 2019, we had a net income of $268,703, which consisted of operating expenses offset by interest income from our trust account. Operating expenses generally consist of the $10,000 monthly payment to our Sponsor for office and administrative support, monthly professional fees owed to our service providers, travel expenses, Nasdaq market listing fees and amortization of our directors and officers insurance policy. Operating expenses after our initial public offering increased dramatically due to our having commenced operations, and certain professional expenses no longer being charged directly against paid-in-capital on our balance sheet, but now being expensed in the statement of operations. Liquidity and Capital Resources As of December 31, 2019, we had cash outside our trust account of $429,447 available for working capital needs. All remaining cash was held in the trust account and is generally unavailable for our use, prior to the business combination. Our management is of the opinion that we have sufficient funds to meet our working capital requirements and debt obligations as they become due for at least one year from the issuance date of this report. On August 6, 2018, we consummated the IPO of 4,600,000 Units (which includes the full exercise of the underwriter’s over-allotment option), at a price of $10.00 per Unit, generating gross proceeds of $46,000,000. Simultaneously with the closing of the IPO, we consummated the sale of 215,000 Private Units, at a price of $10.00 per Unit, generating gross proceeds of $2,150,000. Following the IPO and the exercise of the over-allotment option, a total of $46,000,000 was placed in the Trust Account. We incurred approximately $1,590,000 in IPO related costs, including $1,150,000 of underwriting fees and approximately $440,000 of IPO Costs. Our liquidity needs have been satisfied to date through receipt of $25,000 from the sale of the insider shares, advances from our Sponsor and an affiliate of our Sponsor in an aggregate amount of $189,929, which were repaid upon our IPO and not outstanding as of December 31, 2019, and the remaining net proceeds from our IPO and Private Placement. We intend to use substantially all of the net proceeds of the IPO, including the funds held in the Trust Account, to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our capital stock is used in whole or in part as consideration to effect our business combination, the remaining proceeds held in the Trust Account, as well as any other net proceeds not expended, will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our business combination if the funds available to us outside of the Trust Account were insufficient to cover such expenses. We anticipate that the funds held outside of our trust account will be sufficient to allow us to operate 12 months from the filing date of this Form 10-K, assuming that a business combination is not consummated during that time. Over this time period, we will be using these funds for identifying and evaluating prospective business combination candidates, performing business due diligence on prospective target businesses, traveling to and from the offices, plants or similar locations of prospective target businesses, reviewing corporate documents and material agreements of prospective target businesses, selecting the target business to consummate our initial business combination with and structuring, negotiating and consummating the business combination. If our estimates of the costs of undertaking in-depth due diligence and negotiating our initial business combination is less than the actual amount necessary to do so, or the amount of interest available to us from the trust account is less than we expect as a result of the current interest rate environment, we may have insufficient funds available to operate our business prior to our initial business combination. Moreover, we may need to obtain additional financing either to consummate our initial business combination or because we become obligated to redeem a significant number of our public shares upon consummation of our initial business combination, in which case we may issue additional securities or incur debt in connection with such business combination. Subject to compliance with applicable securities laws, we would only consummate such financing simultaneously with the consummation of our initial business combination. Following our initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations. Off-Balance Sheet Financing Arrangements As of December 31, 2019, we did not have any off-balance sheet arrangements. We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or entered into any non-financial assets. Contractual Obligations At December 31, 2019, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. Critical Accounting Policies Basis of presentation These accompanying financial statements have been prepared in U.S. Dollars in conformity with generally accepted accounting principles in the United States of America (“U.S. GAAP”) and pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). In the opinion of management, all adjustments (consisting of normal recurring adjustments) have been made that are necessary to present fairly the financial position, and the results of its operations and its cash flows. Use of Estimates The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates. Cash The Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. There were no cash equivalents as of December 31, 2019 and 2018. Cash and Investments Held in Trust Account At December 31, 2019 and 2018, the assets held in the Trust Account are held in cash and US Treasury securities. The Company classifies marketable securities as available-for-sale at the time of purchase and reevaluates such classification as of each balance sheet date. All marketable securities are recorded at their estimated fair value. Unrealized gains and losses for available-for-sale securities are recorded in other comprehensive loss. The Company evaluates its investments to assess whether those with unrealized loss positions are other than temporarily impaired. Impairments are considered other than temporary if they are related to deterioration in credit risk or if it is likely the Company will sell the securities before the recovery of the cost basis. Realized gains and losses and declines in value determined to be other than temporary are determined based on the specific identification method and are reported in other income (expense), net in the statements of operations. Ordinary Shares Subject To Possible Redemption The Company accounts for its ordinary shares subject to possible redemption in accordance with the guidance in ASC Topic 480 “Distinguishing Liabilities from Equity.” Ordinary share subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable ordinary shares (including ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) are classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. The Company’s ordinary shares feature certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, at December 31, 2019 and 2018, 3,859,050 and 3,977,835 ordinary shares subject to possible redemption, respectively, are presented as temporary equity, outside of the shareholders’ equity section of the Company’s balance sheet. Offering Costs The Company complies with the requirements of the ASC 340-10-S99-1 and SEC Staff Accounting Bulletin (“SAB”) Topic 5A - “Expenses of Offering”. Offering costs consist principally of professional and registration fees incurred through the balance sheet date that are related to the Public Offering and that were charged to shareholders’ equity upon the completion of the Public Offering. Fair Value of Financial Instruments FASB ASC Topic 820 “Fair Value Measurements and Disclosures” defines fair value, the methods used to measure fair value and the expanded disclosures about fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between the buyer and the seller at the measurement date. In determining fair value, the valuation techniques consistent with the market approach, income approach and cost approach shall be used to measure fair value. FASB ASC Topic 820 establishes a fair value hierarchy for inputs, which represent the assumptions used by the buyer and seller in pricing the asset or liability. These inputs are further defined as observable and unobservable inputs. Observable inputs are those that buyer and seller would use in pricing the asset or liability based on market data obtained from sources independent of the Company. Unobservable inputs reflect the Company’s assumptions about the inputs that the buyer and seller would use in pricing the asset or liability developed based on the best information available in the circumstances. The fair value hierarchy is categorized into three levels based on the inputs as follows: Level 1 - Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Valuation adjustments and block discounts are not being applied. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these securities does not entail a significant degree of judgment. Level 2 - Valuations based on (i) quoted prices in active markets for similar assets and liabilities, (ii) quoted prices in markets that are not active for identical or similar assets, (iii) inputs other than quoted prices for the assets or liabilities, or (iv) inputs that are derived principally from or corroborated by market through correlation or other means. Level 3 - Valuations based on inputs that are unobservable and significant to the overall fair value measurement. The fair value of the Company’s certain assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurements and Disclosures,” approximates the carrying amounts represented in the balance sheet. The fair values of cash and cash equivalents, and other current assets, accrued expenses, due to sponsor are estimated to approximate the carrying values as of December 31, 2019 and 2018due to the short maturities of such instruments. The following table presents information about the Company’s assets and liabilities that were measured at fair value on a recurring basis as of December 31, 2019 and 2018, and indicates the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. *included in cash and investments held in trust account on the Company’s balance sheet. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentration of credit risk consist of cash and trust accounts in a financial institution which, at times may exceed the Federal depository insurance coverage of $250,000. The Company has not experienced losses on these accounts and management believes the Company is not exposed to significant risks on such accounts. Net Income (Loss) Per Share The Company calculates net loss per share in accordance with ASC Topic 260, “Earnings per Share.” Basic loss per share is computed by dividing the net loss by the weighted-average number of ordinary shares outstanding during the period, excluding ordinary shares subject to possible conversion. Diluted loss per share is computed by dividing net loss by the weighted average number of ordinary shares outstanding, plus to the extent dilutive, the incremental number of ordinary shares to settle rights and other ordinary share equivalents (currently none outstanding), as calculated using the treasury stock method. Ordinary shares subject to possible conversion at December 31, 2019 and 2018, which are not currently redeemable and are not redeemable at fair value, have been excluded from the calculation of basic and diluted loss per share since such shares, if redeemed, only participate in their pro rata share of the Trust Account earnings. The Company has not considered the effect of rights that convert into 220,000 ordinary shares in the unit purchase option sold to the underwriter, in the calculation of diluted loss per share, since the conversion of the rights into ordinary is contingent upon the occurrence of future events. Related Parties Parties, which can be a corporation or individual, are considered to be related if the Company has the ability, directly or indirectly, to control the other party or exercise significant influence over the other party in making financial and operational decisions. Companies are also considered to be related if they are subject to common control or common significant influence. Recent Accounting Pronouncements The Company has considered all new accounting pronouncements and has concluded that there are no new pronouncements that may have a material impact on the results of operations, financial condition, or cash flows, based on the current information.

<s>[INST] Overview We were formed on November 13, 2017 for the purpose of entering into a merger, share exchange, asset acquisition, stock purchase, recapitalization, reorganization or other similar business combination with one or more target businesses. Our efforts to identify a prospective target business will not be limited to any particular industry or geographic region, although the Company intends to focus on operating businesses in the TMT (Technology, Media, Telecom), education, ecommerce, healthcare and consumer goods industries with primary operations in Asia (with an emphasis in China). We have not selected any target business for our initial business combination. We presently have no revenue, have had losses since inception from incurring formation costs and have had no operations other than the active solicitation of a target business with which to complete a business combination. We have relied upon the sale of our securities and loans from our officers and directors to fund our operations. On August 6, 2018, the Company consummated its IPO of 4,600,000 Units, which includes the full exercise of the overallotment option. Each Unit consists of one ordinary share, one redeemable warrant, and one right to receive onetenth (1/10) of an ordinary share upon the consummation of a business combination. Each redeemable warrant entitles the holder thereof to purchase onehalf (1/2) of one ordinary share, and each ten rights entitle the holder thereof to receive one ordinary share at the closing of a business combination. The Units were sold at an offering price of $10.00 per Unit, generating gross proceeds of $46,000,000. Simultaneously with the closing of the IPO, the Company consummated a Private Placement of 215,000 units at a price of $10.00 per Private Unit, generating total proceeds of $2,150,000. A total of $46,000,000 of the net proceeds from the sale of Units in the IPO (including the overallotment option units) and the Private Placements were placed in a trust account established for the benefit of the Company’s public shareholders. As of December 31, 2019, a total of $48,300,233 was held in a trust account established for the benefit of the Company’s public shareholders, which included $46,000,000 of the net proceeds from the IPO (including the exercise of the overallotment option) and the Private Placements and subsequent interest income. On July 23, 2019, the Company issued unsecured promissory note in the aggregate principal amount of $460,000 to Norwich in exchange for Norwich depositing such amount into the Company’s trust account in order to extend the amount of time it has available to complete a business combination. On October 25, 2019, the Company issued unsecured promissory note in the aggregate principal amount of $460,000 to Norwich in exchange for Norwich depositing such amount into the Company’s trust account in order to extend the amount of time it has available to complete a business combination. On January 21, 2020, the Company issued the third unsecured promissory note in the aggregate principal amount of $460,000 to Norwich in exchange for Norwich depositing such amount into the Company’s trust account in order to extend the amount of time it has available to complete a business combination. As the date of this Report, we have extended three times the period of time to consummate a business combination until May 6, 2020. Our management has broad discretion with respect to the specific application of the net proceeds of the IPO and the Private Placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. The outbreak of the COVID19 coronavirus has resulted in a widespread health crisis that has adversely affected the economies and financial markets worldwide, and potential target companies may defer or end discussions for a potential business combination with us whether or not COVID19 affects their business operations. The extent to which COVID19 impacts our search for a business combination will depend on future developments, which are highly uncertain and cannot be predicted, including [/INST] Negative. </s>

Allegro Merger Corp.

2019-04-01

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our Financial Statements and footnotes thereto contained in this annual report. Forward Looking Statements All statements other than statements of historical fact included in this annual report on Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this annual report on Form 10-K, words such “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forward-looking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this annual report on Form 10-K should be read as being applicable to all forward-looking statements whenever they appear in this annual report. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company in the development stage, formed on August 7, 2017 for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities. Our efforts in identifying a prospective target business are not limited to a particular industry or geographic region of the world. All activity through December 31, 2018 relates to our formation, initial public offering, and search for a prospective initial business combination. Initial Public Offering On July 6, 2018, we closed our initial public offering of 14,950,000 Units, including 1,950,000 Units that were issued pursuant to the exercise in full of the underwriters’ over-allotment option, with each Unit consisting of one share of Common Stock, one Right, and one Warrant. The initial public offering generated gross proceeds of $149,500,000. Simultaneously with the consummation of the initial public offering, we consummated the private placement of 372,500 Private Placement Units at a price of $10.00 per Private Placement Unit, generating gross proceeds of $3,725,000. The Private Placement Units were purchased by the initial stockholders, Cantor, and Chardan. Following the closing of the initial public offering on July 6, 2018, an amount of $149,500,000 ($10.00 per Unit) from the net proceeds of the sale of the Units and Private Placement Units was placed in trust. Continental Stock Transfer & Trust Company is acting as trustee. The trust funds are invested in U.S. government treasury bills, until the earlier of: (i) the consummation of a business combination or (ii) our failure to consummate a business combination by January 6, 2020. Eric Rosenfeld has agreed that he will be liable under certain circumstances to ensure that the proceeds in the trust account are not reduced by the claims of target businesses or vendors or other entities that are owed money by us for services rendered, contracted for or products sold to the Company. However, he may not be able to satisfy those obligations should they arise. Our management has broad discretion with respect to the specific application of the net proceeds of our initial public offering and simultaneous private placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. Critical Accounting Policy The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. The Company has identified the following critical accounting policy: Common stock subject to possible redemption The Company accounts for its common stock shares subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemptions (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, at December 31, 2018, common stock subject to possible redemption is presented as temporary equity, outside of the stockholders’ equity section of the Company’s balance sheet. Recent Accounting Pronouncements In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, Disclosure Update and Simplification, amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders’ equity for interim financial statements. Under the amendments, an analysis of changes in each caption of stockholders’ equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. The Company anticipates its first presentation of changes in stockholders’ equity, in accordance with the new guidance, will be included in its Form 10-Q for the quarter ended March 31, 2019. The Company’s management does not believe that any other recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements. Results of Operations We have neither engaged in any business operations nor generated any revenues to date. Our entire activity from inception up to the closing of our initial public offering on July 6, 2018 was in preparation for that event. Subsequent to the initial public offering, our activity has been limited to the evaluation of business combination candidates, and we will not be generating any operating revenues until the closing and completion of our initial business combination. We have, and expect to continue to generate small amounts of non-operating income in the form of interest income on cash and cash equivalents. Interest income is not expected to be significant in view of current low interest rates on risk-free investments (treasury securities). We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2018, we had net income of approximately $948,493, which consisted of interest income from our trust account of approximately $1,522,523 offset by operating expenses of $203,780 and franchise and income taxes of $63,950 and $306,301 respectively. For the period from August 7, 2017 (Inception) through December 31, 2017, we had net losses of approximately $983, which solely consisted of operating expenses of approximately $983. Our operating expenses principally consisted of expenses related to our public filings and listing and identification and due diligence related to a potential target business, and to general operating expenses including printing, insurance and office expenses. Until we consummate a business combination, we will have no operating revenues. Liquidity and Capital Resources As of December 31, 2018, we had approximately $408,481 in our operating bank account, $125,000 available to be drawn from the Trust Account, approximately $1,522,523 of interest income held in the trust account available to be released to us, and a working capital of approximately $71,935. We presently have no revenue; our net income of approximately $948,493 for the year ended December 31, 2018 consist primarily of interest income on the trust. Through December 31, 2018, our liquidity needs were satisfied through receipt of approximately $766,268 from the sale of the units held outside of the trust account upon closing of the initial public offering, $25,000 from the sale of the founder shares, an advance from Eric Rosenfeld in an amount of $35,000, which was repaid on July 13, 2018 from the proceeds received upon closing of the initial public offering of approximately $600,000 in 2018 for our working capital needs. In order to finance transaction costs in connection with an intended initial business combination and working capital expenses, our initial stockholders, officers, directors or their affiliates may, but are not obligated to, loan us funds as may be required. In the event that the initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts, but no proceeds from our trust account would be used for such repayment. Such loans would be evidenced by promissory notes. The notes would either be paid upon consummation of our initial business combination, without interest, or, at the lender’s discretion, up to $1,000,000 of the notes may be converted upon consummation of our business combination into additional private units at a price of $10.00 per unit. Based on the foregoing, we believe that we will have sufficient working capital and borrowing capacity to meet our needs through the earlier of consummation of a business combination or January 6, 2020. Related Party Transactions Prior to the closing of our initial public offering, Eric Rosenfeld advanced to us an $35,000 to cover expenses related to our formation and the initial public offering, which we repaid on July 13, 2018 from the proceeds received upon closing of the initial public offering. The Company presently occupies office space provided by an entity controlled by the Company’s Chief Executive Officer. Such entity has agreed that until the Company consummates a business combination, it will make such office space, as well as general and administrative services including utilities and administrative support, available to the Company as may be required by the Company from time to time. The Company has agreed to pay an aggregate of $12,500 per month for such services commencing on the effective date of the Initial Public Offering. The Company paid the affiliate $71,786 for such services for the year ended December 31, 2018. In order to finance transaction costs in connection with an intended initial business combination and working capital expenses, our initial stockholders, officers, directors or their affiliates may, but are not obligated to, loan us funds as may be required. In the event that the initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts, but no proceeds from our trust account would be used for such repayment. Such loans would be evidenced by promissory notes. The notes would either be paid upon consummation of our initial business combination, without interest, or, at the lender’s discretion, up to $1,000,000 of the notes may be converted upon consummation of our business combination into additional private units at a price of $10.00 per unit. Off-balance sheet financing arrangements We did not have any off-balance sheet arrangements as of December 31, 2018 and 2017. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than an agreement to pay an affiliate of our executive officers an aggregate monthly fee of $12,500 for office space and office and administrative support provided to the Company. We began incurring these fees upon the consummation of our initial public offering and will continue to incur these fees monthly until the earlier of the completion of a business combination and the Company’s liquidation. Recent Accounting Pronouncements Management does not believe that any recently issued, but not effective, accounting standards, if currently adopted, would have a material effect on our financial statements.

<s>[INST] Forward Looking Statements All statements other than statements of historical fact included in this annual report on Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this annual report on Form 10K, words such “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forwardlooking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this annual report on Form 10K should be read as being applicable to all forwardlooking statements whenever they appear in this annual report. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company in the development stage, formed on August 7, 2017 for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities. Our efforts in identifying a prospective target business are not limited to a particular industry or geographic region of the world. All activity through December 31, 2018 relates to our formation, initial public offering, and search for a prospective initial business combination. Initial Public Offering On July 6, 2018, we closed our initial public offering of 14,950,000 Units, including 1,950,000 Units that were issued pursuant to the exercise in full of the underwriters’ overallotment option, with each Unit consisting of one share of Common Stock, one Right, and one Warrant. The initial public offering generated gross proceeds of $149,500,000. Simultaneously with the consummation of the initial public offering, we consummated the private placement of 372,500 Private Placement Units at a price of $10.00 per Private Placement Unit, generating gross proceeds of $3,725,000. The Private Placement Units were purchased by the initial stockholders, Cantor, and Chardan. Following the closing of the initial public offering on July 6, 2018, an amount of $149,500,000 ($10.00 per Unit) from the net proceeds of the sale of the Units and Private Placement Units was placed in trust. Continental Stock Transfer & Trust Company is acting as trustee. The trust funds are invested in U.S. government treasury bills, until the earlier of: (i) the consummation of a business combination or (ii) our failure to consummate a business combination by January 6, 2020. Eric Rosenfeld has agreed that he will be liable under certain circumstances to ensure that the proceeds in the trust account are not reduced by the claims of target businesses or vendors or other entities that are owed money by us for services rendered, contracted for or products sold to the Company. However, he may not be able to satisfy those obligations should they arise. Our management has broad discretion with respect to the specific application of the net proceeds of our initial public offering and simultaneous private placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. Critical Accounting Policy The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets [/INST] Negative. </s>

Allegro Merger Corp.

2020-02-19

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our Financial Statements and footnotes thereto contained in this annual report. Forward Looking Statements All statements other than statements of historical fact included in this annual report on Form 10-K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this annual report on Form 10-K, words such “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forward-looking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this annual report on Form 10-K should be read as being applicable to all forward-looking statements whenever they appear in this annual report. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company formed on August 7, 2017 for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities. Our efforts in identifying a prospective target business are not limited to a particular industry or geographic region of the world. Initial Public Offering Prior to our initial public offering, we issued to Eric Rosenfeld, our Chief Executive Officer, an aggregate of 4,312,500 shares of common stock in exchange for a capital contribution of $25,000, or approximately $0.01 per share. Mr. Rosenfeld then transferred all of the shares to two trusts for the benefit of his immediate family members, and subsequently, a portion of such shares was transferred to the other initial stockholders in exchange for $0.01 per share. In April 2018, the initial stockholders contributed to capital an aggregate of 575,000 shares for no additional consideration, leaving them with an aggregate of 3,737,500 shares of common stock. On July 6, 2018, we closed our initial public offering of 14,950,000 units, including 1,950,000 units that were issued pursuant to the exercise in full of the underwriters’ over-allotment option, with each unit consisting of one share of common stock, one right, and one warrant. The initial public offering generated gross proceeds of $149,500,000. Simultaneously with the consummation of the initial public offering, we consummated the private placement of 372,500 private placement units at a price of $10.00 per private placement unit, generating gross proceeds of $3,725,000. The private placement units were purchased by the initial stockholders, Cantor, and Chardan. Following the closing of the initial public offering on July 6, 2018, an amount of $149,500,000 ($10.00 per unit) from the net proceeds of the sale of the units and private placement units was placed in the trust account. Continental Stock Transfer & Trust Company is acting as trustee. The trust funds are invested in U.S. government treasury bills, until the earlier of: (i) the consummation of a business combination or (ii) our failure to consummate a business combination by March 31, 2020. Eric Rosenfeld has agreed that he will be liable under certain circumstances to ensure that the proceeds in the trust account are not reduced by the claims of target businesses or vendors or other entities that are owed money by us for services rendered, contracted for or products sold to the Company. However, he may not be able to satisfy those obligations should they arise. Our management has broad discretion with respect to the specific application of the net proceeds of our initial public offering and simultaneous private placement, although substantially all of the net proceeds are intended to be applied generally towards consummating a business combination. Proposed Business Combination On November 8, 2019, we entered into the Merger Agreement with Merger Sub, Holdings, Midco, Rohit Manocha, solely in his capacity as the initial representative of the equityholders of Holdings and Midco. Pursuant to the Merger Agreement, (i) Holdings will effectuate the Distribution, (ii) immediately following the Distribution, the Merger will be consummated, and (iii) immediately following the Merger, the Second Merger will be consummated. Under the Merger Agreement, the equityholders of Midco following the Distribution (which were the equityholders of Holdings prior to the Distribution) will receive an aggregate of $30,000,000 in consideration, in the form of cash and shares of common stock, with the mix of cash and shares of common stock determined at the option of the equityholders. Holders of approximately 86% of the outstanding membership interests of Holdings have elected to receive shares of common stock as consideration in the Merger and holders of approximately 14% of the outstanding membership interests of Holdings have elected to receive cash. Therefore, upon consummation of the Merger, we will issue an aggregate of 2,561,786 shares of common stock and $3,997,919 in cash to the equityholders of Midco. The equityholders of Midco will also have the right to receive up to 2,000,000 shares of common stock upon the first to occur of: (i) Allegro’s adjusted EBITDA equals or exceeds $70,000,000 as reported in Allegro’s annual report on Form 10-K for the year ended December 31, 2020, December 31, 2021, or December 31, 2022 or (ii) the reported last sale price of our common stock equals or exceeds $15.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations or other similar actions) for any 20 trading days in a 30 trading day period at any time after the closing of the Transactions and prior to December 31, 2022. The equityholders of Midco receiving shares of common stock upon the closing of the Transactions will be subject to a lockup period for all shares of common stock received as part of the closing consideration, which terminates on the earlier of (i) December 15, 2020, (ii) our completion of a liquidation, merger, stock exchange, or other similar transaction that results in all holders of our common stock having the right to exchange their shares of common stock for cash or other property, or (iii) the reported closing sale price of our common stock on Nasdaq equals or exceeds $12.00 per share (as adjusted for share splits, share dividends, reorganizations and recapitalizations) for a period of any 20 trading days during a 30-trading day period commencing at least 150 days after the closing of the Transactions. Upon the closing of the Transactions, Cowen will be entitled to a facilitation fee in the amount of (i) $3,800,000 payable by Allegro in cash, (ii) an aggregate of 796,875 shares of common stock to be transferred from David D. Sgro, Eric Rosenfeld 2017 Trust No. 1, Eric Rosenfeld 2017 Trust No. 2, and Gregory Monahan, and (iii) an aggregate of up to an additional 478,125 shares of common stock to be transferred from David D. Sgro, Eric Rosenfeld 2017 Trust No. 1, Eric Rosenfeld 2017 Trust No. 2, and Gregory Monahan, if Allegro requests assistance from Cowen to raise additional capital to satisfy the minimum cash closing condition set forth in the Merger Agreement, with the number of shares of common stock transferrable to be determined by a ratio set forth in the Merger Agreement. For one year after the closing of the Transactions, all shares of common stock transferred to Cowen will continue to be subject to the transfer restrictions applicable to such shares prior to such transfer. The Transactions will result in Allegro acquiring the TGI Fridays business, an American casual dining bar and grill concept. Consummation of the Transactions is subject to customary conditions and covenants of the respective parties, including approval of our stockholders and us having cash on hand of at least $30 million. Further information regarding the proposed business combination, the proposed business of the combined company following consummation of the Transactions and the risks related to the proposed business of the combined company following consummation of the Transactions can be found in our Current Report on Form 8-K filed with the SEC on November 8, 2019, the preliminary proxy statement filed by the Company with the SEC on January 24, 2020, and the definitive proxy statement to be filed by the Company with the SEC. Unless otherwise indicated, the information in this annual report assumes we will not consummate the Transactions, will not find an alternative target with which to consummate an initial business combination, and will be forced to liquidate. Extension Amendment On January 3, 2020, the Company received stockholder approval to extend the date by which it must complete an initial business combination from January 6, 2020 to March 31, 2020. In connection with such extension, holders of 3,782,869 public shares exercised their right to convert their shares into a pro rata portion of the cash held in the trust account and certain of Allegro’s initial stockholders made aggregate contributions of $781,699. Critical Accounting Policy The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. The Company has identified the following critical accounting policy: Common stock subject to possible redemption The Company accounts for its common stock shares subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemptions (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, at December 31, 2019 and 2018, common stock subject to possible redemption is presented as temporary equity, outside of the stockholders’ equity section of the Company’s consolidated balance sheets. Recent Accounting Pronouncements The Company’s management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements. Results of Operations We have neither engaged in any business operations nor generated any revenues to date. Our entire activity up to December 31, 2019 has been related to our company’s formation, the initial public offering, and since the closing of the initial public offering, a search for a business combination candidate and expenses incurred in connection with the proposed business combination with TGI Fridays. We have, and expect to continue to generate small amounts of non-operating income in the form of interest income on cash and cash equivalents. Interest income is not expected to be significant in view of current low interest rates on risk-free investments (treasury securities). We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2019, we had net income of $1,927,147, which consisted of interest income from our trust account of $3,234,522 offset by operating expenses of $523,845 and franchise and income taxes of $132,000 and $651,530, respectively. For the year ended December 31, 2018, we had net income of $948,493, which consisted of interest income from our trust account of $1,522,523 offset by operating expenses of $204,780 and franchise and income taxes of $63,950 and $306,301, respectively. Our operating expenses principally consisted of expenses related to our public filings and listing and identification and due diligence related to a potential target business, and to general operating expenses including printing, insurance and office expenses. Until we consummate a business combination, we will have no operating revenues. Liquidity and Capital Resources We presently have no revenue; our net income of $1,927,147 for the year ended December 31, 2019 consists primarily of interest income on the trust account. Through December 31, 2019, our liquidity needs were satisfied through receipt of $3,234,522 in interest income on the trust account, the proceeds from the consummation of the private placement not held in Trust Account of approximately $766,000, and $25,000 from the sale of the private shares. In order to finance transaction costs in connection with an initial business combination and working capital expenses, our initial stockholders, officers, directors or their affiliates may, but are not obligated to, loan us funds as may be required. In the event that the initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts, but no proceeds from our trust account would be used for such repayment. Such loans would be evidenced by promissory notes. The notes would either be paid upon consummation of our initial business combination, without interest, or, at the lender’s discretion, up to $1,000,000 of the notes may be converted upon consummation of our business combination into additional private placement units at a price of $10.00 per unit. The accompanying financial statements have been prepared assuming we will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the normal course of business. As of December 31, 2019, we had working capital of $101,158 (excluding income taxes and franchise fees which may be paid out of the trust account). Further, we have incurred and expect to continue to incur significant costs in pursuit of our financing and acquisition plans. Our plans to raise capital or to consummate the initial business combination may not be successful. These matters, among others, raise substantial doubt about our ability to continue as a going concern. Based on the foregoing, we currently do not have sufficient cash and working capital to meet our needs through the mandatory liquidation date unless our initial stockholders provide us additional funds for our working capital needs or we obtain other financing. The accompanying financial statements do not include any adjustments that might be necessary if we are unable to continue as a going concern. Related Party Transactions Private Shares In connection with Allegro’s organization in August 2017, Allegro issued to Eric Rosenfeld, the Chief Executive Officer, an aggregate of 4,312,500 shares of common stock in exchange for a capital contribution of $25,000, or approximately $0.01 per share. The foregoing issuance was made pursuant to the exemption from registration contained in Section 4(a)(2) of the Securities Act. Prior to the initial public offering, Mr. Rosenfeld then transferred all of the shares to two trusts for the benefit of his immediate family members, and subsequently, the trusts transferred a portion of such private shares to the other initial stockholders in exchange for $0.01 per share. In April 2018, the initial stockholders contributed to Allegro’s capital an aggregate of 575,000 shares for no additional consideration, leaving them with an aggregate of 3,737,500 private shares. The private shares are identical to the shares of common stock included in the units sold in the initial public offering. However, the initial stockholders have agreed (A) not to transfer, assign or sell any of their private until the earlier to occur of: (i) one year after the completion of Allegro’s initial business combination or (ii) the date on which Allegro completes a liquidation, merger, stock exchange or other similar transaction after the initial business combination that results in all stockholders having the right to exchange their shares of common stock for cash, securities or other property, or (iii) if the last sale price of our common stock equals or exceeds $12.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after Allegro’s initial business combination, and (B) each holder of private shares has agreed to waive his, her or its redemption rights with respect to the private shares, (i) in connection with the consummation of a business combination, (ii) in connection with a stockholder vote to amend Allegro’s charter to modify the substance or timing of Allegro’s obligation to redeem 100% of the public shares if Allegro does not complete an initial business combination by the required deadline, (iii) if Allegro fails to consummate an initial business combination by the required deadline, and (iv) upon Allegro’s liquidation. Additionally, the initial stockholders have agreed to vote their private shares in favor of the initial business combination. Promissory Notes Allegro issued two notes totaling $30,000 in unsecured promissory notes to Eric S. Rosenfeld, Allegro’s Chief Executive Officer, in 2017. On February 5, 2018, Allegro issued a $35,000 principal amount unsecured promissory note to Eric S. Rosenfeld. The notes were non-interest bearing. Due to the short-term nature of these notes, the fair value of the notes approximated their carrying amount. Allegro fully repaid these amounts on July 13, 2018. In connection with the Extension Amendment, Allegro’s initial stockholders and their affiliates contributed to Allegro, pro rata in accordance with their purchases of private placement units, a Contribution in the form of a loan for each public share that is not converted in connection with the stockholder vote to approve the Extension Amendment in an amount of $0.02 as a prorated amount for the partial month of January 2020 and $0.025 for each of February 2020 and March 2020, for an aggregate Contribution of $781,699. The obligation of the insiders to make each Contribution shall be subject to the continued effectiveness of the Merger Agreement as of the Contribution date, or, if the Merger Agreement is earlier terminated, the affirmative majority vote of the board of directors of Allegro requiring such Contribution. If the board of directors determined not to require the Contribution, Allegro would distribute the remaining amounts in the trust account to the then holders of public shares. Subject to the foregoing proviso, each Contribution will be deposited in the trust account established in connection with Allegro’s initial public offering. The first Contribution of $223,343 and a second Contribution of $279,178 was deposited into the trust account on January 6, 2020 and January 31, 2020, respectively. Allegro will deposit the third Contribution on or before February 29, 2020, to the same trust account. The Contributions will not bear any interest and will be repayable by Allegro to the insiders or their affiliates upon consummation of an initial business combination. The loans will be forgiven if Allegro is unable to consummate an initial business combination except to the extent of any funds held outside of Allegro’s trust account. Administrative Service Fee The Company presently occupies office space provided by Crescendo Advisors II, LLC an entity controlled by Eric Rosenfeld, the Company’s Chief Executive Officer. Such entity has agreed that until the Company consummates a business combination, it will make such office space, as well as general and administrative services including utilities and administrative support, available to the Company as may be required by the Company from time to time. The Company has agreed to pay an aggregate of $12,500 per month for such services commencing on the effective date of the initial public offering. The Company paid $150,000 and $71,786, for such services for the years ended December 31, 2019 and 2018, respectively. Private Placement Units Simultaneous with the consummation of the initial public offering, Allegro consummated the private placement of 372,500 private placement units at a price of $10.00 per private placement unit, generating total proceeds of $3,725,000. The private placement units were purchased by the initial stockholders, Cantor, and Chardan. Allegro’s initial stockholders, Cantor, and Chardan have the right to require Allegro to register the private placement units for resale, as described below under “-Registration Rights”. Allegro will bear the costs and expenses of filing any such registration statements. The private placement rights are identical to the rights that were sold as part of the units in Allegro’s initial public offering. The private placement warrants are non-redeemable so long as they are held by the initial stockholders or their permitted transferees. The private placement warrants may also be exercised by the initial stockholders or their permitted transferees, for cash or on a cashless basis. Other than as stated above, the private placement warrants have terms and provisions that are identical to those of the warrants sold as part of the units in Allegro’s initial public offering. The private placement units are not transferrable until 30 days after the consummation of Allegro’s initial business combination; provided, however, that the transfer restrictions will lapse earlier if following the completion of Allegro’s initial business combination Allegro completes a liquidation, merger, stock exchange or other similar transaction that results in all of Allegro’s stockholders having the right to exchange their shares of common stock for cash, securities or other property. Off-balance sheet financing arrangements We did not have any off-balance sheet arrangements as of December 31, 2019 and 2018. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities. As discussed above, we entered into an agreement to pay an affiliate of our Chief Executive Officer an aggregate monthly fee of $12,500 for office space and office and administrative support provided to the Company. We began incurring these fees upon the consummation of our initial public offering and will continue to incur these fees monthly until the earlier of the completion of a business combination and the Company’s liquidation. We have engaged our underwriters as advisors in connection an initial business combination to assist us in holding meetings with our shareholders to discuss the potential business combination and the target business’ attributes, introduce us to potential investors that are interested in purchasing our securities, assist us in obtaining shareholder approval for the business combination and assist us with our press releases and public filings in connection with the business combination. The Company will pay the underwriters a cash fee for such services upon the consummation of our initial business combination in an amount of $5,622,500. In connection with the proposed business combination with TGI Fridays, we engaged Piper Jaffray as an investment advisor to assist us in in identifying and communicating with potential new investors in the combined company and performing other related services. Upon consummation of the proposed business combination we will pay Piper Jaffray an aggregate of $1.1 million which we are permitted to allocate from the deferred underwriting fee.

<s>[INST] Forward Looking Statements All statements other than statements of historical fact included in this annual report on Form 10K including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this annual report on Form 10K, words such “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other SEC filings. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forwardlooking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this annual report on Form 10K should be read as being applicable to all forwardlooking statements whenever they appear in this annual report. Actual results could differ materially from those contemplated by the forward looking statements as a result of certain factors detailed in our filings with the SEC. All subsequent written or oral forward looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company formed on August 7, 2017 for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or other similar business combination with one or more businesses or entities. Our efforts in identifying a prospective target business are not limited to a particular industry or geographic region of the world. Initial Public Offering Prior to our initial public offering, we issued to Eric Rosenfeld, our Chief Executive Officer, an aggregate of 4,312,500 shares of common stock in exchange for a capital contribution of $25,000, or approximately $0.01 per share. Mr. Rosenfeld then transferred all of the shares to two trusts for the benefit of his immediate family members, and subsequently, a portion of such shares was transferred to the other initial stockholders in exchange for $0.01 per share. In April 2018, the initial stockholders contributed to capital an aggregate of 575,000 shares for no additional consideration, leaving them with an aggregate of 3,737,500 shares of common stock. On July 6, 2018, we closed our initial public offering of 14,950,000 units, including 1,950,000 units that were issued pursuant to the exercise in full of the underwriters’ overallotment option, with each unit consisting of one share of common stock, one right, and one warrant. The initial public offering generated gross proceeds of $149,500,000. Simultaneously with the consummation of the initial public offering, we consummated the private placement of 372,500 private placement units at a price of $10.00 per private placement unit, generating gross proceeds of $3,725,000. The private placement units were purchased by the initial stockholders, Cantor, and Chardan. Following the closing of the initial public offering on July 6, 2018, an amount of $149,500,000 ($10.00 per unit) from the net proceeds of the sale of the units and private placement units was placed in the trust account. Continental Stock Transfer & Trust Company is acting as trustee. The trust funds are invested in U.S. government treasury bills, until the earlier of: (i) the consummation of a business combination or (ii) our failure to consummate a business combination by March 31, 2020. Eric Rosenfeld has agreed that he will be liable under certain circumstances to ensure that the proceeds in the trust account are not reduced by the claims of target businesses or vendors or other entities that are owed money by us for services rendered, contracted for or products sold to the Company [/INST] Positive. </s>

Carbon Black, Inc.

2019-03-08

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. As discussed in the section titled "Special Note Regarding Forward-Looking Statements," the following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those discussed below. Factors that could cause or contribute to such difference include, but are not limited to, those identified below and those discussed in the section titled "Risk Factors" and elsewhere in this Annual Report on Form 10-K. Overview Carbon Black is a leading, global provider of cloud-delivered, next-generation endpoint security solutions. As an innovator in the Endpoint Protection Platform (EPP) market, our technology enables customers to address the complete endpoint security lifecycle and stay ahead of advanced cyberattacks. Our big data and analytics platform, the CB Predictive Security Cloud (PSC), consolidates endpoint security and IT operations into an extensible cloud platform that prevents advanced threats, provides actionable insight and enables businesses of all sizes to simplify operations. By analyzing billions of security events per day across the globe, Carbon Black has key insights into attackers’ behavior patterns, enabling customers to detect, respond to and prevent emerging attacks. We believe the depth, breadth and real-time nature of our unfiltered endpoint data, combined with the analytic power of our Predictive Security Cloud platform, provides customers with world-class security efficacy and operational efficiency. Organizations globally are re-platforming their IT operations by investing in cloud computing and workforce mobility, which has resulted in enterprise environments that are more open, interconnected, and vulnerable to cyber attacks. Today, an increasingly mobile workforce and the explosion of enterprise data and applications in the cloud have expanded the attack surface beyond the traditional network perimeter. In response, attackers have adapted their methods and tools to directly target the endpoint. In short, the endpoint is the new perimeter. Endpoints are the primary focus of attacks because they store valuable data that attackers seek to steal; perform critical operations that attackers seek to disrupt; and are the interface where attackers can target humans through email, social engineering and other tactics. Endpoints are the physical and virtual locations where sensitive data resides and include desktops, laptops, servers, virtual machines, cloud workloads (services running on cloud servers), containers, fixed-function devices such as ATMs, point of sale systems, and control and data systems for power plants and other industrial assets. Our approach to solving these endpoint security challenges focuses on leveraging our big data and our security analytics platform in the cloud (the CB Predictive Security Cloud) to better detect and prevent the behaviors and specific techniques used by attackers. Based on our experience and investment in next-generation solutions designed to address the full endpoint security lifecycle, we have developed a highly differentiated technology approach with four main pillars: (1) unfiltered data collection, (2) proprietary data shaping technology, (3) streaming analytics, and (4) extensible open architecture. We began selling our initial product in 2005, which was the precursor to CB Protection. Our initial product focused on delivering endpoint protection for desktops and servers through application control. In February 2014, we acquired Carbon Black, whose solution was the precursor to CB Response. The acquisition of Carbon Black strengthened our position as a leader in advanced threat detection and incident response management solutions, and was an important event for us as it enabled us to provide our customers with solutions designed to address the full endpoint security lifecycle. We believe that our ability to address the full lifecycle of an attack is a critical differentiator versus other endpoint security technologies that address only a portion of the attack lifecycle. In more recent periods, we have focused on satisfying the increasing demand for cloud-based software from our customers and prospects and intend to continue to expand our cloud-based product offerings. In August 2015, we released a cloud-based version of CB Response to our customers under a software-as-a-service, or SaaS, model. In June 2016, we acquired Confer Technologies, Inc., or Confer, whose solution is currently sold to customers as CB Defense. The acquisition of Confer was an important event for us as it added key capabilities in the areas of cloud-based, multi-tenant, big-data processing and streaming detection and prevention. With this acquisition, we also entered the next-generation antivirus market. The technology that we acquired in this acquisition is foundational to our predictive security cloud platform, which is designed to address the full endpoint security lifecycle, and to our strategy. For more information regarding the Confer acquisition, see Note 3 to our consolidated financial statements at the end of this Annual Report on Form 10-K. The percentage of our total revenue generated by sales of our cloud-based solutions was 29% in 2018, 16% in 2017 and 6% in 2016. We have experienced growth in the number of customers who purchase our cloud-based solutions, with 2,851 customers in 2018, up from 1,605 customers in 2017, and 398 customers in 2016. A substantial majority of our customers purchase our solutions under a subscription license. Our subscription licenses include: access to and the right to utilize the threat intelligence capabilities of the CB Predictive Security Cloud; ongoing support, which provides our customers with telephone and web-based support, bug fixes and repairs; and software updates on a when-and-if-available basis. Additionally, a substantial amount of those customers who purchase licenses on a perpetual basis also purchase an agreement for access to and the right to utilize the threat intelligence capabilities of the CB Predictive Security Cloud. Subscription (i.e. term-based) revenue is recognized on a ratable basis over the contract term beginning on the date the software is delivered to the customer. Revenue for cloud-based subscriptions is recognized on a ratable basis over the term of the subscription beginning on the date the customer is given access to the platform. Maintenance services and customer support revenue related to subscription licenses is recognized ratably over the term of the maintenance and support arrangement as this performance obligation is satisfied. Revenue from the infrequent sales of perpetual software licenses is recognized ratably over the customer’s estimated economic life, which we have estimated to be five years, beginning on the date the software is delivered to the customer. Maintenance services and customer support revenue related to perpetual licenses is recognized ratably over the term of the maintenance and support arrangement as this performance obligation is satisfied. Revenue from perpetual licenses represented less than 5% of our $198.5 million of subscription, license and support revenue in 2018. Due to our revenue recognition model, all of our subscription, license and support revenue is recognized on a ratable basis, providing us with strong visibility into future revenue. We primarily sell our products through a channel partner go-to-market model, which significantly extends our global market reach and ability to rapidly scale our sales efforts. Our inside sales and field sales representatives work alongside an extensive network of value-added resellers, or VARs, distributors, managed security service providers, or MSSPs, and incident response, or IR, firms. Our MSSP and IR firm channel partners both use and recommend our products to their clients. We have established significant relationships with leading channel partners, including Optiv Security, Inc., a leading VAR and MSSP; CDW Corporation, one of the world’s largest software VARs; Arrow Electronics, Inc., a major global distributor; SecureWorks, Inc., a leading MSSP; and Kroll, a leading IR firm. For the three months and year ended December 31, 2018, 83% and 80%, respectively, of our new and add-on business was closed in collaboration with a channel partner. We expect to continue to focus on generating sales to new and existing customers through our channel partners as a part of our growth strategy. When we transact with a channel partner, our contractual arrangement is with the channel partner and not with the end-use customer. However, whether we receive the order from a channel partner or directly from an end-use customer, our revenue recognition policy and resulting pattern of revenue recognition for the order are the same. Our sales team works closely with our end-use customer prospects at every stage of the sales cycle regardless of whether the prospect is sourced directly or indirectly-from initial information meetings through the implementation of our products with our end-use customers. We believe this coordinated approach to sales allows us to leverage the benefits of channel partners as well as maintain face-to-face connectivity and build long-term, trusted relationships with our customers. Our customers include many of the world’s largest, security-focused enterprises and government agencies that are among the most heavily targeted by cyber adversaries, as well as mid-sized organizations. As of December 31, 2018, we serve over 5,000 customers globally across multiple industries, including 34 of the Fortune 100. We have experienced revenue growth, with revenue increasing to $209.7 million in 2018, up from $160.8 million in 2017, and $112.9 million in 2016. This represents a 36% compound annual growth rate over the same period. We have a subscription-based revenue model that provides visibility into future revenue. Recurring revenue, a non-GAAP financial measure, represented 92%, 89% and 84% of our total revenue in 2018, 2017 and 2016, respectively. Annual recurring revenue, or ARR, was $217.0 million, $174.2 million and $124.2 million as of December 31, 2018, 2017 and 2016, respectively. We define ARR, a non-GAAP financial measure, as the annualized value of all active subscription contracts as of the end of the period. ARR excludes revenue from perpetual licenses and services. The portion of ARR related to our cloud-based subscription contracts was $81.3 million, $46.0 million, and $15.1 million as of December 31, 2018, 2017 and 2016, respectively. The percentage of our total recurring revenue generated by sales of our cloud-based solutions was 31%, 18%, and 7% in 2018, 2017 and 2016, respectively. We incurred net losses of $82.1 million, $53.2 million, and $44.7 million in 2018, 2017, and 2016, respectively, as we continued to invest for growth to address the large market opportunity for our platform. In May 2018, we closed our initial public offering, or IPO, of 9,200,000 shares of common stock inclusive of the underwriters’ option to purchase additional shares that was exercised in full. The price per share to the public was $19.00 per share. We received aggregate proceeds of $162.6 million from the IPO, net of underwriters’ discounts and commissions, and before deducting offering costs of $4.9 million. Effective January 1, 2018, we adopted the requirements of Accounting Standards Update, or ASU, No. 2014-09, Revenue from Contracts with Customers (Topic 606), or ASC 606 on a full retrospective basis as discussed in detail in Note 2 to our unaudited consolidated financial statements. All amounts and disclosures set forth in this Annual Report on Form 10-K have been updated to comply with ASC 606. We believe that the growth of our business and our operating results will be dependent upon many factors, including our ability to capitalize on the market shift from legacy prevention offerings to next-generation endpoint security solutions, our success in growing our customer base and expanding deployments of our platform within existing customers, our ability to enhance our platform and product offerings, and our focus on maintaining strong retention rates. While these areas present significant opportunities for us, they also pose challenges and risks that we must successfully address in order to sustain the growth of our business and improve our operating results. We have experienced rapid growth and increased demand for our products over the last few years. To manage any future growth effectively, we must continue to improve and expand our information technology and financial infrastructure, our operating and administrative systems and controls, and our ability to manage headcount, capital and processes in an efficient manner. Additionally, we face intense competition in our market, and to succeed, we need to innovate and offer products that are differentiated from legacy antivirus products, established network security products and point solutions provided by smaller security providers. We must also effectively hire, retain, train and motivate qualified personnel and senior management. If we are unable to successfully address these challenges, our business, operating results and prospects could be adversely affected. Our marketing is focused on building our brand reputation, increasing market awareness of our platform, driving customer demand and a strong sales pipeline, and collaborating with our channel partners around the globe. Key Factors Affecting Our Performance Our historical financial performance has been, and we expect our financial performance in the future to be, primarily driven by the following factors: Market Adoption. We believe our future success will depend, in large part, on the market for next-generation endpoint security. Because network-centric security is no longer adequate, organizations must focus on securing the endpoint. However, while organizations have made significant investments in upgrading to advanced network security solutions, the majority of endpoint security technology in use today relies on multiple agents and uses ineffective, traditional signature-based antivirus software. As a result, organizations are increasingly shifting their security budgets toward next-generation endpoint security solutions. We believe that we are well positioned as a market leader to capitalize on this investment cycle and that our ability to address the full lifecycle of a cyber attack will help to drive our market adoption. Additionally, the number of security professionals has not kept pace with total demand. As the number of threats multiplies, legacy solutions either miss threats or produce more alerts than security teams are able to process and investigate. Organizations are increasingly turning to next-generation solutions, advanced analytics and automation tools to empower their security professionals to increase their efficiency and focus on the highest value cyber security tasks, thereby reducing the need for additional security headcount. Organizations are also addressing the talent gap by relying more on security-focused VARs and trusted partners to augment their internal teams of security experts. Add New Customers. Our ability to add new customers is a key indicator of our increasing market adoption and future revenue potential. Our customer count, which includes both direct sale customers and customers with one or more subscriptions to our platform through channel partners, grew to 5,025 in 2018, up from 3,739 in 2017, and 2,516 in 2016, representing year-over-year increases of 34% in 2018 and 49% in 2017. We expect this trend to continue in future periods as we focus on adding new customers and renewing existing customers through our channel partners. We are focused on continuing to grow our customer base. We have continuously enhanced our endpoint security platform and product offerings, and we have expanded both our domestic and international sales force to drive new customer acquisition. However, our ability to continue to grow our customer base is dependent on a number of factors, including our ability to compete within the increasingly competitive markets in which we participate. Maintain Strong Retention Rates. An important component of our revenue growth strategy is to have our existing customers renew their agreements with us. To assess our performance against this objective, we monitor the retention rate of our existing customers. We calculate retention rate by comparing the annual recurring subscription and support revenue from our customers at the beginning of a measurement period to the annual recurring subscription and support revenue from those same customers at the end of a measurement period. We divide the ending annual recurring revenue by the beginning annual recurring revenue to arrive at our retention rate metric. We exclude the impact of any add-on purchases from these customers during the measurement period; accordingly, our retention rate cannot exceed 100%. In addition, the metric reflects the loss of customers who elected not to renew contracts expiring during the measurement period. Our retention rate was 87% in 2018, 93% in 2017, and 92% in 2016. Increase Sales to Existing Customers. Our current customer base provides us with a significant opportunity to drive incremental sales. Our extensible platform allows us to develop new solutions rapidly and at lower cost over time. As we develop and deploy additional security offerings on the CB Predictive Security Cloud platform, we see significant additional opportunity to cross-sell as customers benefit by addressing multiple security requirements through a single platform. Our ability to increase sales to existing customers will depend on a number of factors, including customers’ satisfaction or dissatisfaction with our solutions, our ability to develop new products, pricing, economic conditions or overall reductions in our customers’ spending levels. Invest in Growth. We will continue to focus on long-term revenue growth. We believe that our market opportunity is large and we will continue to invest significantly in research and development to enhance our technology platform and product functionality. We also expect to continue to invest in sales and marketing to grow our customer base, both domestically and internationally. In addition to our ongoing investment in research and development, we may also pursue acquisitions of businesses, technologies and assets that complement and expand the functionality of our products and services, expand the functionality of our solutions, add to our technology or security expertise, or bolster our leadership position by gaining access to new customers or markets. Key Metrics We regularly monitor a number of financial and operating metrics, including the following key metrics, in order to measure our current performance and estimate our future performance, as follows: Billings. We define billings, a non-GAAP financial measure, as total revenue plus the change in deferred revenue during the period, excluding acquired deferred revenue. Our deferred revenue consists of amounts that have been invoiced to customers but that have not yet been recognized as revenue. Our deferred revenue balance primarily consists of the portion of products and support revenue that will be recognized ratably over the term of the subscription as the performance obligation is satisfied. Most of our revenue is derived from subscriptions to our products with a duration of one or three years. For our subscription arrangements, we typically bill our customers the fee on an annual basis for the upcoming year. For 2017, we changed our policy to require customers with multi-year contract commitments to agree to multi-year upfront billing for the total contract fee. In 2018, we reverted to our former standard practice to bill multi-year contracts on an annual basis, which resulted in lower upfront multi-year billings as compared to 2017. Some of our revenue is derived from perpetual licenses of our products sold with a maintenance and support agreement. For our perpetual licenses, we bill our customers the entire license fee upon delivery of the software, and for support, we typically bill our customers the support fee on an annual basis for the upcoming year. For services sold on a fixed-price basis, we bill customers in advance. For services sold on a time-and-materials basis, we bill customers as such services are performed. We use billings as one factor to evaluate our business because billings is an indicator of current period sales activity and provides visibility into corresponding future revenue growth due to our subscription-based revenue model. Accordingly, we believe that billings provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management. However, it is important to note that billings, in any period, may be impacted by the timing of customer renewals, including early renewals, and customers’ preferences for multi-year upfront or annual billing terms, which could favorably or unfavorably impact year-over-year comparisons. While we believe that billings is useful in evaluating our business, billings is a non-GAAP financial measure that has limitations as an analytical tool, and billings should not be considered as an alternative to, or substitute for, total revenue recognized in accordance with GAAP. In addition, other companies, including companies in our industry, may calculate billings differently or not at all, which reduces the usefulness of billings as a tool for comparison. We recommend that you review the reconciliation of billings to total revenue, the most directly comparable GAAP financial measure, provided below, and that you not rely on billings or any single financial measure to evaluate our business. Short-term billings. We define short-term billings, a non-GAAP financial measure, as total revenue plus the change in current deferred revenue during the period, excluding acquired deferred revenue. We believe that short-term billings provides useful information to investors and others in evaluating our operating performance because it excludes the impact of upfront multi-year billings, which can vary from period to period depending on the timing of large, multi-year customer contracts and customer preferences for annual billing versus multi-year upfront billing. However, it is important to note that short-term billings, in any period, may be impacted by the timing of customer renewals, including early renewals, which could favorably or unfavorably impact year-over-year comparisons. While we believe that short-term billings is useful in evaluating our business, short-term billings is a non-GAAP financial measure that has limitations as an analytical tool, and short-term billings should not be considered as an alternative to, or substitute for, total revenue recognized in accordance with GAAP. In addition, other companies, including companies in our industry, may calculate short-term billings differently or not at all, which reduces the usefulness of short-term billings as a tool for comparison. We recommend that you review the reconciliation of short-term billings to total revenue, the most directly comparable GAAP financial measure, provided below, and that you not rely on short-term billings or any single financial measure to evaluate our business. Recurring revenue. We define recurring revenue, a non-GAAP financial measure, as subscription, license and support revenue (which includes revenue relating to support for perpetual licenses) less perpetual license revenue for the period. We use recurring revenue as one factor to evaluate our business because we believe that recurring revenue provides visibility into the revenue expected to be recognized in the current and future periods. Accordingly, we believe that recurring revenue provides useful information to investors and others in understanding and evaluating our operating results in the same manner as our management. While we believe that recurring revenue is useful in evaluating our business, recurring revenue is a non-GAAP financial measure that has limitations as an analytical tool, and recurring revenue should not be considered as an alternative to, or substitute for, subscription, license and support revenue recognized in accordance with GAAP. In addition, other companies, including companies in our industry, may calculate recurring revenue differently or not at all, which reduces the usefulness of recurring revenue as a tool for comparison. We recommend that you review the reconciliation of recurring revenue to subscription, license and support revenue, the most directly comparable GAAP financial measure, provided below, and that you not rely on recurring revenue or any single financial measure to evaluate our business. The percentage of our total recurring revenue generated by sales of our cloud-based solutions was 31% in 2018, 18% in 2017, and 7% in 2016. Free cash flow and free cash flow margin. We define free cash flow, a non-GAAP financial measure, as net cash used in operating activities less purchases of property and equipment and capitalized internal-use software. We define free cash flow margin as free cash flow divided by total revenue. For the 2016 free cash flow calculation, we have also excluded the impact of the management incentive liability payment as this payment was not part of our core operating results. See Note 15 to our consolidated financial statements included in this Annual Report on Form 10-K. We monitor free cash flow as one measure of our overall business performance, which enables us to analyze our future performance without the effects of non-cash items and allow us to better understand the cash needs of our business. While we believe that free cash flow is useful in evaluating our business, free cash flow is a non-GAAP financial measure that has limitations as an analytical tool, and free cash flow should not be considered as an alternative to, or substitute for, net cash used in operating activities in accordance with GAAP. The utility of free cash flow as a measure of our liquidity is further limited as it does not represent the total increase or decrease in our cash balance for any given period. In addition, other companies, including companies in our industry, may calculate free cash flow differently or not at all, which reduces the usefulness of free cash flow as a tool for comparison. A summary of our cash flows from operating, investing and financing activities is provided below. We recommend that you review the reconciliation of free cash flow to net cash used in operating activities, the most directly comparable GAAP financial measure, and the reconciliation of free cash flow margin to net cash used in operating activities (as a percentage of revenue), the most directly comparable GAAP financial measure, provided below, and that you not rely on free cash flow, free cash flow margin or any single financial measure to evaluate our business. As discussed above, beginning in 2018, we reverted to our former policy of offering customers who make multi-year contract commitments the option to be billed the total contract fee upfront or to be billed on an annual basis. During 2018, many customers who made a multi-year contract commitment selected to be billed on an annual basis, which resulted in less benefit to free cash flow in 2018 compared to 2017. Non-GAAP operating loss. We define non-GAAP operating loss as loss from operations excluding stock-based compensation and amortization of acquired intangible assets. For the year ended December 31, 2018, we have also excluded from non-GAAP operating loss the $3.9 million expense related to the payments we agreed to make in 2018 pursuant to the Finjan legal settlement. See Note 15 to our consolidated financial statements included in this Annual Report on Form 10-K. We consider non-GAAP operating loss to be a useful metric for investors and other users of our financial information in evaluating our operating performance because it excludes the impact of stock-based compensation and amortization of acquired intangible assets, each of which is a non-cash charge that can vary from period to period for reasons that are unrelated to our core operating performance, and expense recorded by us pursuant to the legal settlement because it is a non-recurring item. While we believe that non-GAAP operating loss is useful in evaluating our business, non-GAAP operating loss is a non-GAAP financial measure that has limitations as an analytical tool, and non-GAAP operating loss should not be considered as an alternative to, or substitute for, loss from operations in accordance with GAAP. In addition, other companies, including companies in our industry, may calculate non-GAAP operating loss differently or not at all, which reduces the usefulness of non-GAAP operating loss as a tool for comparison. We recommend that you review the reconciliation of non-GAAP operating loss to loss from operations, the most directly comparable GAAP financial measure, provided below, and that you not rely on non-GAAP operating loss or any single financial measure to evaluate our business. Components of Results of Operations Revenue We generate revenue through relationships with channel partners and through our direct sales force primarily from three sources: (i) the sale of subscription (i.e., term-based) and perpetual licenses for our CB Protection and CB Response software products along with access to and the right to utilize the threat intelligence capabilities of the CB Predictive Security Cloud, as well as maintenance services and customer support, collectively referred to as support, (ii) cloud-based software-as-a-service, or SaaS, subscriptions for access to our CB Predictive Security Cloud software products and CB Response Cloud, and (iii) professional services and training, collectively referred to as services. Subscription, License and Support Our CB Protection and CB Response products are offered through subscription or perpetual software licenses, with a substantial majority of our customers selecting a subscription license. Subscription licenses include access to and the right to utilize the threat intelligence capabilities of the CB Predictive Security Cloud as well as ongoing support, which provides our customers with telephone and web-based support, bug fixes and repairs and software updates on a when-and-if-available basis. Substantially all customers who purchase licenses on a perpetual basis also purchase an agreement for access to and the right to utilize the threat intelligence capabilities of the CB Predictive Security Cloud. Subscription (i.e. term-based) revenue is recognized on a ratable basis over the contract term beginning on the date the software is delivered to the customer. Maintenance services and customer support revenue related to subscription licenses is recognized ratably over the term of the maintenance and support arrangement as this performance obligation is satisfied. Revenue from the infrequent sales of perpetual software licenses is recognized ratably over the customer’s estimated economic life, which we have estimated to be five years, beginning on the date the software is delivered to the customer. Maintenance services and customer support revenue related to perpetual licenses is recognized ratably over the term of the maintenance and support arrangement as this performance obligation is satisfied. During 2015, we began offering our CB Response product through cloud-based subscriptions. During 2016, we began offering our CB Defense product, a cloud-based next-generation antivirus solution, representing our first offering on the CB Predictive Security Cloud Platform. During 2018, we launched four new products on the CB Predictive Security Cloud Platform: CB ThreatSight, CB Defense for VMWare, CB LiveOps and CB ThreatHunter. Revenue for cloud-based subscriptions is deferred on our balance sheet and subsequently recognized as revenue ratably over the term of the subscription. Our term-based and cloud-based subscription agreements and perpetual license support agreements typically have one- or three-year terms. For multi-year arrangements, we typically bill on an annual basis. Prior to 2017, we typically billed multi-year arrangements on an annual basis. For 2017, we changed our policy to require customers with multi-year contract commitments to agree to multi-year upfront billing for the total contract fee. Beginning in 2018, we reverted to our former policy and offered customers who make a multi-year contract commitment the option to be billed the total contract fee upfront or to be billed on an annual basis. Services We generate services revenue from the sale of professional services related to deployment and training services. Customers primarily purchase our professional services together with our product offerings and, to a lesser extent, on a stand-alone basis. Services are typically sold together with licenses of our software products and, to a lesser extent, on a stand-alone basis. Services are priced separately and are considered distinct from our software license. The professional services can be performed by a third party and have a history of consistent pricing by us. Professional services are sold as time-and-materials contracts based on the number of hours worked and at contractually agreed-upon hourly rates, and also on a fixed-fee basis. Revenue from professional services and training sold on a stand-alone basis or in a combined arrangement is recognized as those services are rendered as control of the services passes to the customer over time. As more customers select our cloud-based offerings, we expect our services revenue to decrease in absolute dollars and decrease as a percentage of total revenue over time as our cloud-based offerings are typically easier to deploy. Cost of Revenue Our total cost of revenue consists of the costs of subscription, license and support revenue as well as the costs of services revenue. Cost of Subscription, License and Support Revenue Cost of subscription, license and support revenue consists of hosting costs associated with our cloud-based offerings, personnel-related costs for our support and hosting personnel, including salaries, benefits, bonuses, payroll taxes, stock-based compensation and allocated overhead costs. Also included in cost of subscription, license and support revenue are costs associated with amortization of capitalized software development costs for internal-use software and amortization of developed technology intangible assets related to our prior acquisitions. We expect cost of subscription, license and support revenue to increase on an absolute dollar basis in the near term due to the acceleration of our cloud-based offerings. We will incur additional personnel-related costs, including salaries, benefits, bonuses, payroll taxes, stock-based compensation and allocated overhead costs, for employees who support our cloud-based subscriptions and hosting services. The hosting costs for our cloud-based offerings will also increase as the number of customers who purchase our cloud-based offerings increases. We expect gross margin on our subscription, license and support revenue to decline as more customers purchase our cloud-based offerings at a comparable rate to the decline from 2017 to 2018. Cost of Services Revenue Cost of services revenue consists of personnel-related costs for our professional services team, including salaries, benefits, bonuses, payroll taxes, stock-based compensation, travel expenses and allocated overhead costs. We recognize the costs of providing services when we incur them. We expect cost of services revenue to decrease as more customers purchase our cloud-based subscription products, which require fewer deployment services as they are typically easier to deploy than our on-premise solutions. Operating Expenses Operating expenses consist of sales and marketing, research and development, and general and administrative expenses. Sales and Marketing Expense Sales and marketing expense consists of personnel-related costs for our sales and marketing teams, including salaries, benefits, amortization of deferred commissions, bonuses, payroll taxes, stock-based compensation and other related costs. Additional expenses include costs of marketing activities and promotional events, travel, amortization of trade name and customer relationship intangible assets related to our prior acquisitions, and allocated overhead costs. We capitalize commission costs that are incremental and directly related to the acquisition of customer agreements. Commissions are earned by our sales force and paid in full upon the receipt of customer orders, or bookings, for new and add-on arrangements or renewals. Commission costs are capitalized when earned and are amortized as expense over an estimated customer relationship period of five years. In addition to our field sales staff, we have a dedicated channel team that works with our field and inside sales organizations to manage our relationships with channel partners and work with our channel partners to win end-use customers. As a result, our sales team works closely with our end-use customer prospects at every stage of the sales cycle regardless of whether the prospect is sourced directly or indirectly-from initial information meetings through the implementation of our products. This sales approach allows us to leverage the benefits of the channel while also building long-term, trusted relationships with our customers. Additionally, we believe this approach delivers the security expertise and support that leads to full realization of the benefits of our technology platform. For the three months and year ended December 31, 2018, 83% and 80%, respectively, of our new and add-on business was closed in collaboration with a channel partner. We expect sales and marketing expense to remain flat in the near term. Research and Development Expense Research and development expense consists of personnel-related costs for our research and development team, including salaries, benefits, bonuses, payroll taxes, stock-based compensation and other related costs. Additional expenses include subcontracting for third-party engineering resources as well as allocated overhead costs. We expect research and development expense to increase on an absolute dollar basis in the near term as we continue to increase investments in our technology architecture and software platform. General and Administrative Expense General and administrative expense consists of personnel-related costs for our executive, administrative, legal, human resources, security, finance and accounting personnel, including salaries, benefits, bonuses, payroll taxes, stock-based compensation and other related costs. Additional expenses include bad debt expense related to customer receivables, recruiting costs, professional fees, travel, insurance and allocated overhead costs. We expect general and administrative expense to increase on an absolute dollar basis in the near term as we continue to increase investments to support our anticipated growth. Interest Income, Net Interest income, net consists of interest income related to our invested balances of cash, cash equivalents and short-term investments, as well as interest expense related to our outstanding debt obligations and the amortization of deferred financing costs and debt discount associated with such arrangements. Other Income (Expense), Net Other income (expense), net historically consisted primarily of gains and losses related to the revaluation of certain of our outstanding warrant liabilities, foreign currency transactions gains and losses and loss on extinguishment of debt. As of December 31, 2018, we no longer had any outstanding warrant liabilities. Income Taxes Provision for income taxes consists primarily of foreign income taxes. We maintain a full valuation allowance for our net deferred tax assets with the exception of certain foreign deferred tax assets which have been determined to be more likely than not realizable. Results of Operations The following table sets forth our consolidated statements of operations in dollar amounts and as a percentage of revenue for the periods indicated: (1) The following table summarizes the classification of stock-based compensation expense in our consolidated statements of operations: Revenue Comparison of the Years Ended December 31, 2018 and 2017 Total revenue increased by $48.9 million in the year ended December 31, 2018 compared to the same period in 2017, primarily due to an increase of $49.7 million in our subscription, license and support revenue. Subscription, license and support revenue increased 33% in 2018 due to an increase in total customers and an increase in sales to existing customers. Of the $48.9 million increase in total revenue from 2017 to 2018, $28.2 million was due to additional sales to existing customers and $20.7 million was due to sales to new customers. We added 1,286 net new customers in 2018. Revenue generated by sales of our cloud-based solutions increased to $60.4 million in the year ended December 31, 2018, up from $26.0 million in the year ended December 31, 2017. Services revenue decreased by $0.8 million in the year ended December 31, 2018 compared to the same period in 2017 due to an increase in customers selecting our cloud-based offerings, which require fewer deployment services as they are typically easier to deploy than our on-premise solutions. Comparison of the Years Ended December 31, 2017 and 2016 Total revenue increased by $47.9 million in the year ended December 31, 2017 compared to the same period in 2016, primarily due to an increase of $47.0 million in our subscription, license and support revenue. Subscription, license and support revenue increased 42% in 2017 due to an increase in total customers and an increase in sales to existing customers. Of the $47.9 million increase in total revenue from 2016 to 2017, $28.0 million was due to additional sales to existing customers and $19.9 million was due to sales to new customers. The growth in total revenue was driven by sales of our CB Response, CB Protection and CB Defense products, our increased sales representative capacity to meet the market demand and the expansion of our strategic relationships with channel partners. We added 1,223 net new customers in 2017. Revenue generated by sales of our cloud-based solutions increased to $26.0 million in the year ended December 31, 2017, from $6.5 million in the year ended December 31, 2016. Services revenue increased $1.0 million in the year ended December 31, 2017 compared to the same period in 2016 due to increased demand for deployment and training services. Cost of Revenue Comparison of the Years Ended December 31, 2018 and 2017 Total cost of revenue increased by $10.1 million in the year ended December 31, 2018 compared to the same period in 2017, primarily due to a $9.7 million increase in the cost of subscription, license and support revenue. The $9.7 million increase in cost of subscription, license and support revenue was primarily due to a $4.1 million increase in hosting costs primarily related to cloud-based subscriptions for our CB Response and CB Defense products and a $2.5 million increase in employee-related costs (including an increase of $0.2 million in stock-based compensation) resulting from an increase in our customer support and hosting headcount. We also incurred a $1.1 million increase in expense related to a software license agreement, a $0.8 million increase in allocated overhead costs, a $0.6 million increase in software expenses, and a $0.6 million increase in other operating costs. The $0.4 million increase in cost of services revenue was primarily due to an increase in employee-related costs. Gross margin remained the same in 2018 and 2017. We experienced a slight decrease in gross margin on our subscription, license and support revenue, which comprised 83% of total revenue in 2018 and 84% in 2017. This slight decrease was primarily due to an increase in the number of customers purchasing our cloud-based subscription products during 2018 and the associated hosting and support personnel costs. We also experienced a decline in gross margin on our services revenue. We offer services to support successful software deployments and to ensure our customers realize the full value of our products. We expect gross margin on our service revenue in future periods to continue to be at or near break-even. Comparison of the Years Ended December 31, 2017 and 2016 Total cost of revenue increased by $14.6 million in the year ended December 31, 2017 compared to the same period in 2016, primarily due to a $12.9 million increase in the cost of subscription, license and support revenue. The $12.9 million increase in cost of subscription, license and support revenue was primarily due to a $6.5 million increase in hosting costs primarily related to cloud-based subscriptions for our CB Response and CB Defense products and a $4.8 million increase in employee-related costs (including an increase of $0.2 million in stock-based compensation). We also incurred a $0.4 million increase in amortization expense related to developed technology intangible assets acquired in the acquisition of Confer, a $0.4 million increase in outside services for contractors hired to augment our customer service staff, a $0.4 million increase in meeting and travel costs, a $0.2 million increase in allocated overhead costs, and a $0.2 million increase in amortization expense related to capitalized internal-use software development costs. The $1.7 million increase in cost of services revenue was largely due to a $1.3 million increase in employee-related costs resulting from an increase in the headcount of our professional services team, a $0.2 million increase in allocated overhead costs, a $0.1 million increase on outside services for contractors hired to augment our professional services staff and a $0.1 million increase in meeting and travel costs. Gross margin decreased from 2016 to 2017. We experienced a decrease in gross margin on our subscription, license and support revenue, which comprised 92% of total revenue in 2017 and 90% in 2016. This decrease was primarily due to increase in the number of customers purchasing our cloud-based subscription products during 2017 and the associated personnel and hosting costs. We also experienced a decline in gross margin on our services revenue, which was primarily due to the increase in employee-related costs. Operating Expenses Sales and Marketing Comparison of the Years Ended December 31, 2018 and 2017 Sales and marketing expense increased by $36.9 million in the year ended December 31, 2018 compared to the same period in 2017 as we continued to invest to support our current and anticipated revenue growth. This increase was primarily due to an increase of $26.0 million in employee-related costs, a $2.9 million increase in meeting and travel costs, a $3.0 million increase in allocated overhead costs, a $2.1 million increase in spending on marketing programs, a $1.5 million increase in software-related expenses, a $0.8 million increase in outside services for contractors to augment our sales and marketing staff and a $0.6 million increase in other operating costs. The $26.0 million increase in employee-related costs was primarily due to a $23.4 million increase in compensation expense (including an increase of $2.2 million in stock-based compensation) resulting from an increase in sales, marketing and business development headcount and a $2.6 million increase in amortization of deferred commissions. Comparison of the Years Ended December 31, 2017 and 2016 Sales and marketing expense increased by $25.6 million in the year ended December 31, 2017 compared to the same period in 2016 as we continued to invest to support our current and anticipated revenue growth. This increase was primarily due to an increase of $19.4 million in employee-related costs, an increase of $4.5 million related to spending on marketing programs and corporate branding initiatives, an increase of $1.4 million in allocated overhead costs, a $1.2 million increase in outside services for contractors hired to augment our sales and marketing staff, an increase of $0.9 million in meeting and travel costs, and an increase of $0.8 million related to the cost of software subscriptions and hosting services. These increases were offset by a $2.6 million decrease in amortization expense related to the customer relationship intangible assets acquired in the acquisition of Confer. The $19.4 million increase in employee-related costs was primarily due to a $15.6 million increase in compensation expense (including an increase of $0.8 million in stock-based compensation) resulting from an increase in sales, marketing and business development headcount and a $3.8 million increase in amortization of deferred commissions. Research and Development Comparison of the Years Ended December 31, 2018 and 2017 Research and development expense increased by $12.6 million in the year ended December 31, 2018 compared to the same period in 2017 as we continued to invest in our technology architecture and software platform. This increase was primarily due to a $11.0 million increase in employee-related costs (including an increase of $0.7 million in stock-based compensation) resulting from an increase in the headcount of research and development personnel. We also incurred a $1.4 million increase in allocated overhead costs, a $1.1 million increase in event and travel costs as a result of the higher headcount and more frequent product roadmap planning events and a $0.7 million increase related to the cost of software subscriptions and hosting services. These were partially offset by a $0.2 million decrease in other operating costs and higher capitalized internal-use software development costs of $1.4 million. Comparison of the Years Ended December 31, 2017 and 2016 Research and development expense increased by $15.6 million in the year ended December 31, 2017 compared to the same period in 2016 as we continued to invest in our technology architecture and software platform. This increase was primarily due to a $10.2 million increase in employee-related costs (including an increase of $0.5 million in stock-based compensation). We also incurred a $2.4 million increase in allocated overhead costs, a $1.6 million increase in hosting costs related to software development, a $1.0 million increase in event and travel costs as a result of the increase in headcount and more frequent product roadmap planning events, a $0.6 million increase in outside services for contractors hired to augment our research and development staff and a $0.3 million increase in subscription services costs related to threat research. Our capitalized internal-use software development costs were higher by $0.5 million in 2017 compared to 2016. General and Administrative Comparison of the Years Ended December 31, 2018 and 2017 General and administrative expense increased by $11.3 million in the year ended December 31, 2018 compared to the same period in 2017. The increase was due to a $4.1 million increase in employee-related costs (including an increase of $1.5 million in stock-based compensation) resulting from an increase in the headcount of general and administrative personnel, an increase of $3.9 million in expense related to the settlement agreement with Finjan, an increase of $0.6 million in bad debt expense primarily due to a benefit in the prior year of $0.3 million, a $0.6 million increase in insurance costs, a $0.5 million increase related to outside services for contractors hired to augment our staff capacity, a $0.4 million increase in software related expenses, a $0.4 million increase in professional fees expense, and a $0.8 million in other operating costs. Comparison of the Years Ended December 31, 2017 and 2016 General and administrative expense decreased by $1.0 million in the year ended December 31, 2017 compared to the same period in 2016. The decrease was primarily due to decreases of $0.8 million in bad debt expense, $0.4 million in legal, audit and tax fees, $0.3 million in non-income taxes and fees, $0.2 million in outside service costs for contractors and $0.3 million in severance costs. These decreases were partially offset by a $0.4 million increase in employee-related costs (including an increase of $0.1 million in stock-based compensation) resulting from an increase in the headcount of general and administrative personnel. We also incurred increases of $0.3 million in allocated overhead costs, $0.2 million in software subscription costs and $0.1 million in travel costs. Interest Income, Net Comparison of the Years Ended December 31, 2018 and 2017 Interest income, net increased by $2.0 million in the year ended December 31, 2018 compared to the same period in 2017. The increase was primarily due to an increase in interest income earned on higher cash and short-term investment balances resulting from the proceeds of our initial public offering. Comparison of the Years Ended December 31, 2017 and 2016 Interest income, net increased by $0.6 million in the year ended December 31, 2017 compared to the same period in 2016. The increase was primarily due to the repayment of all principal amounts outstanding under the line of credit in April 2017 which resulted in lower interest expense during 2017. Other Expense, Net Comparison of the Years Ended December 31, 2018 and 2017 Other expense, net increased by $9.1 million in the year ended December 31, 2018 compared to the same period in 2017, primarily due to the expenses associated with the change in the fair value of our warrant liabilities which increased by $8.0 million and a $1.1 million increase in losses associated with foreign currency, principally due to fluctuations in the British pound. Comparison of the Years Ended December 31, 2017 and 2016 Other expense, net decreased by $0.1 million in the year ended December 31, 2017 compared to the same period in 2016, primarily due to a change in the amount of foreign currency transaction gains and losses, from a loss of $0.5 million in 2016 to a gain of $0.2 million in 2017, as well as no loss on extinguishment of debt in 2017, partially offset by a $0.8 million increase from 2016 to 2017 in the expense associated with the change in the fair value of our warrant liabilities. Benefit from (Provision for) Income Taxes Comparison of the Years Ended December 31, 2018 and 2017 The benefit from income taxes was $0.2 million in the year ended December 31, 2018 compared to a provision for income taxes of $0.1 million in the same period in 2017. The benefit recognized in 2018 was due primarily to the release of a valuation allowance against certain foreign deferred tax assets which were determined to be more likely than not realizable. Comparison of the Years Ended December 31, 2017 and 2016 The provision for income taxes was $0.1 million in the year ended December 31, 2017 compared to a benefit from income taxes of $2.2 million in the same period in 2016. The provision recognized in 2017 was due primarily to foreign income taxes. The benefit recognized in 2016 was due to the release of a portion of our deferred tax asset valuation in connection with the acquisition of Confer; otherwise, no other income tax benefit was recognized in 2017 or 2016 due to the uncertainty of realizing a benefit from our incurred losses for the periods. Quarterly Results of Operations The following table sets forth our quarterly consolidated balance sheet and statements of operations data as of and for each of the eight quarters in the period ended December 31, 2018. We have prepared the quarterly financial data on the same basis as the audited consolidated financial statements included in this Annual Report on Form 10-K. In our opinion, the quarterly financial data reflects all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair statement of this data. This quarterly consolidated financial data should be read in conjunction with our consolidated financial statements and related notes appearing at the end of this Annual Report on Form 10-K. Our historical results are not necessarily indicative of the results to be expected in the future. (1) The following table summarizes the classification of stock-based compensation expense in our consolidated statements of operations: The sequential increases in our quarterly revenue have resulted primarily from increases in our number of new customers as well as increased revenue from existing customers as they expanded their use of our solutions. Total costs and expenses generally increased sequentially for the periods presented due primarily to the addition of personnel in connection with the expansion of our business and other related expenses to support our growth. We anticipate these expenses will continue to increase in future periods as we continue to focus on investing in the long-term growth of our business. Our quarterly operating results may fluctuate due to various factors affecting our performance. Backlog We define backlog as contractually committed orders for our subscriptions and support services for which the associated revenue has not been recognized and the customer has not been invoiced. Amounts that have been invoiced but not yet recognized as revenue are reported as deferred revenue on our consolidated balance sheets and are not included in our calculation of backlog. As of December 31, 2018 and 2017, we had backlog of approximately $38.8 million and $40.7 million, respectively. The decrease in backlog was largely due to a decrease in multi-year contract commitments with annual billing. Of the amount of backlog as of December 31, 2018, we expect that approximately $27.0 million will be invoiced to customers within the following twelve months and will be initially recorded as deferred revenue. Liquidity and Capital Resources As of December 31, 2018, our principal sources of liquidity were cash, cash equivalents and short-term investments totaling $160.6 million, which were held for working capital purposes. Our cash equivalents and investments consist of highly liquid investments in money market funds, commercial paper, U.S. treasury securities, corporate debt and asset-backed securities. As of December 31, 2018, we are party to a senior loan and security agreement with Silicon Valley Bank, or the line of credit, which, as amended, provides for $40 million in maximum borrowings. Borrowings under the line of credit accrue interest at Silicon Valley Bank’s prime rate and may be repaid and reborrowed until March 21, 2020, when the line of credit expires and all outstanding amounts must be repaid. As of December 31, 2018, we had $0 of outstanding borrowings under the line of credit. On May 8, 2018, we closed our initial public offering, or IPO, in which we issued and sold 9,200,000 shares of common stock inclusive of the underwriters’ option to purchase additional shares that was exercised in full. The price to the public was $19.00 per share. We received aggregate proceeds of $162.6 million from the IPO, net of underwriters’ discounts and commissions, and before deducting offering costs of approximately $4.9 million. Since our inception, we have generated significant losses and expect to continue to generate losses for the foreseeable future. We believe that our existing cash, cash equivalents and short-term investments will be sufficient to meet our working capital expenditure requirements for at least the next 12 months. Our future capital requirements will depend on many factors, including our growth rate, our activities related to the acquisition of complementary businesses, technologies and assets, the timing and extent of spending to support research and development efforts, the expansion of sales and marketing activities, particularly internationally, and the introduction of new and enhanced products as we continue to innovate. In the event that additional financing is required from outside sources, we may be unable to raise the funds on acceptable terms, if at all. If we are unable to raise additional capital when desired, our business, operating results and financial condition could be adversely affected. Uses of Funds Our historical uses of cash have consisted of cash used for operating activities, such as expansion of our sales and marketing operations, research and development activities and other working capital needs, and cash used for investing activities, including cash paid for business acquisitions and for purchases of property and equipment. The following table shows a summary of our cash flows for the years ended December 31, 2018, 2017 and 2016: Operating Activities During the year ended December 31, 2018, operating activities used $37.3 million of cash, primarily resulting from our net loss of $82.1 million, partially offset by net cash provided by changes in our operating assets and liabilities of $15.1 million and non-cash charges of $29.7 million. Net cash provided by changes in our operating assets and liabilities consisted of a $24.2 million increase in deferred revenue, a $2.2 million increase in accounts payable, and a $1.8 million increase in accrued expenses, partially offset by a $8.2 million increase in deferred commissions, a $2.8 million increase in prepaid expenses and other assets, and a $2.0 million increase in accounts receivable. The increases in deferred revenue and deferred commissions were due to increases in the number of customers and the amounts we billed for our products and services in 2018 compared to 2017. The increase in the amount billed contributed to the increase in deferred revenue as amounts billed for subscriptions, perpetual licenses, support and services are generally deferred on our balance sheet and subsequently recognized over the term of the subscription or maintenance period, except perpetual license revenue, which is recognized over the customer’s estimated economic life, which we have estimated to be five years. The increase in accounts receivable was due to the growth of our business in 2018 compared to 2017. The increases in accounts payable, accrued expenses and prepaid expenses and other assets resulted from our increased spending due to the growth of our business. During the year ended December 31, 2017, operating activities used $7.7 million of cash, primarily resulting from our net loss of $53.2 million, partially offset by net cash provided by changes in our operating assets and liabilities of $29.0 million and non-cash charges of $16.5 million. Net cash provided by changes in our operating assets and liabilities consisted of a $52.0 million increase in deferred revenue and a $4.2 million increase in accrued expenses, both partially offset by a $16.9 million increase in accounts receivable, a $8.3 million increase in deferred commissions, a $0.9 million increase in prepaid expenses and other assets, a $0.7 million decrease in accounts payable and a $0.4 million decrease in deferred rent. The increases in deferred revenue and deferred commissions were due to increases in the number of customers and the amounts we billed for our products and services in 2017 compared to 2016. The increase in the amount billed contributed to the increase in deferred revenue as amounts billed for subscriptions, perpetual licenses, support and services are generally deferred on our balance sheet and subsequently recognized over the term of the subscription or maintenance period, except perpetual license revenue, which is recognized over the customer’s estimated economic life, which we have estimated to be five years. The increase in accounts receivable was due to the growth of our business in 2017 compared to 2016. The increases in accrued expenses and prepaid expenses and other assets resulted from our increased spending due to the growth of our business. The decrease in accounts payable was due to the timing of payments. During the year ended December 31, 2016, operating activities used $33.1 million of cash, primarily resulting from our net loss of $44.7 million and net cash used by changes in our operating assets and liabilities of $2.0 million, partially offset by non-cash charges of $13.7 million. Net cash used by changes in our operating assets and liabilities consisted primarily of a $13.8 million increase in accounts receivable, a $14.0 million decrease in management incentive plan liability, a $7.4 million increase in deferred commissions and a $2.6 million increase in prepaid expenses and other assets, all partially offset by a $31.2 million increase in deferred revenue, a $3.5 million increase in accrued expenses and a $1.0 million increase in accounts payable. The increase in accounts receivable was due to the growth of our business in 2016 compared to 2015. The increases in deferred revenue and deferred commissions were due to increases in the number of customers and the amounts we billed for our products and services in 2016 compared to 2015. The increase in the amount billed contributed to the increase in deferred revenue as amounts billed for subscriptions, perpetual licenses, support and services are generally deferred on our balance sheet and subsequently recognized as revenue ratably over the longest service period of any deliverable in the arrangement. The increases in accrued expenses, accounts payable and in prepaid expenses and other assets resulted from our increased spending due to the growth of our business. The decrease in the management incentive plan liability was due to a $14.0 million cash payment, in addition to our issuance of 960,900 shares of common stock with a fair value of $6.0 million, to settle the management incentive plan obligation. Investing Activities During the year ended December 31, 2018, investing activities used $100.6 million of cash, consisting of purchases of short-term investments of $96.6 million, purchases of property and equipment of $6.0 million and capitalization of internal-use software costs of $2.3 million, partially offset by the sale and maturities of short-term investments of $4.3 million. The purchases of property and equipment in 2018 were primarily computer equipment and software related to the growth of our headcount and general expansion of our business. During the year ended December 31, 2017, investing activities used $6.1 million of cash, consisting of purchases of property and equipment of $5.1 million and capitalization of internal-use software costs of $0.9 million. The purchases of property and equipment in 2017 were primarily related to the growth of our headcount and the general expansion of our business. During the year ended December 31, 2016, investing activities provided $0.7 million of cash, consisting of net cash of $6.9 million received in connection with our acquisition of Confer, which we funded primarily by the issuance of shares of our preferred and common stock, partially offset by purchases of property and equipment of $5.8 million and capitalization of internal-use software costs of $0.4 million. The purchases of property and equipment in 2016 were primarily related to the growth of our headcount and the general expansion of the business. Financing Activities During the year ended December 31, 2018, financing activities provided $169.7 million of cash, resulting from $159.6 million of proceeds from the IPO and $10.1 million from the exercise of stock options. During the year ended December 31, 2017, financing activities used $1.7 million of cash, primarily resulting from payments of $5.6 million related to debt obligations, partially offset by proceeds of $3.9 million from the exercise of stock options. During the year ended December 31, 2016, financing activities provided $15.4 million of cash, primarily resulting from net proceeds of $15.4 million from the issuance of preferred stock, proceeds of $5.5 million from borrowings on our line of credit and proceeds of $2.5 million from the exercise of stock options, partially offset by payments of $6.1 million related to debt obligations and $1.9 million of initial public offering costs. The $15.4 million from the issuance of preferred stock included $2.0 million received upon the exercise of a customer option in connection with our acquisition of Confer, which we were then obligated to remit to the former shareholders of Confer in accordance with the merger agreement. Contractual Obligations and Commitments The following table summarizes our contractual obligations as of December 31, 2018 and the effect such obligations are expected to have on our liquidity and cash flows in future periods: (1) Amounts in the table reflect a non-cancellable capacity commitment with a hosting provider under an agreement that, as amended, expires in November 2020. (2) Amounts in the table reflect payments due for our leases of office space that expire at various dates between April 2019 and June 2027. Off-Balance Sheet Arrangements We had no material off-balance sheet arrangements as of December 31, 2018 or 2017. Critical Accounting Policies Our consolidated financial statements are prepared in accordance with GAAP. The preparation of our consolidated financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenue, costs and expenses. We base our estimates and assumptions on historical experience and other factors that we believe to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates. Our most critical accounting policies are summarized below. See Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K for a description of our other significant accounting policies. Revenue Recognition We generate revenue through relationships with channel partners and through its direct sales force primarily from three sources: (i) the sale of subscription (i.e., term-based) and perpetual licenses for our CB Protection and CB Response software products along with access to and the right to utilize the threat intelligence capabilities of the CB Predictive Security Cloud, as well as maintenance services and customer support (collectively, “support”), (ii) cloud-based software-as-a-service, or SaaS, subscriptions for access to our CB Response and CB Defense software products, and (iii) professional services and training, collectively referred to as services. In accordance with ASC 606, revenue is recognized when a customer obtains control of promised products or services. The amount of revenue recognized reflects the consideration that we expect to be entitled to receive in exchange for these products or services. We apply the following five steps to recognize revenue: (i) Identification of the contract, or contracts, with a customer We consider the terms and conditions of our contracts and our customary business practices to identify contracts under ASC 606. We consider that we have a contract with a customer when the contract is approved, we can identify each party’s rights regarding the products or services to be transferred, we can identify the payment terms for the products or services to be transferred, we have determined that the customer has the ability and intent to pay, and the contract has commercial substance. We apply judgment in determining the customer’s ability and intention to pay, which is based on a variety of factors, including the customer’s historical payment experience or, in the case of a new customer, credit and financial information pertaining to the customer. (ii) Identification of the performance obligation(s) in the contract Performance obligations promised in a contract are identified based on the products or services that will be transferred to the customer that are capable of being distinct, whereby the customer can benefit from the product or services either on their own or together with other resources that are readily available from third parties or from us, and are distinct in the context of the contract, whereby the transfer of the products or services is separately identifiable from other promises in the contract. To the extent a contract includes multiple promised products or services, we apply judgment to determine whether promised products or services are capable of being distinct, and are distinct in the context of the contract. If these criteria are not met, the promised products or services are accounted for as a combined performance obligation. (iii) Determination of the transaction price The transaction price is determined based on the consideration that we will be entitled to in exchange for transferring products or services to the customer. Variable consideration is included in the transaction price, if, in our judgment, it is probable that no significant future reversal of cumulative revenue under the contract will occur. In instances where the timing of revenue recognition differs from the timing of invoicing, we have determined that our contracts generally do not include a significant financing component. The primary purpose of our invoicing terms is to provide customers with simplified and predictable ways of purchasing its products and services, not to receive financing from our customers or to provide customers with financing. An example is invoicing at the beginning of a subscription term with revenue recognized ratably over the contract period. (iv) Allocation of the transaction price to performance obligations in the contract If the contract contains a single performance obligation, the entire transaction price is allocated to the single performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on relative standalone selling price, or SSP, basis. We determine SSP based on the price at which the performance obligation is sold separately. If the SSP is not observable through past transactions, we estimate the SSP taking into account available information such as market conditions and internally approved pricing guidelines related to the performance obligation. (v) Recognition of revenue when, or as, a performance obligation is satisfied Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised product or service to a customer. We recognize revenue when we transfer control of the products or services to the customer for an amount that reflects the consideration that we expect to receive in exchange for those products or services. Subscription, License and Support Revenue Substantially all of our software arrangements contain multiple performance obligations that include a combination of software licenses, cloud-based subscriptions, support, professional services and training. Our CB Protection and CB Response products are offered through subscription or perpetual software licenses, with a substantial majority of its customers selecting a subscription license. Subscription licenses include access to and the right to utilize the threat intelligence capabilities of the CB Predictive Security Cloud as well as ongoing support, which provides customers with telephone and web-based support, bug fixes and repairs and software updates on a when-and-if-available basis. The CB Predictive Security Cloud automatically distributes real-time threat intelligence, such as detection algorithms, reputation scores and attack classifications, to our customers. Substantially all customers who purchase licenses on a perpetual basis also purchase an agreement for support and an agreement for access to and the right to utilize the threat intelligence capabilities of the CB Predictive Security Cloud. For subscription or perpetual license sales of CB Protection and CB Response, we consider the software license and access to the threat intelligence capabilities of the CB Predictive Security Cloud to be a single performance obligation. Subscription (i.e. term-based) revenue is recognized on a ratable basis over the contract term beginning on the date the software is delivered to the customer. Revenue for cloud-based subscriptions is recognized on a ratable basis over the term of the subscription beginning on the date the customer is given access to the platform. Maintenance services and customer support revenue related to subscription licenses is recognized ratably over the term of the maintenance and support arrangement as this performance obligation is satisfied. Revenue from the infrequent sales of perpetual software licenses is recognized ratably over the customer’s estimated economic life, which we have estimated to be five years, beginning on the date the software is delivered to the customer. Maintenance services and customer support revenue related to perpetual licenses is recognized ratably over the term of the maintenance and support arrangement as this performance obligation is satisfied. Services Revenue We provide professional services to customers, primarily in the form of deployment, and training services. Services are typically sold together with licenses of our software products and, to a lesser extent, on a stand-alone basis. Services are priced separately and are considered distinct from our software license. The professional services can be performed by a third party and have a history of consistent pricing by us. Professional services are sold as time-and-materials contracts based on the number of hours worked and at contractually agreed-upon hourly rates, and also on a fixed-fee basis. Revenue from professional services and training sold on a stand-alone basis or in a combined arrangement is recognized as those services are rendered as control of the services passes to the customer over time. Our employees may incur out-of-pocket expenses when providing services to customers that are reimbursable from the customer under the terms of the service contract. We bill any out-of-pocket expenses incurred in the performance of these services to the customer. The expenses are classified on a gross basis as revenue and costs of revenue in the consolidated statements of operations. Our determination of a gross presentation is based on an assessment of the relevant facts and circumstances, including the fact that our customers, rather than us, benefit from the expenditures and we bear the credit risk of the reimbursement until it receives reimbursement from the customer. Variable Consideration Revenue is recorded at the net sales price, which is the transaction price. We do not offer refunds, rebates or credits to customers in the normal course of business. The impact of variable consideration has not been material. Contract Costs We capitalize commission costs that are incremental and directly related to the acquisition of customer agreements. Commissions are earned by our sales force and paid in full upon the receipt of customer orders for new arrangements or renewals. Commission costs are capitalized when earned and are amortized as expense over an estimated customer relationship period of five years. We determined the estimated customer relationship period by taking into consideration the contractual term and expected renewals of customer contracts, our technology and other factors, including the fact that commissions paid on renewals are not commensurate with commissions paid on new sales. Commissions paid relating to contract renewals are deferred and amortized over the related renewal period. Costs to obtain a contract for service arrangements are expensed as incurred in accordance with the practical expedient as the contractual period for services is one year or less. As of December 31, 2018 and 2017, we recorded $38,154 and $29,955 of deferred commission costs in the consolidated balance sheet. Commission costs capitalized as deferred commissions during December 31, 2018, 2017 and 2016, totaled $20,955, $18,308 and $13,871, respectively. Amortization of deferred commissions as of December 31, 2018, 2017 and 2016 totaled $12,756, $10,047 and $6,483, respectively, and is included in sales and marketing expense in the consolidated statements of operations. We periodically review these deferred costs to determine whether events or changes in circumstances have occurred that could impact the period of benefit of these deferred sales commissions. We do not incur any material costs to fulfill customer contracts. Deferred Revenue Contract liabilities consist of deferred revenue and include payments received in advance of performance under the contract. Such amounts are recognized as revenue over the contractual period. During the year ended December 31, 2018, we recognized revenue of $127,487 which was included in the deferred revenue balance as of December 31, 2017. We receive payments from customers based upon contractual billing schedules; accounts receivable are recorded when the right to consideration becomes unconditional. We generally bill customers in advance, and payment terms on invoiced amounts are typically 30 to 90 days. Contract costs include amounts related to our contractual right to consideration for completed and partially completed performance obligations that may not have been invoiced; such amounts have been insignificant to date. Stock-Based Compensation Pre-IPO Methodology Prior to our IPO, we estimated the value of common stock at the grant date with the help of an independent third party service provider. Given the absence of an active market for our common stock prior to our IPO, our board of directors was required to estimate the fair value of our common stock at the time of each option grant based upon several factors, including consideration of input from management and contemporaneous third-party valuations. The exercise price for all stock options granted was at the estimated fair value of the underlying common stock, as estimated on the date of grant by our board of directors in accordance with the guidelines outlined in the American Institute of Certified Public Accountants, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Each fair value estimate was based on a variety of factors, which included the following: · our historical operating and financial performance; · a discounted cash flow analysis; · the market performance of comparable publicly traded technology companies; · the identification and analysis of mergers and acquisitions of comparable technology companies; · the prices, rights, preferences and privileges of our preferred stock relative to the common stock; · the likelihood of achieving a liquidity event such as an initial public offering or sale given prevailing market conditions and the nature and history of our business; · any adjustments necessary to recognize a lack of marketability for our common stock; and · U.S. and global economic market conditions. Post-IPO Methodology Following the closing of our IPO, we measure stock options and other stock-based awards granted to employees and directors based on the fair value on the date of the grant and recognize the corresponding compensation expense of those awards, net of estimated forfeitures, over the requisite service period, which is generally the vesting period of the respective award. Generally, we issue stock option awards with only service-based vesting conditions and record the expense for these awards using the straight-line method. We measure stock-based awards granted to non-employee consultants based on the fair value of the award on the date at which the related service is complete. Compensation expense is recognized over the period during which services are rendered by such non-employee consultants until completed. At the end of each financial reporting period prior to completion of the service, we remeasure the fair value of these awards using the then-current fair value of the underlying preferred stock or common stock and updated assumption inputs in the Black-Scholes option-pricing model. We estimate the fair value of each stock option grant using the Black-Scholes option-pricing model, which uses as inputs the fair value of our common stock and assumptions we make for the volatility of our common stock, the expected term of our stock options, the risk-free interest rate for a period that approximates the expected term of our stock options and our expected dividend yield. We estimate the fair value of each restricted stock award or restricted stock unit award based on the fair value per share of our common stock on the date of grant. Business Combinations We account for business combinations using the acquisition method of accounting. Application of this method of accounting requires that (i) identifiable assets acquired (including identifiable intangible assets) and liabilities assumed generally be measured and recognized at fair value as of the acquisition date and (ii) the excess of the purchase price over the net fair value of identifiable assets acquired and liabilities assumed be recognized as goodwill, which is not amortized for accounting purposes but is subject to testing for impairment at least annually. Transaction costs related to business combinations are expensed as incurred. Determining the fair value of assets acquired and liabilities assumed and the allocation of the purchase price requires management to use significant judgment and estimates, especially with respect to intangible assets. Critical estimates in valuing certain identifiable assets include, but are not limited to, the selection of valuation methodologies; estimates of future revenue and cash flows, expected long-term market growth, future expected operating expenses, costs of capital and appropriate discount rates. Our estimates of fair value are based upon assumptions we believe to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. During the measurement period, we may record certain adjustments to the carrying value of the assets acquired and liabilities assumed with the corresponding offset to goodwill. After the measurement period, which could last up to one year after the transaction date, all adjustments are recorded in the consolidated statements of operations and comprehensive loss. Impairment of Goodwill and Long-Lived Assets Goodwill represents the excess of cost over the fair value of the net tangible and identifiable intangible assets acquired in a business combination. Goodwill is not subject to amortization, but is tested annually for impairment or more frequently if there are indicators of impairment. We consider the following potential indicators of impairment: significant underperformance relative to historical or projected future operating results, significant changes in our use of acquired assets or the strategy of our overall business, significant negative industry or economic trends and a significant decline in our stock price for a sustained period and a reduction of our market capitalization relative to net book value. We perform an annual impairment test on December 1 or whenever events or changes in circumstances indicate that goodwill may be impaired. Significant judgments required in testing goodwill for impairment and changes in estimates and assumptions could materially affect the determination of whether impairment exists and, if so, the amount of that impairment. We have determined that there is one reporting unit for purposes of testing goodwill for impairment. In testing goodwill for impairment, we first consider qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. Such qualitative factors include macroeconomic conditions, industry and market considerations, cost factors, entity-specific financial performance and other events, such as changes in management, strategy and primary customer base. We also have the option to perform step one of the goodwill impairment test. We will compare the fair value of the reporting unit to the carrying amount of a reporting unit, including goodwill. If the fair value exceeds the carrying amount, no impairment loss is recognized. However, if the carrying amount of the reporting unit exceeds its fair value, we will record an impairment charge in the consolidated statements of operations to reduce the carrying value of the assets to the reporting unit's implied fair value. In each of the annual goodwill impairment tests performed as of December 1, 2018, 2017 and 2016, the estimated fair value of our single reporting unit significantly exceeded its carrying amount. During the years ended December 31, 2018, 2017 and 2016, we did not recognize any impairment charges related to goodwill. Long-lived assets consist of property and equipment, including internal-use software, and finite-lived acquired intangible assets, such as developed technology, trade name and customer relationships. Long-lived assets to be held and used are tested for recoverability whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Factors that we consider in deciding when to perform an impairment review include significant underperformance of the business in relation to expectations, significant negative industry or economic trends and significant changes or planned changes in the use of the assets. If an impairment review is performed to evaluate a long-lived asset group for recoverability, we compare forecasts of undiscounted cash flows expected to result from the use and eventual disposition of the long-lived asset group to its carrying value. An impairment loss would be recognized when estimated undiscounted future cash flows expected to result from the use of an asset group are less than its carrying amount. The impairment loss would be based on the excess of the carrying value of the impaired asset group over its fair value, determined based on discounted cash flows. To date, we have not recorded any impairment losses on long-lived assets. No events or changes in circumstances existed to require an impairment assessment during the years ended December 31, 2018, 2017 and 2016. Valuation of Warrant Liability Preferred Stock Warrants We classified warrants to purchase shares of our preferred stock as a liability on our consolidated balance sheets as the warrants were free-standing financial instruments that may have required us to transfer assets upon exercise. See Note 13 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K. The warrants were initially recorded at their fair values on date of issuance, and were subsequently remeasured to fair value at each balance sheet date. Changes in the fair values of the warrants were recognized as other income or expense in the consolidated statements of operations. Upon closing of the IPO, the warrants became warrants to purchase common stock. Common Stock Warrants In connection with our issuance and sale of Series D redeemable convertible preferred stock, we issued to an investor a warrant to purchase shares of our common stock. This warrant was exercisable upon completion of the IPO into the number of shares of common stock equal to 12.5% of the sum of (a) the number of shares into which the shares of our Series A preferred stock, including shares issuable upon the exercise of outstanding options to purchase shares of Series A preferred stock, convert upon an IPO and (b) the number of shares of common stock underlying the warrant. This warrant met the definition of a derivative instrument under the relevant accounting guidance and was recorded as a liability in our consolidated balance sheets. The fair value of the warrant on the date of issuance was recorded as reduction of the carrying value of the Series D redeemable convertible preferred stock and as a long-term liability in our consolidated balance sheet. The fair value of the warrant was subsequently remeasured to its fair value at each balance sheet date. Changes in the fair value of the warrant were recognized as other income or expense in our consolidated statements of operations and comprehensive loss. Upon closing of the IPO, the common stock warrant issued in connection with the Series D redeemable convertible preferred stock became exercisable and was net exercised at an exercise price of $0.002 per share to purchase 485,985 shares of common stock. Valuation We utilize the Black-Scholes option-pricing model, which incorporates assumptions and estimates, to value the preferred stock warrants and common stock warrant that were classified as liabilities in our consolidated balance sheets. We assessed these assumptions and estimates on a quarterly basis as additional information impacting the assumptions is obtained. Estimates and assumptions impacting the fair value measurement included the fair value per share of the underlying common stock and Series B and Series D redeemable convertible preferred stock, the remaining contractual terms of the warrants, risk-free interest rates, expected dividend yields, and expected volatility of the price of the underlying common or preferred stock. We determined the fair value per share of the underlying common and preferred stock by taking into consideration our most recent sales of preferred stock, results obtained from third-party valuations, and additional factors that we deemed relevant. We have historically been a private company and lack company-specific historical and implied volatility information of our stock. Therefore, we estimated expected stock volatility based on the historical volatility of publicly traded peer companies for a term equal to the remaining contractual term of the warrants. The risk-free interest rates were determined by reference to the U.S. Treasury yield curve for time periods approximately equal to the remaining contractual terms of the warrants. We estimated the dividend yield based on the fact that we have never paid cash dividends and do not expect to pay any cash dividends in the foreseeable future. Carrying Value and Fair Value of Preferred Stock We recognized changes in the redemption values of our Series B, C, D, E, E-1 and F redeemable convertible preferred stock immediately as they occurred and adjusted the carrying value of each series of the redeemable convertible preferred stock to equal its redemption value at the end of each reporting period as if the end of each reporting period were the redemption date. Adjustments to the carrying values of the Series B, C, D, E, E-1 and F redeemable convertible preferred stock at each reporting date resulted in an increase or decrease to net income (loss) attributable to common stockholders. Because shares of our Series D, E and F redeemable convertible preferred stock were redeemable in an amount equal to the greater of the original issue price per share of each series plus all declared but unpaid dividends thereon or the estimated fair value of the Series D, E or F redeemable convertible preferred stock at the date of the redemption request, and because shares of our Series E-1 redeemable convertible preferred stock were redeemable in an amount equal to the estimated fair value of the Series E-1 redeemable convertible preferred stock at the date of the redemption request, it was necessary for us to determine the fair value of each of these series of preferred stock in order to determine the redemption value at each reporting date. As there had been no public market for our preferred stock, the estimated fair value of our preferred stock was determined by management as of each reporting date based, in part, on the results of third-party valuations of our preferred stock performed as of each reporting date as well as our assessment of additional objective and subjective factors that it believed were relevant. These third-party valuations were performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation. Our preferred stock valuations at each reporting date were prepared using either a probability-weighted expected return method, or PWERM, or a hybrid method, which used a combination of market and income approaches or a market approach to estimate our enterprise value. The hybrid method is a PWERM where the equity value in one or more of the scenarios is allocated using an option-pricing method, or OPM. The assumptions underlying these valuations represented our best estimates, which involved inherent uncertainties and the application of management judgment. Upon closing of the IPO, all outstanding shares of redeemable convertible preferred stock automatically converted into shares of common stock. Capitalization of Software Development Costs We capitalize certain costs related to the development of software for internal use and the development of software for license or sale to customers, including costs incurred for certain upgrades and enhancements that are expected to result in increased functionality. Costs incurred to develop software to be licensed or sold to customers are expensed prior to the establishment of technological feasibility of the software and are capitalized thereafter until commercial release of the software. To date, we have not capitalized software development costs related to software to be licensed or sold to customers as the establishment of technological feasibility typically occurs shortly before the commercial release of our software products. As such, all software development costs related to software for license or sale to customers are expensed as incurred and included within research and development expense in our consolidated statements of operations and comprehensive loss. Qualifying costs incurred to develop internal-use software are capitalized when (1) the preliminary project stage is completed, (2) we have authorized further funding for the completion of the project and (3) it is probable that the project will be completed and performed as intended. These capitalized costs include salaries for employees who devote time directly to developing internal-use software and external direct costs of services consumed in developing the software. Capitalization of these costs ceases once the project is substantially complete and the software is ready for its intended purpose. Capitalized internal-use software development costs are amortized using the straight-line method over an estimated useful life of three years. Such amortization expense for internal-use software is classified as a cost of revenue in our consolidated statements of operations and comprehensive loss. Emerging Growth Company Status The Jumpstart Our Business Startups Act of 2012, or the JOBS Act, permits an “emerging growth company” such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies until those standards would otherwise apply to private companies. We have irrevocably elected to “opt out” of this provision and, as a result, we will comply with new or revised accounting standards when they are required to be adopted by public companies that are not emerging growth companies. Recent Accounting Pronouncements We have reviewed all recently issued standards and have determined that, other than as disclosed in Note 2 to our consolidated financial statements appearing at the end of this Annual Report on Form 10-K, such standards will not have a material impact on our consolidated financial statements or do not otherwise apply to our operations. Internal-Use Software In August 2018, the Financial Accounting Standards Board, or FASB, issued ASU No. 2018-15, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40), or ASU 2018-15. ASU 2018-15 was issued in order to address a customer's accounting for implementation costs incurred in a cloud computing arrangement, or CCA that is considered a service contract. Under this guidance, implementation costs for a CCA should be evaluated for capitalization using the same approach as implementation costs associated with internal-use software. The capitalized implementation costs should be expensed over the term of the hosting arrangement, which includes any reasonably certain renewal periods. The pronouncement is effective for fiscal years beginning after December 15, 2019, with early adoption permitted. We are currently evaluating the impact of this pronouncement on our consolidated financial statements. Stock Compensation In June 2018, the FASB issued ASU No. 2018-07, Compensation - Stock Compensation (Topic 718), or ASU 2018-07. ASU 2018-07 was issued in order to expand the guidance for stock-based compensation, to include share-based payment transactions for acquiring goods and services from nonemployees. The pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted. We will adopt ASU 2018-07 in the first quarter of 2019 and its adoption is not expected to have a material impact on our consolidated financial statements. Comprehensive Income In February 2018, the FASB issued ASU 2018-02, Income Statement - Reporting Comprehensive Income, or ASU 2018-02, which provides for the reclassification of the effect of remeasuring deferred tax balances related to items within accumulated other comprehensive income to retained earnings resulting from the Tax Cuts and Jobs Act, or Tax Act. The guidance is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. Early adoption is permitted. We will adopt ASU 2018-02 in the first quarter of 2019 and its adoption is not expected to have a material impact on our consolidated financial statements. Leases In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842), or ASU 2016-02. ASU 2016-02 was issued to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. We will be adopting the new standard effective January 1, 2019 using the modified retrospective transition method. We will not apply the standard to the comparative periods presented in the year of adoption. We will elect available practical expedients permitted under the guidance, which among other items, allow the Company to carry forward its historical lease classification and not reassess leases for the definition of lease under the new standard. Upon the adoption of ASC 842, we do not expect to record a right-of-use asset and related lease liability for leases with an initial term of 12 months or less and plan to account for lease and non-lease components as a single lease component. The standard will have a material impact on our consolidated balance sheet but will not have a material impact on our consolidated statement of operations, consolidated statement of comprehensive loss, or consolidated statement of cash flows. The most significant impact will be the recognition of right-of-use assets and lease liabilities for operating leases as we expect the obligations under existing operating leases, as disclosed in Note 15 to the consolidated financial statements, will be reported in the consolidated balance sheet upon adoption. We are currently evaluating the potential changes from this guidance to future financial reporting and disclosures and designing and implementing related processes and controls. We are still assessing the incremental borrowing rates to be used in determining the quantitative impact of adoption on our financial position.

<s>[INST] Overview Carbon Black is a leading, global provider of clouddelivered, nextgeneration endpoint security solutions. As an innovator in the Endpoint Protection Platform (EPP) market, our technology enables customers to address the complete endpoint security lifecycle and stay ahead of advanced cyberattacks. Our big data and analytics platform, the CB Predictive Security Cloud (PSC), consolidates endpoint security and IT operations into an extensible cloud platform that prevents advanced threats, provides actionable insight and enables businesses of all sizes to simplify operations. By analyzing billions of security events per day across the globe, Carbon Black has key insights into attackers’ behavior patterns, enabling customers to detect, respond to and prevent emerging attacks. We believe the depth, breadth and realtime nature of our unfiltered endpoint data, combined with the analytic power of our Predictive Security Cloud platform, provides customers with worldclass security efficacy and operational efficiency. Organizations globally are replatforming their IT operations by investing in cloud computing and workforce mobility, which has resulted in enterprise environments that are more open, interconnected, and vulnerable to cyber attacks. Today, an increasingly mobile workforce and the explosion of enterprise data and applications in the cloud have expanded the attack surface beyond the traditional network perimeter. In response, attackers have adapted their methods and tools to directly target the endpoint. In short, the endpoint is the new perimeter. Endpoints are the primary focus of attacks because they store valuable data that attackers seek to steal; perform critical operations that attackers seek to disrupt; and are the interface where attackers can target humans through email, social engineering and other tactics. Endpoints are the physical and virtual locations where sensitive data resides and include desktops, laptops, servers, virtual machines, cloud workloads (services running on cloud servers), containers, fixedfunction devices such as ATMs, point of sale systems, and control and data systems for power plants and other industrial assets. Our approach to solving these endpoint security challenges focuses on leveraging our big data and our security analytics platform in the cloud (the CB Predictive Security Cloud) to better detect and prevent the behaviors and specific techniques used by attackers. Based on our experience and investment in nextgeneration solutions designed to address the full endpoint security lifecycle, we have developed a highly differentiated technology approach with four main pillars: (1) unfiltered data collection, (2) proprietary data shaping technology, (3) streaming analytics, and (4) extensible open architecture. We began selling our initial product in 2005, which was the precursor to CB Protection. Our initial product focused on delivering endpoint protection for desktops and servers through application control. In February 2014, we acquired Carbon Black, whose solution was the precursor to CB Response. The acquisition of Carbon Black strengthened our position as a leader in advanced threat detection and incident response management solutions, and was an important event for us as it enabled us to provide our customers with solutions designed to address the full endpoint security lifecycle. We believe that our ability to address the full lifecycle of an attack is a critical differentiator versus other endpoint security technologies that address only a portion of the attack lifecycle. In more recent periods, we have focused on satisfying the increasing demand for cloudbased software from our customers and prospects and intend to continue to expand our cloudbased product offerings. In August 2015, we released a cloudbased version of CB Response to our customers under a softwareasaservice, or SaaS, model. In June 2016, we acquired Confer Technologies, Inc., or Confer, whose solution is currently sold to customers as CB Defense. The acquisition of Confer was an important event for us as it added key capabilities in the areas of cloudbased, multitenant, bigdata processing and streaming detection and prevention. With this acquisition, we also entered the nextgeneration antivirus market. The technology that we acquired in this acquisition is foundational to our predictive security cloud platform, which is designed to address the full endpoint security lifecycle, and to our strategy. For more information regarding the Confer acquisition, see Note 3 to our consolidated financial statements at the end of this Annual Report on Form 10K. The percentage of our total revenue generated by sales of our cloudbased solutions was 29% in 2018, 16% in 2017 and 6 [/INST] Positive. </s>

Level One Bancorp Inc

2019-03-22

2018-12-31

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion explains our financial condition as of December 31, 2018 and 2017 and results of operations for the years ended December 31, 2018, 2017, and 2016. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes presented elsewhere in this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under "Forward-Looking Statements," "Risk Factors" and elsewhere in this Form 10-K, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements. Critical Accounting Policies Our consolidated financial statements are prepared based on the application of accounting policies generally accepted in the United States. Our critical accounting policies require reliance on estimates and assumptions, which are based upon historical experience and on various other assumptions that management believes are reasonable under current circumstances, but may prove to be inaccurate or can be subject to variations. Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations. The most critical of these significant accounting policies are set forth in Note 1 - Summary of Significant Accounting Policies of the Notes to the Consolidated Statements in our consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this Form 10-K. Overview Level One Bancorp, Inc. is a bank holding company headquartered in Farmington Hills, Michigan, with its primary branch operations in southeastern Michigan and Grand Rapids, Michigan. Through our wholly owned subsidiary, Level One Bank, we offer a broad range of loan products to the residential and commercial markets, as well as retail and business banking services. Another wholly owned subsidiary, Hamilton Court Insurance Company, provides property and casualty insurance to the Company and the Bank, and reinsurance to ten other third-party insurance captives for which insurance may not be currently available or economically feasible in the insurance marketplace. Since 2007, we have grown substantially through organic growth and a series of four successful acquisitions, all of which have been fully integrated into our operations. We have made significant investments over the last several years in hiring additional staff and upgrading technology and system security. In 2016, we opened our first branch in the Grand Rapids, Michigan market. In the third quarter of 2017, we opened our second location in Bloomfield Township located in Oakland County. In the third quarter of 2018, we doubled the size of our mortgage division with the addition of new mortgage officers and support staff. We had net income of $14.4 million for the year ended December 31, 2018, compared to $9.8 million for the year ended December 31, 2017. As of December 31, 2018, the Company had total consolidated assets of $1.42 billion, total consolidated deposits of $1.13 billion and total consolidated shareholders' equity of $151.8 million. We continue to focus on growing our commercial real estate, commercial business and residential mortgage lending portfolios. At December 31, 2018, we had $1.13 billion in total loans. Of this amount $1.04 billion, or 92.5%, consisted of loans we originated, and $84.7 million, or 7.5%, consisted of loans we acquired (all of which were recorded at their estimated fair values at the time of acquisition). Recent Developments Fourth Quarter Dividend. On December 20, 2018, the Company’s Board of Directors declared a quarterly cash dividend of $0.03 per share. This dividend was paid out on January 15, 2019, to stockholders of record at the close of business on December 31, 2018. Share Buyback Program. On January 23, 2019, the Company announced that its Board of Directors approved a repurchase program under which the Company is authorized to repurchase, from time to time as the Company deems appropriate, shares of the Company’s common stock with an aggregate purchase price of up to $5 million. The repurchase program began on January 23, 2019, and expires on December 31, 2020. The repurchase program does not obligate the Company to repurchase any dollar amount or number of shares, and the program may be extended, modified, suspended or discontinued at any time. As of March 15, 2019, the Company had repurchased a total of 46,626 shares at an average price of $23.67 per share. The shares repurchased in the amount of $1.1 million are held as treasury stock. On March 21, 2019, the Company declared a first quarter 2019 cash dividend of $0.04 per share, payable on April 15, 2019. The first quarter cash dividend of $0.04 per share represents an increase of $0.01 per share, compared to $0.03 per share declared in prior quarter. Results of Operations Net Income We had net income of $14.4 million, or $1.91 per diluted common share, for the year ended December 31, 2018, compared to $9.8 million, or $1.49 per diluted common share, for the year ended December 31, 2017. The increase of $4.6 million in net income attributable to common shareholders in 2018 primarily reflects an increase of $2.9 million in net interest income, a decrease in income tax provision of $3.7 million, a decrease in provision expense for loan losses of $1.0 million, and an increase of $553 thousand in noninterest income. This was partially offset by an increase of $3.6 million in noninterest expenses. We had net income of $9.8 million, or $1.49 per diluted common share, for the year ended December 31, 2017 compared to $11.0 million, or $1.69 per diluted common share, for the year ended December 31, 2016. The decrease of $1.2 million in net income attributable to common shareholders in 2017 primarily reflects an increase in noninterest expense of $3.7 million, partially offset by a decrease in provision for loan losses of $2.5 million. Net Interest Income Net interest income is the difference between interest income and yield-related fees earned on assets and interest expense paid on liabilities. We had net interest income of $50.4 million and $47.5 million for the years ended December 31, 2018 and 2017, respectively. The year ended December 31, 2018 included a $8.2 million increase in interest income as well as a $5.3 million increase in interest expense, compared to the same period in 2017. The increase in interest income was primarily driven by an increase of $6.2 million in interest and fees on loans and an increase of $1.9 million in interest income from investment securities, whereas the increase in interest expense was primarily driven by an increase of $4.8 million in deposit interest expense and an increase of $533 thousand in interest expense on borrowed funds. The change in interest and fees on loans and interest income from investment securities for the year ended December 31, 2018 compared to 2017, was primarily driven by the growth in total loans and investment securities portfolios. In addition, the prime rate increases also resulted in a higher loan yield year over year. The increase in deposit interest expense during the year ended December 31, 2018 was primarily due to higher average rates paid on deposits as a result of the increase in the target federal fund rate, as well as an increase in total deposits compared to 2017. Our net interest margin (on a fully tax equivalent basis ("FTE")) for the year ended December 31, 2018 was 0.0392%, compared to 0.0418% for the same period in 2017. The decrease of 26 basis points was primarily a result of higher cost of funds compared to the same period in 2017. Our net interest margin benefits from discount accretion on our purchased credit impaired loan portfolios, a component of our accretable yield. The accretable yield represents the excess of the net present value of expected future cash flows over the acquisition date fair value and includes both the expected coupon of the loan and the discount accretion. The accretable yield is recognized as interest income over the expected remaining life of the purchased credit impaired loan. The difference between the actual yield earned on total loans and the yield generated based on the contractual coupon (not including any interest income for loans in nonaccrual status) represents excess accretable yield. The contractual coupon of the loan considers the contractual coupon rates of the loan and does not include any interest income for loans in nonaccrual status. For the years ended December 31, 2018 and 2017, the average yield on total loans was 5.43% and 5.35%, respectively. The yield on total loans was impacted by 28 basis points and 46 basis points, respectively, due to the accretable yield on purchased credit impaired loans. Our net interest margin for the years ended December 31, 2018 and 2017, benefited by 23 basis points and 39 basis points, respectively, as a result of the excess accretable yield. As of December 31, 2018 and December 31, 2017, our remaining accretable yield was $10.9 million and $14.5 million, respectively, and our nonaccretable difference was $5.6 million and $10.1 million, respectively. We had net interest income of $47.5 million and $47.1 million for the years ended December 31, 2017 and 2016, respectively. The year ended December 31, 2017 included a $2.7 million increase in interest income as well as a $2.2 million increase in interest expense compared to 2016. The increase in interest income was primarily driven by an increase of $1.3 million in interest and fees on loans and an increase of $829 thousand in interest income from investment securities, whereas the increase in interest expense was primarily driven by an increase of $1.8 million in deposit interest expense. The change in interest and fees on loans and interest income from investment securities for the year ended December 31, 2017 compared to 2016, was primarily driven by the growth in total loans and investment securities portfolios. The increase in deposit interest expense during the year ended December 31, 2017 was primarily due to an increase in the volume of deposits as well as higher average rates paid on deposits compared to 2016. Our net interest margin (FTE) for the year ended December 31, 2017 decreased 55 basis points to 4.18% from 4.73% for 2016. For the years ended December 31, 2017 and 2016, the average yield on total loans was 5.35% and 5.74%, respectively. The yield on total loans was impacted by 46 basis points and 83 basis points, respectively, due to the accretable yield on purchased credit impaired loans. Our net interest margin for the years ended December 31, 2017 and 2016, benefited by 39 basis points and 73 basis points, respectively, as a result of the excess accretable yield. As of December 31, 2017, and December 31, 2016, our accretable yield was $14.5 million and $19.9 million, respectively, and our nonaccretable difference was $10.1 million and $12.0 million, respectively. The following tables set forth information related to our average balance sheet, average yields on assets, and average rates of liabilities for the periods indicated. We derived these yields by dividing income or expense by the average daily balance of the corresponding assets or liabilities. In these tables, adjustments are made to the yields on tax-exempt assets in order to present tax-exempt income and fully taxable income on a comparable basis. Analysis of Net Interest Income-Fully Taxable Equivalent ______________________________________________________________________ 1. Interest income is shown on actual basis and does not include taxable equivalent adjustments. 2. Average rates and yields are presented on an annual basis and include a taxable equivalent adjustment to interest income of $319 thousand, $434 thousand, and $205 thousand on tax-exempt securities for the years ended December 31, 2018, 2017, and 2016, respectively, using the federal corporate tax rate of 21% for the period ended December 31, 2018 and 35% for the periods ended December 31, 2017 and 2016. 3. Includes nonaccrual loans 4. For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts. 5. Net interest margin represents net interest income divided by average total interest-earning assets. Rate/Volume Analysis The tables below present the effect of volume and rate changes on interest income and expense for the periods indicated. Changes in volume are changes in the average balance multiplied by the previous year's average rate. Changes in rate are changes in the average rate multiplied by the average balance from the previous year. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate. The average rate for tax-exempt securities is reported on a fully taxable equivalent basis. Provision for Loan Losses We established an allowance for loan losses through a provision for loan losses charged as an expense in our consolidated statements of income. Management reviews the loan portfolio, consisting of originated loans and purchased loans, on a quarterly basis to evaluate the outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Loans acquired in connection with acquisitions that have evidence of credit deterioration since origination and for which it is probable at the date of acquisition that we will not collect all contractually required principal and interest payments are accounted for under ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, or ASC 310-30. These credit-impaired loans have been recorded at their estimated fair value on the respective acquisition date, based on subjective determinations regarding risk ratings, expected future cash flows and fair value of the underlying collateral, without a carryover of the related allowance for loan losses. At the acquisition date, the Company recognizes the expected shortfall of expected future cash flows, as compared to the contractual amount due, as a nonaccretable discount. Any excess of the net present value of expected future cash flows over the acquisition date fair value is recognized as the accretable discount, or accretable yield. We evaluate these loans semi-annually to assess expected cash flows. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges or a reclassification of the difference from nonaccretable to accretable with a positive impact on interest income. As of December 31, 2018, and December 31, 2017, our remaining accretable yield was $10.9 million and $14.5 million, respectively, and our nonaccretable difference was $5.6 million and $10.1 million, respectively. The provision for loan losses was $412 thousand for the year ended December 31, 2018, compared to $1.4 million for the year ended December 31, 2017. The decrease in the provision for loan losses was primarily due to a decrease in specific reserves on impaired loans, less impairment recorded resulting from our semi-annual re-estimation of cash flows on acquired loans, and a decrease in net chargeoffs, partially offset by additional provision from the continued growth in our originated loan portfolio as a percentage of our total loans. Our total nonaccrual loans increased to $18.4 million at December 31, 2018 compared to $14.0 million at December 31, 2017. The increase in nonaccrual loans is primarily due to a large loan relationship of $7.2 million moving to nonaccrual, partially offset by the payoff of $2.9 million on a nonaccrual loan relationship during the fourth quarter 2018. The provision for loan losses was $1.4 million for the year ended December 31, 2017, compared to $3.9 million for the year ended December 31, 2016. The decrease in provision for loan losses in 2017 was primarily due to a decrease in specific reserves on impaired loans and a decrease in general reserves on originated loans due to slower loan growth in 2017. Our total nonaccrual loans decreased by $1.0 million as compared to an increase of $13.4 million in total nonaccrual loans during the year ended December 31, 2016. Noninterest Income The following table presents noninterest income for the years ended December 31, 2018, 2017 and 2016. Noninterest income increased $553 thousand to $7.1 million for the year ended December 31, 2018, compared to $6.5 million for the same period in 2017. The increase in noninterest income was primarily due to an increase in mortgage banking activities of $632 thousand and an increase in interest rate swap fees of $535 thousand (included in "other charges and fees" in the table above). This was partially offset by a decrease in net gain on sale of securities of $279 thousand, a decrease in gains on real estate owned of $189 thousand (included in "other charges and fees" in the table above) and a decrease in net gain on sale of commercial loans of $135 thousand. The increase in mortgage banking activities was primarily due to the Company's investment in the expansion of the mortgage banking division, which contributed to higher volume of loans sales, therefore resulting in higher income as compared to prior year. The increase in interest rate swap fees was due to the Company beginning to offer customer-initiated derivatives in 2018. The decrease in the gain on sale of securities was due to the lack of sale opportunities at acceptable prices and selling securities at a loss. The decrease in net gain on sale of commercial loans was primarily due to the lack of SBA loan sale opportunities during the year ended December 31, 2018, compared to 2017. Noninterest income was $6.5 million and $6.4 million for the years ended December 31, 2017 and 2016, respectively. Noninterest income for the year ended December 31, 2017, compared to the year ended December 31, 2016, benefited primarily from an increase in service charges on deposits of $658 thousand, increases in gain on sale of real estate owned of $202 thousand and BOLI income of $147 thousand (both included in "other charges and fees" in the table above), and an increase of $146 thousand in net gain on sale of commercial loans. The increases to these items of noninterest income were offset in part by a decrease in net gain on sale of securities of $718 thousand and a decrease in mortgage banking activities of $551 thousand. The increase in service charges on deposits was driven by deposit growth as well as higher income from MSB due to an increase in fees year over year. The decrease in net gain on sales of securities was due to fewer sales of securities during the year ended December 31, 2017 as a result of fewer market opportunities. The decrease in mortgage banking activities was driven by a lower volume of residential mortgage loan sales during the year ended December 31, 2017 reflecting decreased loan originations due to reduced refinancing activity as a result of increased home mortgage rates throughout the year. Noninterest Expense The following table presents noninterest expense for the years ended December 31, 2018, 2017 and 2016. Noninterest expenses increased $3.6 million to $39.7 million for the year ended December 31, 2018, as compared to $36.1 million for the same period in 2017. The increase in noninterest expense was primarily due to an increase in salary and employee benefits of $4.2 million, partially offset by a decrease in professional service fees of $642 thousand. The increase in salary and employee benefits between the periods resulted from an increase of 27 full-time employees, which includes the expansion of the mortgage team. The decrease in professional services fees was primarily due to lower legal fees and other professional fees between the periods. The decrease in legal fees in 2018 was due to higher legal fees incurred in 2017 in preparation for the Company's initial public offering, whereas the decrease in other professional fees in 2018 was due to the formation of the captive insurance company in 2017. Noninterest expenses increased $3.7 million to $36.1 million for the year ended December 31, 2017, from $32.4 million for 2016. The increase in noninterest expense was primarily due to an increase in salary and employee benefits of $3.6 million, an increase in professional service fees of $1.1 million, and an increase in occupancy and equipment expense of $838 thousand, partially offset by decreases in acquisition and due diligence fees of $2.7 million. The increase in noninterest expense excluding acquisition and due diligence fees was $6.4 million for the year ended December 31, 2017 compared to 2016. The increase in salary and employee benefits for the year ended December 31, 2017, as compared to 2016, resulted from an increase of 23 full-time equivalent employees, with a portion of the increase in headcount due to the opening of the Grand Rapids banking center. The increase in professional service fees was due primarily to regulatory and compliance services as a result of our growth and compliance related costs associated with our acquired MSB business. The increase in occupancy and equipment expense was primarily due to higher software maintenance costs to sustain the growth of the Company as well as higher building rent expense resulting from the opening of a new banking center in Grand Rapids during the year ended December 31, 2017. Acquisition and due diligence fees of $2.7 million for the year ended December 31, 2016 included severance expense, bank acquisition and due diligence fees and bonus payments related to our acquisition of Bank of Michigan. Income Taxes and Tax-Related Items During the year ended December 31, 2018, we recognized income tax expense of $3.0 million on $17.4 million of pre-tax income resulting in an effective tax rate of 17.3%, compared to the same period in 2017, in which we recognized an income tax expense of $6.7 million on $16.6 million of pre-tax income, resulting in an effective tax rate of 40.6%. The decrease in income tax rate for the year ended December 31, 2018, compared to the same period in 2017, primarily resulted from the decrease in the federal corporate income tax rate and the recording of a $1.3 million deferred tax asset impairment in the fourth quarter of 2017 as a result of the enactment of the TCJA in December 2017. Please refer to Note 9 - Income Taxes in the notes to the consolidated statements for a reconciliation between expected and actual income tax expense for the years ended December 31, 2018, 2017 and 2016. During the year ended December 31, 2017, we recognized income tax expense of $6.7 million on $16.6 million of pre-tax income resulting in an effective tax rate of 40.6%, compared to the year ended December 31, 2016, in which we recognized an income tax expense of $6.1 million on $17.1 million of pre-tax income, resulting in an effective tax rate of 35.6%. The increase in income tax rate for the year ended December 31, 2017 compared to 2016 primarily resulted from the Company recognizing an impairment on its deferred tax assets of $1.3 million related to the enactment of the TCJA. Financial Condition Total assets were $1.42 billion at December 31, 2018 and $1.30 billion at December 31, 2017. Total assets increased by $114.9 million between these two dates primarily due to increases of $91.6 million in gross loans and $53.3 million in securities available-for-sale, partially offset by a decrease of $30.4 million in cash and cash equivalents. The increase in loans was primarily driven by the growth in our commercial real estate, commercial and industrial, and residential real estate portfolios. The increase in securities available-for-sale reflects management's decision to invest in liquid assets while retaining accessibility to the funds for potential liquidity needs. The decrease in cash and cash equivalents was primarily due to a decrease in cash balances held with the Federal Reserve Bank by $40.7 million. The Company maintains a cash balance at the Federal Reserve and manages this liquidity balance on a daily basis as required, and may have significant cash balance fluctuations in the ordinary course of business based on inflows and outflows from changing loan totals, investment activity, and deposit flows. Investment Securities The following table presents the fair value of the Company's investment securities portfolio, all of which were classified as available-for-sale as of December 31, 2018, 2017 and 2016: The composition of our investment securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity for both normal operations and potential acquisitions while providing an additional source of revenue. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet, while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as collateral. At December 31, 2018, total investment securities were $204.3 million, or 14.4% of total assets, compared to $151.0 million, or 11.6% of total assets, at December 31, 2017. The $53.3 million increase in securities available for sale from December 31, 2017 to December 31, 2018, primarily reflected increases in obligations of state and political subdivisions, collateralized mortgage obligations: commercial, corporate bonds, SBA securities and asset backed securities. Securities with a carrying value of $22.7 million and $36.5 million were pledged at December 31, 2018 and December 31, 2017, respectively, to secure borrowings and deposits. As of December 31, 2018, the Company held 51 tax-exempt state and local municipal securities totaling $37.2 million backed by the Michigan School Bond Loan Fund. Other than the aforementioned investments, at December 31, 2018 and December 31, 2017, there were no holdings of securities of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of shareholders' equity. The securities available for sale presented in the following tables are reported at amortized cost and by contractual maturity as of December 31, 2018 and December 31, 2017. Actual timing may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, residential mortgage-backed securities and collateralized mortgage obligations receive monthly principal payments, which are not reflected below. The yields below are calculated on a tax equivalent basis. Loans Our loan portfolio represents a broad range of borrowers comprised of commercial real estate, commercial and industrial, residential real estate, and consumer financing loans. Commercial real estate loans consist of term loans secured by a mortgage lien on the real property, such as office and industrial buildings, retail shopping centers and apartment buildings, as well as commercial real estate construction loans that are offered to builders and developers. Commercial real estate loans are then segregated into two classes: non-owner occupied and owner occupied commercial real estate loans. Non-owner occupied loans, which include loans secured by non-owner occupied and nonresidential properties, generally have a greater risk profile than owner-occupied loans, which include loans secured by multifamily structures and owner-occupied commercial structures. Commercial and industrial loans include financing for commercial purposes in various lines of businesses, including manufacturing, service industry and professional service areas. Commercial and industrial loans are generally secured with the assets of the company and/or the personal guarantee of the business owners. Residential real estate loans represent loans to consumers for the purchase or refinance of a residence. These loans are generally financed over a 15- to 30-year term and, in most cases, are extended to borrowers to finance their primary residence with both fixed-rate and adjustable-rate terms. Real estate construction loans are also offered to consumers who wish to build their own homes and are often structured to be converted to permanent loans at the end of the construction phase, which is typically twelve months. Residential real estate loans also include home equity loans and lines of credit that are secured by a first- or second-lien on the borrower's residence. Home equity lines of credit consist mainly of revolving lines of credit secured by residential real estate. Consumer loans include loans made to individuals not secured by real estate, including loans secured by automobiles or watercraft, and personal unsecured loans. The following table details our loan portfolio by loan type at the dates presented: Total loans were $1.13 billion at December 31, 2018, an increase of $91.6 million from December 31, 2017. The total increase in loans of $91.6 million was primarily due to an increase in commercial real estate loans of $50.3 million, an increase in residential real estate loans of $35.6 million, and an increase in commercial and industrial loans of $5.8 million. In general, we target a loan portfolio mix of approximately one-half commercial real estate, approximately one-third commercial and industrial loans and one-sixth a mix of residential real estate and consumer loans. As of December 31, 2018, approximately 49.9% of our loans were commercial real estate, 34.0% were commercial and industrial, and 16.1% were residential real estate and consumer loans. We originate both fixed and adjustable rate residential real estate loans conforming to the underwriting guidelines of the Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation, as well as home equity loans and lines of credit that are secured by first or junior liens. Most of our fixed rate residential loans, along with some of our adjustable rate mortgages, are sold to other financial institutions with which we have established a correspondent lending relationship. The Company is in the process of establishing a direct relationship with FNMA and hopes to begin locking and selling loans to FNMA in mid 2019. Loan Maturity/Rate Sensitivity The following table shows the contractual maturities of our loans as of December 31, 2018. Summary of Impaired Assets and Past Due Loans Nonperforming assets consist of nonaccrual loans and other real estate owned. We do not consider performing troubled debt restructurings (TDRs) to be nonperforming assets, but they are included as part of impaired assets. The level of nonaccrual loans is an important element in assessing asset quality. Loans are classified as nonaccrual when, in the opinion of management, collection of principal or interest is not expected according to the terms of the agreement. Generally, loans are placed on nonaccrual status due to the continued failure by the borrower to adhere to contractual payment terms coupled with other pertinent factors, such as insufficient collateral value. A loan is categorized as a troubled debt restructuring if a concession is granted, such as to provide for the reduction of either interest or principal, due to deterioration in the financial condition of the borrower. Typical concessions include reduction of the interest rate on the loan to a rate considered lower than the current market rate, forgiveness of a portion of the loan balance, extension of the maturity date, and/or modifications from principal and interest payments to interest-only payments for a certain period. Loans are not classified as TDRs when the modification is short-term or results in only an insignificant delay or shortfall in the payments to be received. Credit Quality Indicators: The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes commercial and industrial and commercial real estate loans and is performed on an annual basis. The Company uses the following definitions for risk ratings: Pass. Loans classified as pass are higher quality loans that do not fit any of the other categories described below. This category includes loans risk rated with the following ratings: cash/stock secured, excellent credit risk, superior credit risk, good credit risk, satisfactory credit risk, and marginal credit risk. Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company's credit position at some future date. Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. For residential real estate loans and consumer loans, the Company evaluates credit quality based on the aging status of the loan and by payment activity. Residential real estate loans and consumer loans are considered nonperforming if they are 90 days or more past due. Consumer loan types are continuously monitored for changes in delinquency trends and other asset quality indicators. Purchased credit impaired loans accounted for under ASC 310-30 are classified as performing, even though they may be contractually past due, as any nonpayment of contractual principal or interest is considered in the semi-annual re-estimation of expected cash flows and is included in the resulting recognition of current period loan loss provision or future period yield adjustments. Total classified and criticized loans as of December 31, 2018 compared to December 31, 2017 were as follows: A summary of nonperforming assets (defined as nonaccrual loans and other real estate owned), performing troubled debt restructurings and loans 90 days or more past due and still accruing, as of the dates indicated, are presented below. ______________________________________________________ (1) Nonaccrual loans include nonperforming troubled debt restructurings of $5.0 million, $6.4 million, $5.8 million, $564 thousand and $636 thousand, at the respective dates indicated above. During the years ended December 31, 2018 and 2017, the Company recorded $394 thousand and $75 thousand, respectively, of interest income on nonaccrual loans and performing TDRs excluding PCI loans. In addition to nonperforming and impaired assets, the Company had purchased credit impaired loans accounted for under ASC 310-30 which amounted to $7.9 million, $9.7 million, $11.6 million, $17.6 million and $24.9 million at the respective dates indicated in the table above. Impaired assets increased as of December 31, 2018 compared to December 31, 2017. Commercial real estate nonaccrual loans increased significantly along with small increases in commercial and industrial and residential real estate nonaccrual loans. The increase in nonaccrual loans is primarily due to a large commercial real estate loan relationship moving to nonaccrual status. There was also an increase in residential real estate performing TDRs partially offset by a decrease in commercial and industrial performing TDRs. Allowance for Loan Losses We maintain the allowance for loan losses at a level we believe is sufficient to absorb probable incurred losses in our loan portfolio given the conditions at the time. Management determines the adequacy of the allowance based on periodic evaluations of the loan portfolio and other factors. These evaluations are inherently subjective as they require management to make material estimates, all of which may be susceptible to significant change. The allowance is increased by provisions charged to expense and decreased by actual charge-offs, net of recoveries. Purchased Loans The allowance for loan losses on purchased loans is based on credit deterioration subsequent to the acquisition date. In accordance with the accounting guidance for business combinations, there was no allowance brought forward on any of the acquired loans as any credit deterioration evident in the loans was included in the determination of the fair value of the loans at the acquisition date. For purchased credit impaired loans, accounted for under ASC 310-30, management establishes an allowance for credit deterioration subsequent to the date of acquisition by re-estimating expected cash flows on a semi-annual basis with any decline in expected cash flows recorded as provision for loan losses. Impairment is measured as the excess of the recorded investment in a loan over the present value of expected future cash flows discounted at the pre-impairment accounting yield of the loan. For increases in cash flows expected to be collected, we first reverse any previously recorded allowance for loan losses, then adjust the amount of accretable yield recognized on a prospective basis over the loan's remaining life. These cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. For non-purchased credit impaired loans acquired in our acquisitions that are accounted for under ASC 310-20, the historical loss estimates are based on the historical losses experienced since acquisition. We record an allowance for loan losses only when the calculated amount exceeds the discount remaining from acquisition that was established for the similar period covered in the allowance for loan loss calculation. For all other purchased loans, the allowance is calculated in accordance with the methods used to calculate the allowance for loan losses for originated loans, as described below. Originated Loans The allowance for loan losses represents management's assessment of probable credit losses inherent in the loan portfolio. The allowance for loan losses consists of specific components, based on individual evaluation of certain loans, and general components for homogeneous pools of loans with similar risk characteristics. Impaired loans include loans placed on nonaccrual status and troubled debt restructurings. Loans are considered impaired when based on current information and events it is probable that we will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreements. When determining if we will be unable to collect all principal and interest payments due in accordance with the original contractual terms of the loan agreement, we consider the borrower's overall financial condition, resources and payment record, support from guarantors, and the realizable value of any collateral. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. All impaired loans are identified to be individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the discounted expected future cash flows or at the fair value of collateral if repayment is collateral dependent. The allowance for our nonimpaired loans, which includes commercial real estate, commercial and industrial, residential, and consumer loans that are not individually evaluated for impairment, begins with a process of estimating the probable incurred losses in the portfolio. These estimates are established based on our historical loss data. Additional allowance estimates for commercial and industrial and commercial real estate loans are based on internal credit risk ratings. Internal credit risk ratings are assigned to each business loan at the time of approval and are subjected to subsequent periodic reviews by senior management, at least annually or more frequently upon the occurrence of a circumstance that affects the credit risk of the loan. As our operating history is limited and we have grown rapidly, the historical loss estimates for loans prior to 2017 were based primarily on the actual historical loss experienced by our peer banks combined with a small factor representing our own loss history. Starting in 2017, the Company modified its methodology on historical loss analysis to incorporate and fully rely on the Company's own historical loss data, which did not have a material impact. The historical loss estimates are established by loan type including commercial real estate, commercial and industrial, residential, and consumer. In addition, consideration is given to borrower’s rating for commercial and industrial and commercial real estate loans. The following table presents, by loan type, the changes in the allowance for loan losses for the periods presented. Our allowance for loan losses was $11.6 million, or 1.03% of loans, at December 31, 2018 compared to $11.7 million, or 1.13% of loans at December 31, 2017. The $147 thousand decrease in the allowance for loan losses during the year ended December 31, 2018 was primarily due to a $976 thousand decrease in specific reserves related to impaired loans and a $161 thousand decrease in reserves related to purchase credit impaired loans, partially offset by a $990 thousand increase in general reserves related to net loan growth. Our allowance for loan losses was $11.7 million, or 1.13% of loans, at December 31, 2017, compared to $11.1 million, or 1.16% of loans, at December 31, 2016. The $624 thousand increase in the allowance for loan losses during the year ended December 31, 2017 was primarily due to a $511 thousand increase in general reserve driven by growth in the originated loan portfolio. The following table presents, by loan type, the allocation of the allowance for loan losses for the dates presented. Deposits Total deposits were $1.13 billion at December 31, 2018 and $1.12 billion at December 31, 2017, representing 89.7% and 93.9% of total liabilities at each date, respectively. The increase in deposits of $14.3 million was due to an increase of $41.4 million in time deposits, partially offset by decreases of $25.3 million in demand deposits and $1.8 million in money market and savings deposits. Our average interest-bearing deposit costs were 1.38% and 0.91% for the years ended December 31, 2018 and 2017, respectively. The increase in interest-bearing deposit costs between the two periods was impacted by the changing mix of deposit types, as well as by the increase in overnight market rates, as measured by the target federal funds rate. The target federal funds rate rose 0.75% during 2017 and 1.00% during the year ended December 31, 2018, with additional increases expected in future periods, subject to economic conditions. Brokered deposits. Brokered deposits are marketed through national brokerage firms to their customers in $1,000 increments. For these brokered deposits, detailed records of owners are maintained by the Depository Trust Company under the name of CEDE & Co. This relationship provides a large source of deposits for the Company. Due to the competitive nature of the brokered deposit market, brokered deposits tend to bear higher rates of interest than non-brokered deposits. At December 31, 2018 and December 31, 2017, the Company had approximately $110.3 million and $87.8 million in brokered deposits, respectively. The Company's ability to accept, roll-over or renew brokered deposits is contingent upon the Bank maintaining a capital level of "well-capitalized." For periods prior to September 30, 2018, Certificate of Deposit Account Registry Service (CDARS) and reciprocal money market accounts were considered to be brokered deposits by regulatory authorities and were reported as such on quarterly Call Reports. With the passage of The Economic Growth, Regulatory Relief and Consumer Protection Act in May 2018, these items are no longer considered brokered deposits. Included in the brokered deposits total at December 31, 2018 and 2017 were $1.8 million and $3.3 million in CDARS customer deposit accounts. Management understands the importance of core deposits as a stable source of funding and may periodically implement various deposit promotion strategies to encourage core deposit growth, including recent promotions for time deposits and money market deposits. For periods of rising interest rates, management has modeled the aggregate yields for non-maturity deposits and time deposits to increase at a slower pace than the increase in underlying market rates, which is intended to result in net interest margin expansion and an increase in net interest income. The following tables set forth the distribution of average deposits by account type for the periods indicated below. The following table shows the contractual maturity of time deposits, including CDARs and IRA deposits and other brokered funds, of $100 thousand and over that were outstanding as of the date presented. Borrowings Total debt outstanding at December 31, 2018 was $114.5 million, an increase of $51.8 million from $62.7 million at December 31, 2017. The increase in total borrowings was primarily due to an increase of $55.0 million in short-term FHLB advances and $5.0 million in federal funds purchased, partially offset by a $10.0 million payoff in our long-term FHLB advances. The increase in total borrowings was a result of loan growth surpassing deposit growth. At December 31, 2018, FHLB advances were secured by a blanket lien on $372.5 million of real estate-related loans, and repurchase agreements were secured by securities with a fair value of $1.0 million At December 31, 2017, FHLB advances were secured by a blanket lien on $316.5 million of real estate-related loans, and repurchase agreements were secured by securities with a fair value of $2.5 million. As of December 31, 2018, the Company had $15.0 million of subordinated notes outstanding, and debt issuance costs of $109 thousand related to these subordinated notes. The notes bear a fixed interest rate of 6.375% per annum, payable semi-annually through December 15, 2020. The notes will bear a floating interest rate of three-month LIBOR plus 477 basis points payable quarterly after December 15, 2020 through maturity. The notes mature December 15, 2025, and the Company has the option to redeem or prepay any or all of the subordinated notes without premium or penalty any time after December 15, 2020 or at any time in the event of certain changes that affect the deductibility of interest for tax purposes or the treatment of the notes as Tier 2 Capital. Selected financial information pertaining to the components of our short-term borrowings for the periods and as of the dates indicated is as follows: Capital Resources Shareholders' equity is influenced primarily by earnings, dividends, sales of common stock and changes in accumulated other comprehensive income caused primarily by fluctuations in unrealized gains or losses, net of taxes, on available for sale securities. Shareholders' equity increased $43.8 million to $151.8 million at December 31, 2018 as compared to $108.0 million at December 31, 2017. The increase in shareholders' equity was primarily impacted by the issuance of 1,150,765 shares of common stock in our initial public offering, which resulted in net proceeds of $29.0 million, as well as $14.4 million of net income generated during the year ended December 31, 2018. These increases in shareholders' equity were partially offset by a $969 thousand increase in accumulated other comprehensive losses due to increases in unrealized losses on available for sale securities and $895 thousand in dividends declared in 2018. The following table summarizes the changes in our shareholders' equity for the periods indicated below: We strive to maintain an adequate capital base to support our activities in a safe and sound manner while at the same time attempting to maximize shareholder value. We assess capital adequacy against the risk inherent in our balance sheet, recognizing that unexpected loss is the common denominator of risk and that common equity has the greatest capacity to absorb unexpected loss. We are subject to various regulatory capital requirements both at the Company and at the Bank level. Failure to meet minimum capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting policies. We have consistently maintained regulatory capital ratios at or above the well-capitalized standards. During the first quarter of 2015, regulations implementing the Basel III regulatory capital framework and the Dodd-Frank Wall Street Reform and Consumer Protection Act became effective, certain provisions of which are subject to a multi-year phase-in period. As of January 1, 2019, the rules require the Company to maintain a capital conservation buffer of common equity capital that exceeds by more than 2.5% the minimum risk-weighted assets ratios, which is the fully phased-in amount of the capital conservation buffer. The capital conservation buffer requirement was 1.875% as of December 31, 2018 and 1.25% as of December 31, 2017, which is reflected in the table below. At December 31, 2018, the Company and the Bank met all the capital adequacy requirements to which they were subject. The summary below compares the actual capital ratios with the minimum quantitative measures established by regulation to ensure capital adequacy: _______________________________________________________________________________ (1) Reflects the capital conservation buffer of 1.875% and 1.25% applicable during 2018 and 2017, respectively. Contractual Obligations and Off-Balance Sheet Arrangements Contractual Obligations. In the ordinary course of our operations, we enter into certain contractual obligations. Total contractual obligations at December 31, 2018 were $607.2 million, an increase of $94.4 million, from $512.8 million at December 31, 2017. The increase of $94.4 million was primarily due to an increase of $61.8 million in short-term borrowings and $41.4 million in time deposits, partially offset by a decrease of $10.1 million in long-term borrowings. The following tables present our contractual obligations as of December 31, 2018 and December 31, 2017. Off- Balance Sheet Arrangements. In the normal course of business, the Company offers a variety of financial instruments with off-balance sheet risk to meet the financing needs of its customers. These financial instruments include outstanding commitments to extend credit, credit lines, commercial letters of credit and standby letters of credit. These are agreements to provide credit, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies used for loans are used to make such commitments, including obtaining collateral at exercise of the commitment. We maintain an allowance to cover probable losses inherent in our financial instruments with off-balance sheet risk. At December 31, 2018, the allowance for off-balance sheet risk was $38 thousand, and included in "Other liabilities" on our consolidated balance sheets. A summary of the contractual amounts of our exposure to off-balance sheet risk is as follows. Of the total unused lines of credit of $248.2 million at December 31, 2018, $54.5 million was comprised of undisbursed construction loan commitments. The Company expects to have sufficient access to liquidity to fund its off-balance sheet commitments. Liquidity Liquidity management is the process by which we manage the flow of funds necessary to meet our financial commitments on a timely basis and at a reasonable cost and to take advantage of earnings enhancement opportunities. These financial commitments include withdrawals by depositors, credit commitments to borrowers, expenses of our operations, and capital expenditures. Liquidity is monitored and closely managed by the Bank's Asset and Liability Committee (ALCO), a group of senior officers from the finance, enterprise risk management, treasury, and lending areas, as well as two Board members. It is ALCO's responsibility to ensure we have the necessary level of funds available for normal operations as well as maintain a contingency funding policy to ensure that potential liquidity stress events are planned for and quickly identified, and management has plans in place to respond. ALCO has created policies which establish limits and require measurements to monitor liquidity trends, including modeling and management reporting that identifies the amounts and costs of all available funding sources. In addition, we have implemented modeling software that projects cash flows from the balance sheet under a broad range of potential scenarios, including severe changes in the economic environment. At December 31, 2018, we had liquid assets of $213.7 million, compared to $178.1 million at December 31, 2017. Liquid assets include cash and due from banks, federal funds sold, interest-bearing deposits with banks and unencumbered securities available-for-sale. The Bank is a member of the FHLB, which provides short- and long-term funding to its members through advances collateralized by real estate-related assets and other select collateral, most typically in the form of debt securities. The actual borrowing capacity is contingent on the amount of collateral available to be pledged to the FHLB. As of December 31, 2018, we had $92.5 million of outstanding borrowings from the FHLB. The advances were secured by a blanket lien on $372.5 million of real estate-related loans as of December 31, 2018. Based on this collateral and the Company's holdings of FHLB stock, the Company is eligible to borrow up to an additional $131.6 million. In addition, the Bank can borrow up to $125.0 million through the unsecured lines of credit it has established with nine other banks, as well as $5.0 million through a secured line with the Federal Reserve Bank. We also maintain relationships with correspondent banks which could provide funds on short notice, if needed. In addition, because the Bank is "well capitalized," it can accept wholesale funding up to approximately $565.5 million based on current policy limits. Management believed that we had adequate resources to fund all of our commitments as of December 31, 2018. The following liquidity ratios compare certain assets and liabilities to total deposits or total assets.

<s>[INST] This discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under "ForwardLooking Statements," "Risk Factors" and elsewhere in this Form 10K, may cause actual results to differ materially from those projected in the forwardlooking statements. We assume no obligation to update any of these forwardlooking statements. Critical Accounting Policies Our consolidated financial statements are prepared based on the application of accounting policies generally accepted in the United States. Our critical accounting policies require reliance on estimates and assumptions, which are based upon historical experience and on various other assumptions that management believes are reasonable under current circumstances, but may prove to be inaccurate or can be subject to variations. Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations. The most critical of these significant accounting policies are set forth in Note 1 Summary of Significant Accounting Policies of the Notes to the Consolidated Statements in our consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this Form 10K. Overview Level One Bancorp, Inc. is a bank holding company headquartered in Farmington Hills, Michigan, with its primary branch operations in southeastern Michigan and Grand Rapids, Michigan. Through our wholly owned subsidiary, Level One Bank, we offer a broad range of loan products to the residential and commercial markets, as well as retail and business banking services. Another wholly owned subsidiary, Hamilton Court Insurance Company, provides property and casualty insurance to the Company and the Bank, and reinsurance to ten other thirdparty insurance captives for which insurance may not be currently available or economically feasible in the insurance marketplace. Since 2007, we have grown substantially through organic growth and a series of four successful acquisitions, all of which have been fully integrated into our operations. We have made significant investments over the last several years in hiring additional staff and upgrading technology and system security. In 2016, we opened our first branch in the Grand Rapids, Michigan market. In the third quarter of 2017, we opened our second location in Bloomfield Township located in Oakland County. In the third quarter of 2018, we doubled the size of our mortgage division with the addition of new mortgage officers and support staff. We had net income of $14.4 million for the year ended December 31, 2018, compared to $9.8 million for the year ended December 31, 2017. As of December 31, 2018, the Company had total consolidated assets of $1.42 billion, total consolidated deposits of $1.13 billion and total consolidated shareholders' equity of $151.8 million. We continue to focus on growing our commercial real estate, commercial business and residential mortgage lending portfolios. At December 31, 2018, we had $1.13 billion in total loans. Of this amount $1.04 billion, or 92.5%, consisted of loans we originated, and $84.7 million, or 7.5%, consisted of loans we acquired (all of which were recorded at their estimated fair values at the time of acquisition). Recent Developments Fourth Quarter Dividend. On December 20, 2018, the Company’s Board of Directors declared a quarterly cash dividend of $0.03 per share. This dividend was paid out on January 15, 2019, to stockholders of record at the close of business on December 31, 2018. Share Buyback Program. On January 23, 2019, the Company announced that its Board of Directors approved a repurchase program under which the Company is authorized to repurchase, from time to time as the Company deems appropriate, shares of the Company’s common stock with an aggregate purchase price of up to $5 million. The repurchase program began on January 23, 2019, and expires on December 31, 2020. The repurchase program does not obligate the Company [/INST] Positive. </s>

Level One Bancorp Inc

2020-03-13

2019-12-31

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion explains our financial condition as of December 31, 2019 and 2018 and results of operations for the years ended December 31, 2019, 2018 and 2017. The following discussion and analysis should be read in conjunction with the consolidated financial statements and related notes presented in Item 8 of this report. This discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under "Forward-Looking Statements," "Risk Factors" and elsewhere in this Form 10-K, may cause actual results to differ materially from those projected in the forward-looking statements. We assume no obligation to update any of these forward-looking statements. Critical Accounting Policies Our consolidated financial statements are prepared based on the application of accounting policies generally accepted in the United States. Our critical accounting policies require reliance on estimates and assumptions, which are based upon historical experience and on various other assumptions that management believes are reasonable under current circumstances, but may prove to be inaccurate or can be subject to variations. Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations. The most critical of these significant accounting policies are set forth in Note 1 - Basis of Presentation and Summary of Significant Accounting Policies of the Notes to the Consolidated Statements in our consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this Form 10-K. Overview Level One Bancorp, Inc. is a financial holding company headquartered in Farmington Hills, Michigan, with its primary branch operations in southeastern and west Michigan. Through our wholly owned subsidiary, Level One Bank, we offer a broad range of loan products to the residential and commercial markets, as well as retail and business banking services. Hamilton Court Insurance Company, a wholly owned subsidiary of the Company, provides property and casualty insurance to the Company and the Bank and reinsurance to ten other third-party insurance captives for which insurance may not be currently available or economically feasible in the insurance marketplace. Since 2007, we have grown substantially through organic growth and a series of four acquisitions, all of which have been fully integrated into our operations. We have made significant investments over the last several years in hiring additional staff and upgrading technology and system security. In 2016, we opened our first branch in the Grand Rapids, Michigan market. In the third quarter of 2017, we opened our second location in Bloomfield Township located in Oakland County. In the third quarter of 2018, we doubled the size of our mortgage division with the addition of new mortgage officers and support staff. As of December 31, 2019, the Company had total consolidated assets of $1.58 billion, total consolidated deposits of $1.14 billion and total consolidated shareholders' equity of $170.7 million. Our principal business activity has been lending to and accepting deposits from individuals, businesses, municipalities and other entities. We derive income principally from interest charged on loans and leases and, to a lesser extent, from interest and dividends earned on investment securities. We have also derived income from noninterest sources, such as fees received in connection with various lending and deposit services and originations and sales of residential mortgage loans. Our principal expenses include interest expense on deposits and borrowings, operating expenses, such as salaries and employee benefits, occupancy and equipment expenses, data processing costs, professional fees and other noninterest expenses, provisions for loan losses and income tax expense. Recent Developments Merger with Ann Arbor Bancorp, Inc. On January 2, 2020, the Company completed its previously announced acquisition of Ann Arbor Bancorp, Inc. (“AAB”) and its wholly owned subsidiary, Ann Arbor State Bank. The transaction was completed pursuant to a merger of the Company’s wholly owned merger subsidiary (“Merger Sub”) with and into AAB, pursuant to the Agreement and Plan of Merger, dated as of August 12, 2019, among the Company, Merger Sub and AAB. Level One paid aggregate consideration of approximately $67.9 million in cash. Level One expects to have approximately $1.4 million in expenses related to the acquisition in the first quarter of 2020. As of December 31, 2019, Ann Arbor State Bank had total assets of $319.4 million, total loans of $222.1 million and total deposits of $267.7 million. Fourth Quarter Dividend. On December 19, 2019, the Company declared a fourth quarter 2019 cash dividend of $0.04 per share, payable on January 15, 2020 to shareholders of record on December 31, 2019. Results of Operations Net Income We had net income of $16.1 million, or $2.05 per diluted common share, for the year ended December 31, 2019, compared to $14.4 million, or $1.91 per diluted common share, for the year ended December 31, 2018. The increase of $1.7 million in net income in 2019 primarily reflected an increase of $7.1 million in noninterest income and an increase of $631 thousand in net interest income. This was partially offset by increases of $4.7 million in noninterest expense, $971 thousand in provision for loan losses and $400 thousand in income tax provision. For a discussion on the comparison of results of operations for the years ended December 31, 2018 and 2017, refer Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operation in the Company's Annual Form 10-K, filed with the SEC on March 22, 2019. Net Interest Income Our primary source of revenue is net interest income, which is the difference between interest income from interest-earning assets (primarily loans and securities) and interest expense of funding sources (primarily interest-bearing deposits and borrowings). Net interest income was $51.1 million and $50.4 million for the years ended December 31, 2019 and 2018, respectively. The year ended December 31, 2019 included a $6.6 million increase in interest income as well as a $6.0 million increase in interest expense, compared to the same period in 2018. The increase in interest income was primarily driven by increases of $5.1 million in interest and fees on loans and $1.2 million in interest income from investment securities, and the increase in interest expense was primarily driven by an increase of $5.9 million in deposit interest expense. The increase in interest and fees on loans for the year ended December 31, 2019 compared to 2018, was mainly attributable to the increase in the average balance of loans of $96.7 million. The increase in interest income from investment securities was primarily due to the increase in the average balance of investment securities of $29.0 million and an increase in average interest rate paid of 0.43%. The increase in deposit interest expense during the year ended December 31, 2019 compared to 2018 was primarily due to a higher average rate paid on deposits of 1.95% compared to 1.52%, which was mainly as a result of increased competition and the federal funds rate increase of 100 basis points during the year ended December 31, 2018, compared to a 75 basis point decrease in the second half of 2019, leaving the cost of funds higher year over year. In addition, the increase in deposit expense was impacted by an increase in average balance of deposits of $98.0 million compared to the same period in 2018. Our net interest margin (on a fully tax equivalent basis ("FTE")) for the year ended December 31, 2019 was 3.60%, compared to 3.92% for the same period in 2018. The decrease of 32 basis points in the net interest margin year over year was primarily due to the federal funds rate increase of 100 basis points during the year ended December 31, 2018, compared to a 75 basis point decrease in the second half of 2019, leaving the cost of funds higher year over year. Our net interest margin benefits from discount accretion on our purchased credit impaired loan portfolios, a component of our accretable yield. The accretable yield represents the excess of the net present value of expected future cash flows over the acquisition date fair value and includes both the expected coupon of the loan and the discount accretion. The accretable yield is recognized as interest income over the expected remaining life of the purchased credit impaired loan. The difference between the actual yield earned on total loans and the yield generated based on the contractual coupon (not including any interest income for loans in nonaccrual status) represents excess accretable yield. The contractual coupon of the loan considers the contractual coupon rates of the loan and does not include any interest income for loans in nonaccrual status. For the years ended December 31, 2019 and 2018, the average yield on total loans was 5.42% and 5.43%, respectively. The yield on total loans was impacted by 16 basis points and 28 basis points, respectively, due to the accretable yield on purchased credit impaired loans. Our net interest margin for the years ended December 31, 2019 and 2018, benefited by 15 basis points and 23 basis points, respectively, as a result of the excess accretable yield. As of December 31, 2019 and December 31, 2018, our remaining accretable yield was $9.1 million and $10.9 million, respectively, and our nonaccretable difference was $3.9 million and $5.6 million, respectively. The following table sets forth information related to our average balance sheet, average yields on assets, and average rates on liabilities for the periods indicated. We derived these yields by dividing income or expense by the average daily balance of the corresponding assets or liabilities. In this table, adjustments were made to the yields on tax-exempt assets in order to present tax-exempt income and fully taxable income on a comparable basis. Analysis of Net Interest Income-Fully Taxable Equivalent ______________________________________________________________________ (1) Interest income is shown on actual basis and does not include taxable equivalent adjustments. (2) Average rates and yields are presented on an annual basis and include a taxable equivalent adjustment to interest income of $453 thousand, $319 thousand, and $434 thousand on tax-exempt securities for the years ended December 31, 2019, 2018 and 2017, respectively, using the federal corporate tax rate of 21% for the periods ended December 31, 2019 and 2018 and 35% for the period ended December 31, 2017. (3) Includes nonaccrual loans (4) For presentation in this table, average balances and the corresponding average rates for investment securities are based upon historical cost, adjusted for amortization of premiums and accretion of discounts. (5) Net interest margin represents net interest income divided by average total interest-earning assets. Rate/Volume Analysis The table below presents the effect of volume and rate changes on interest income and expense for the periods indicated. Changes in volume are changes in the average balance multiplied by the previous year's average rate. Changes in rate are changes in the average rate multiplied by the average balance from the previous year. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate. The average rate for tax-exempt securities is reported on a fully taxable equivalent basis. Provision for Loan Losses We established an allowance for loan losses through a provision for loan losses charged as an expense in our consolidated statements of income. Management reviews the loan portfolio, consisting of originated loans and purchased loans, on a quarterly basis to evaluate the outstanding loans and to measure both the performance of the portfolio and the adequacy of the allowance for loan losses. Loans acquired in connection with acquisitions that have evidence of credit deterioration since origination and for which it is probable at the date of acquisition that we will not collect all contractually required principal and interest payments are accounted for under ASC Topic 310-30, Loans and Debt Securities Acquired with Deteriorated Credit Quality, or ASC 310-30. These credit-impaired loans have been recorded at their estimated fair value on the respective acquisition date, based on subjective determinations regarding risk ratings, expected future cash flows and fair value of the underlying collateral, without a carryover of the related allowance for loan losses. At the acquisition date, the Company recognizes the expected shortfall of expected future cash flows, as compared to the contractual amount due, as a nonaccretable discount. Any excess of the net present value of expected future cash flows over the acquisition date fair value is recognized as the accretable discount, or accretable yield. We evaluate these loans semi-annually to assess expected cash flows. Subsequent decreases to the expected cash flows will generally result in a provision for loan losses. Subsequent increases in cash flows result in a reversal of the provision for loan losses to the extent of prior charges or a reclassification of the difference from nonaccretable to accretable with a positive impact on interest income. As of December 31, 2019, and December 31, 2018, our remaining accretable yield was $9.1 million and $10.9 million, respectively, and our nonaccretable difference was $3.9 million and $5.6 million, respectively. The provision for loan losses was a provision expense of $1.4 million for the year ended December 31, 2019 compared to a $412 thousand provision expense for the same period in 2018. The increase in the provision for loan losses was primarily due to a $839 thousand increase in specific reserves on impaired loans and a $414 thousand increase in general reserves due to continued growth in our originated loan portfolio as a percentage of our total loans. This was partially offset by $284 thousand lower charge-offs during the 2019 period compared to the same period in 2018. The increase in specific reserves on impaired loans was primarily due to the release in 2018 of $729 thousand of specific reserves on a commercial loan relationship that paid off in the fourth quarter of 2018. Noninterest Income The following table presents noninterest income for the years ended December 31, 2019, 2018, and 2017. Noninterest income increased $7.1 million to $14.2 million for the year ended December 31, 2019 compared to $7.1 million for the same period in 2018. The increase in noninterest income was primarily due to an increase in mortgage banking activities of $5.6 million, an increase in net gains on sales of securities of $1.2 million and an increase in interest rate swap fees of $576 thousand (included in "other charges and fees" in the table above). The increase in the mortgage banking activities income was a result of secondary market fees and application/origination fees on increased volumes of mortgage loans sold and the fair value adjustment and derivatives on higher volumes of loans held for sale. The increased volumes were predominantly a result of expanding the mortgage banking division in the third quarter of 2018 as well as lower interest rates throughout 2019. The increase in net gain on sales of securities was primarily due to the sale of securities which reflected our efforts to better position our combined investment portfolio in connection with the merger with Ann Arbor State Bank. The increase in interest rate swap fees was due to the Company offering customer-initiated derivatives for all of 2019. Noninterest Expense The following table presents noninterest expense for the years ended December 31, 2019, 2018, and 2017. Noninterest expense increased $4.7 million to $44.4 million for the year ended December 31, 2019, as compared to $39.7 million for the same period in 2018. The increase in noninterest expense was primarily due to increases in salary and employee benefits of $3.0 million, acquisition and due diligence fees of $539 thousand, occupancy and equipment expense of $514 thousand, other expense of $307 thousand, and data processing expense of $228 thousand. The increase in salary and employee benefits between the periods was primarily due to an increase of $1.8 million in mortgage commissions expense as a result of higher loan volumes as well as having the expanded mortgage team for the full 2019 calendar year. The increase in acquisition and due diligence fees was related to the merger with Ann Arbor State Bank, which closed on January 2, 2020. The increases in the data processing and occupancy and equipment expenses were primarily attributable to incremental increases in software costs and building expenses to sustain the growth of the Company. The increase in other expense was primarily due to an increase in the provision for unfunded commitments as a result of a change in the assumptions within the calculation, which resulted in a better representation of our line of credit utilization. Income Taxes and Tax-Related Items Refer to Note 9 - Income Taxes in the notes to the consolidated financial statements for a reconciliation between expected and actual income tax expense for the years ended December 31, 2019 and 2018. Financial Condition Total assets increased $168.7 million to $1.58 billion at December 31, 2019 as compared to $1.42 billion at December 31, 2018. The increase in total assets was primarily due to increases of $101.0 million in gross loans, $70.6 million in cash and cash equivalents, $8.3 million in mortgage loans held for sale, $5.1 million in receivables from a loan sub-servicer (included in "other assets" on the consolidated balance sheet), and $3.6 million in fair value of interest rate swaps (included in "other assets" on the consolidated balance sheet), partially offset by a decrease of $23.4 million in securities available-for-sale. The year over year increase in loans was primarily driven by the growth in both our commercial real estate, residential real estate, and commercial and industrial loan portfolios. Cash and cash equivalents increased primarily as a result of a $74.4 million increase in cash balances held with the Federal Reserve Bank in preparation for the closing of the merger with Ann Arbor State Bank. The Company maintains a cash balance at the Federal Reserve and manages this liquidity balance on a daily basis as required, and may have significant cash balance fluctuations in the ordinary course of business based on inflows and outflows from changing loan totals, investment activity, and deposit flows. The increase in mortgage loans held for sale was attributable to the increase in volumes of loans held for sale as a result of the doubling of our mortgage team during the third quarter of 2018 as well as the decrease in interest rates during 2019, which resulted in a higher demand for mortgage loans. The increase in the fair value of interest rate swaps was partly volume driven as a result of the Company offering interest rate swaps to customers during all of 2019, as well as due to the changes in interest rates. The decrease in securities available-for-sale reflected our efforts to better position our combined investment portfolio in connection with the merger with Ann Arbor State Bank. Investment Securities The following table presents the fair value of the Company's investment securities portfolio, all of which were classified as available-for-sale as of December 31, 2019, 2018 and 2017. The composition of our investment securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity for both normal operations and potential acquisitions, while providing an additional source of revenue. The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet, while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as collateral. At December 31, 2019, total investment securities were $180.9 million, or 11.4% of total assets, compared to $204.3 million, or 14.4% of total assets, at December 31, 2018. The $23.4 million decrease in securities available-for-sale from December 31, 2018 to December 31, 2019, primarily reflected decreases in obligations of U.S. Treasury, corporate bonds, collateralized mortgage obligations: residential, collateralized mortgage obligations: commercial, mortgage backed securities: commercial, and U.S. government sponsored entities and agencies, partially offset by increases in state and political subdivisions, SBA, and asset backed securities. The decrease in securities available-for-sale year over year reflected our efforts to better position our combined investment portfolio in connection with the merger with Ann Arbor State Bank. Securities with a carrying value of $27.3 million and $22.7 million were pledged at December 31, 2019 and December 31, 2018, respectively, to secure borrowings, deposits and mortgage derivatives. As of December 31, 2019, the Company held 56 tax-exempt state and local municipal securities totaling $40.1 million backed by the Michigan School Bond Loan Fund. Other than the aforementioned investments, at December 31, 2019 and December 31, 2018, there were no holdings of securities of any one issuer, other than the U.S. government and its agencies, in an amount greater than 10% of shareholders' equity. The securities available-for-sale presented in the following tables are reported at amortized cost and by contractual maturity as of December 31, 2019 and December 31, 2018. Actual timing may differ from contractual maturities if borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Additionally, residential mortgage-backed securities and collateralized mortgage obligations receive monthly principal payments, which are not reflected below. The yields below are calculated on a tax equivalent basis. Loans Our loan portfolio represents a broad range of borrowers comprised of commercial real estate, commercial and industrial, residential real estate, and consumer financing loans. Commercial real estate loans consist of term loans secured by a mortgage lien on the real property, such as office and industrial buildings, retail shopping centers and apartment buildings, as well as commercial real estate construction loans that are offered to builders and developers. Commercial real estate loans are then segregated into two classes: non-owner occupied and owner occupied commercial real estate loans. Non-owner occupied loans, which include loans secured by non-owner occupied and nonresidential properties, generally have a greater risk profile than owner-occupied loans, which include loans secured by multifamily structures and owner-occupied commercial structures. Commercial and industrial loans include financing for commercial purposes in various lines of businesses, including manufacturing, service industry and professional service areas. Commercial and industrial loans are generally secured with the assets of the company and/or the personal guarantee of the business owners. Residential real estate loans represent loans to consumers for the purchase or refinance of a residence. These loans are generally financed over a 15- to 30-year term and, in most cases, are extended to borrowers to finance their primary residence with both fixed-rate and adjustable-rate terms. Real estate construction loans are also offered to consumers who wish to build their own homes and are often structured to be converted to permanent loans at the end of the construction phase, which is typically twelve months. Residential real estate loans also include home equity loans and lines of credit that are secured by a first- or second-lien on the borrower's residence. Home equity lines of credit consist mainly of revolving lines of credit secured by residential real estate. Consumer loans include loans made to individuals not secured by real estate, including loans secured by automobiles or watercraft, and personal unsecured loans. The following table details our loan portfolio by loan type at the dates presented: Total loans were $1.23 billion at December 31, 2019, an increase of $101.0 million from December 31, 2018. The total increase in loans from December 31, 2018 was primarily due to an increase in commercial real estate loans of $42.6 million, commercial and industrial loans of $26.8 million and residential real estate of $31.8 million. In general, we target a loan portfolio mix of approximately one-half commercial real estate, approximately one-third commercial and industrial loans and one-sixth a mix of residential real estate and consumer loans. As of December 31, 2019, approximately 49.3% of our loans were commercial real estate, 33.4% were commercial and industrial, and 17.3% were residential real estate and consumer loans. We originate both fixed and adjustable rate residential real estate loans conforming to the underwriting guidelines of Fannie Mae and Freddie Mac, as well as home equity loans and lines of credit that are secured by first or junior liens. Most of our fixed rate residential loans, along with some of our adjustable rate mortgages, are sold to other financial institutions with which we have established a correspondent lending relationship. The Company has established a direct relationship with Fannie Mae and began locking and selling loans to Fannie Mae during the third quarter of 2019. Loan Maturity/Rate Sensitivity The following table shows the contractual maturities of our loans as of December 31, 2019. Summary of Impaired Assets and Past Due Loans Nonperforming assets consist of nonaccrual loans and other real estate owned. We do not consider performing troubled debt restructurings (TDRs) to be nonperforming assets, but they are included as part of impaired assets. The level of nonaccrual loans is an important element in assessing asset quality. Loans are classified as nonaccrual when, in the opinion of management, collection of principal or interest is not expected according to the terms of the agreement. Generally, loans are placed on nonaccrual status due to the continued failure by the borrower to adhere to contractual payment terms coupled with other pertinent factors, such as insufficient collateral value. A loan is categorized as a troubled debt restructuring if a concession is granted, such as to provide for the reduction of either interest or principal, due to deterioration in the financial condition of the borrower. Typical concessions include reduction of the interest rate on the loan to a rate considered lower than the current market rate, forgiveness of a portion of the loan balance, extension of the maturity date, and/or modifications from principal and interest payments to interest-only payments for a certain period. Loans are not classified as TDRs when the modification is short-term or results in only an insignificant delay or shortfall in the payments to be received. Credit Quality Indicators: The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. The Company analyzes loans individually by classifying the loans as to credit risk. This analysis includes commercial and industrial and commercial real estate loans and is performed on an annual basis. The Company uses the following definitions for risk ratings: Pass. Loans classified as pass are higher quality loans that do not fit any of the other categories described below. This category includes loans risk rated with the following ratings: cash/stock secured, excellent credit risk, superior credit risk, good credit risk, satisfactory credit risk, and marginal credit risk. Special Mention. Loans classified as special mention have a potential weakness that deserves management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the Company's credit position at some future date. Substandard. Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Doubtful. Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. For residential real estate loans and consumer loans, the Company evaluates credit quality based on the aging status of the loan and by payment activity. Residential real estate loans and consumer loans are considered nonperforming if they are 90 days or more past due. Consumer loan types are continuously monitored for changes in delinquency trends and other asset quality indicators. Purchased credit impaired loans accounted for under ASC 310-30 are classified as performing, even though they may be contractually past due, as any nonpayment of contractual principal or interest is considered in the semi-annual re-estimation of expected cash flows and is included in the resulting recognition of current period loan loss provision or future period yield adjustments. Total classified and criticized loans as of December 31, 2019 compared to December 31, 2018 were as follows: A summary of nonperforming assets (defined as nonaccrual loans and other real estate owned), performing troubled debt restructurings and loans 90 days or more past due and still accruing, as of the dates indicated, are presented below. ______________________________________________________ (1) Nonaccrual loans include nonperforming troubled debt restructurings of $3.0 million, $5.0 million, $6.4 million, $5.8 million, and $564 thousand at the respective dates indicated above. During the years ended December 31, 2019 and 2018, the Company recorded $865 thousand and $394 thousand, respectively, of interest income on nonaccrual loans and performing TDRs excluding PCI loans. In addition to nonperforming and impaired assets, the Company had purchased credit impaired loans accounted for under ASC 310-30 which amounted to $6.0 million, $7.9 million, $9.7 million, $11.6 million, and $17.6 million at the respective dates indicated in the table above. Impaired assets increased $1.0 million as of December 31, 2019 compared to December 31, 2018. Commercial and industrial nonaccrual loans increased by $1.5 million, commercial real estate nonaccrual loans decreased by $1.1 million and residential real estate nonaccrual loans decreased by $346 thousand. The increase in nonaccrual loans is primarily due to three commercial loan relationships totaling $12.8 million moving to nonaccrual status. This was partially offset by the payoff of three large commercial loan relationships on nonaccrual status totaling $12.4 million. There was also an increase of $921 thousand in other real estate owned due to the addition of two residential properties and one commercial property during 2019. Allowance for Loan Losses We maintain the allowance for loan losses at a level we believe is sufficient to absorb probable incurred losses in our loan portfolio given the conditions at the time. Management determines the adequacy of the allowance based on periodic evaluations of the loan portfolio and other factors. These evaluations are inherently subjective as they require management to make material estimates, all of which may be susceptible to significant change. The allowance is increased by provisions charged to expense and decreased by actual charge-offs, net of recoveries. Purchased Loans The allowance for loan losses on purchased loans is based on credit deterioration subsequent to the acquisition date. In accordance with the accounting guidance for business combinations, there was no allowance brought forward on any of the acquired loans as any credit deterioration evident in the loans was included in the determination of the fair value of the loans at the acquisition date. For purchased credit impaired loans, accounted for under ASC 310-30, management establishes an allowance for credit deterioration subsequent to the date of acquisition by re-estimating expected cash flows on a semi-annual basis with any decline in expected cash flows recorded as provision for loan losses. Impairment is measured as the excess of the recorded investment in a loan over the present value of expected future cash flows discounted at the pre-impairment accounting yield of the loan. For increases in cash flows expected to be collected, we first reverse any previously recorded allowance for loan losses, then adjust the amount of accretable yield recognized on a prospective basis over the loan's remaining life. These cash flow evaluations are inherently subjective as they require material estimates, all of which may be susceptible to significant change. For non-purchased credit impaired loans acquired in our acquisitions that are accounted for under ASC 310-20, the historical loss estimates are based on the historical losses experienced since acquisition. We record an allowance for loan losses only when the calculated amount exceeds the discount remaining from acquisition that was established for the similar period covered in the allowance for loan loss calculation. For all other purchased loans, the allowance is calculated in accordance with the methods used to calculate the allowance for loan losses for originated loans, as described below. Originated Loans The allowance for loan losses represents management's assessment of probable credit losses inherent in the loan portfolio. The allowance for loan losses consists of specific components, based on individual evaluation of certain loans, and general components for homogeneous pools of loans with similar risk characteristics. Impaired loans include loans placed on nonaccrual status and troubled debt restructurings. Loans are considered impaired when based on current information and events it is probable that we will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreements. When determining if we will be unable to collect all principal and interest payments due in accordance with the original contractual terms of the loan agreement, we consider the borrower's overall financial condition, resources and payment record, support from guarantors, and the realizable value of any collateral. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. All impaired loans are identified to be individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the discounted expected future cash flows or at the fair value of collateral if repayment is collateral dependent. The allowance for our nonimpaired loans, which includes commercial real estate, commercial and industrial, residential real estate, and consumer loans that are not individually evaluated for impairment, begins with a process of estimating the probable incurred losses in the portfolio. These estimates are established based on our historical loss data. Additional allowance estimates for commercial and industrial and commercial real estate loans are based on internal credit risk ratings. Internal credit risk ratings are assigned to each business loan at the time of approval and are subjected to subsequent periodic reviews by senior management, at least annually or more frequently upon the occurrence of a circumstance that affects the credit risk of the loan. The Company's current methodology on historical loss analysis incorporates and fully relies on the Company's own historical loss data. The historical loss estimates are established by loan type including commercial real estate, commercial and industrial, residential real estate, and consumer. In addition, consideration is given to the borrower’s rating for commercial and industrial and commercial real estate loans. The following table presents, by loan type, the changes in the allowance for loan losses for the periods presented. Our allowance for loan losses was $12.7 million, or 1.03% of loans, at December 31, 2019 compared to $11.6 million, or 1.03% of loans, at December 31, 2018. The $1.1 million increase in the allowance for loan losses during the year ended December 31, 2019 was primarily due to a $1.4 million increase in general reserves related to organic loan growth, partially offset by a $158 thousand decrease in reserves related to purchase credit impaired loans and $137 thousand decrease in specific reserves related to impaired loans. The following table presents, by loan type, the allocation of the allowance for loan losses at the dates presented. Deposits Total deposits were $1.14 billion at December 31, 2019 and $1.13 billion at December 31, 2018, representing 80.3% and 89.7% of total liabilities, respectively. The increase in deposits of $793 thousand was due to increases of $26.3 million in money market and savings deposits and $26.3 million in demand deposits, partially offset by a decrease of $51.8 million in time deposits. Our average interest-bearing deposit costs were 1.88% and 1.38% for the years ended December 31, 2019 and 2018, respectively. The increase in interest-bearing deposit costs between the two periods was impacted by the changing mix of deposit types, as well as by the increase in overnight market rates, as measured by the target federal funds rate. The target federal funds rate rose 0.25% every quarter during 2018 and decreased 0.75% during the second half of the year ended December 31, 2019. Brokered deposits. Brokered deposits are marketed through national brokerage firms to their customers in $1,000 increments. For these brokered deposits, detailed records of owners are maintained by the Depository Trust Company under the name of CEDE & Co. This relationship provides a large source of deposits for the Company. Due to the competitive nature of the brokered deposit market, brokered deposits tend to bear higher rates of interest than non-brokered deposits. At December 31, 2019 and December 31, 2018, the Company had approximately $67.4 million and $110.3 million in brokered deposits, respectively. The Company's ability to accept, roll-over or renew brokered deposits is contingent upon the Bank maintaining a capital level of "well-capitalized." For periods prior to September 30, 2018, Certificate of Deposit Account Registry Service (CDARS) and reciprocal money market accounts were considered to be brokered deposits by regulatory authorities and were reported as such on quarterly Call Reports. With the passage of The Economic Growth, Regulatory Relief and Consumer Protection Act in May 2018, these items are no longer considered brokered deposits. Included in the brokered deposits total at December 31, 2019 and December 31, 2018 were $514 thousand and $1.8 million in CDARS customer deposit accounts, respectively. The $514 thousand at December 31, 2019 was due to an early withdrawal from a CDARS customer deposit account in the first quarter of 2018 that will be paid at maturity. Management understands the importance of core deposits as a stable source of funding and may periodically implement various deposit promotion strategies to encourage core deposit growth. For periods of rising interest rates, management has modeled the aggregate yields for non-maturity deposits and time deposits to increase at a slower pace than the increase in underlying market rates, which is intended to result in net interest margin expansion and an increase in net interest income. The following table sets forth the distribution of average deposits by account type for the periods indicated below. The following table shows the contractual maturity of time deposits, including CDARs and IRA deposits and other brokered funds, of $100 thousand and over that were outstanding as of the date presented. Borrowings Total debt outstanding at December 31, 2019 was $256.7 million, an increase of $142.2 million from $114.5 million at December 31, 2018. The increase in total borrowings was primarily due to increases of $145.0 million in long-term FHLB advances and $29.5 million in subordinated notes, partially offset by a decrease of $30.0 million in short-term FHLB advances and $2.5 million in our FHLB line of credit. The increase in total borrowings as well as the issuance of the $30.0 million subordinated notes reflected management's efforts to fund the liquidity needs of the Company. At December 31, 2019, FHLB advances were secured by a blanket lien on $408.9 million of real estate-related loans, and repurchase agreements were secured by securities with a fair value of $1.2 million. At December 31, 2018, FHLB advances were secured by a blanket lien on $372.5 million of real estate-related loans, and repurchase agreements were secured by securities with a fair value of $1.0 million. As of December 31, 2019, the Company had $45.0 million of subordinated notes outstanding and debt issuance costs of $560 thousand related to these subordinated notes. As of December 31, 2018, the Company had $15.0 million of subordinated notes outstanding and debt issuance costs of $109 thousand related to these subordinated notes. The $15.0 million of subordinated notes issued on December 21, 2015 bear a fixed interest rate of 6.375% per annum, payable semiannually through December 15, 2020. The notes will bear a floating interest rate of three-month LIBOR plus 477 basis points payable quarterly after December 15, 2020 through maturity. The notes mature no later than December 15, 2025, and the Company has the option to redeem or prepay any or all of the subordinated notes without premium or penalty any time after December 15, 2020 or upon an occurrence of a Tier 2 capital event or tax event. The $30.0 million of subordinated notes issued on December 18, 2019 bear a fixed interest rate of 4.75% per annum, payable semiannually through December 18, 2024. The notes will bear a floating interest rate of three-month SOFR plus 311 basis points payable quarterly after December 18, 2024 through maturity. The notes mature no later than December 18, 2029, and the Company has the option to redeem any or all of the subordinated notes without premium or penalty any time after December 18, 2024 or upon the occurrence of a Tier 2 capital event or tax event. Selected financial information pertaining to the components of our short-term borrowings for the periods and as of the dates indicated is as follows: Capital Resources Shareholders' equity is influenced primarily by earnings, dividends, the Company's sales and repurchases of its common stock and changes in accumulated other comprehensive income caused primarily by fluctuations in unrealized gains or losses, net of taxes, on available for sale securities. Shareholders' equity increased $18.9 million to $170.7 million at December 31, 2019 as compared to $151.8 million at December 31, 2018. The increase in shareholders' equity was primarily impacted by $16.1 million of net income generated during the year ended December 31, 2019 as well as an increase of $5.3 million of other comprehensive income due to increases in net unrealized gains on available-for-sale securities, partially offset by $2.2 million of stock repurchased through the share buyback program and $1.2 million of dividends declared on our common stock during the year ended December 31, 2019. The following table summarizes the changes in our shareholders' equity for the periods indicated below: We strive to maintain an adequate capital base to support our activities in a safe and sound manner while at the same time attempting to maximize shareholder value. We assess capital adequacy against the risk inherent in our balance sheet, recognizing that unexpected loss is the common denominator of risk and that common equity has the greatest capacity to absorb unexpected loss. We are subject to various regulatory capital requirements both at the Company and at the Bank level. Failure to meet minimum capital requirements could result in certain mandatory and possible additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on our financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting policies. We have consistently maintained regulatory capital ratios at or above the well-capitalized standards. The Basel III Rule requires the Company and the Bank to maintain a capital conservation buffer of common equity capital of greater than 2.5% above the minimum risk-weighted assets ratios, which is the fully phased-in amount of the capital conservation buffer. The capital conservation buffer requirement was 2.5% as of December 31, 2019 and 1.875% as of December 31, 2018, which is reflected in the table below. At December 31, 2019, the Company and the Bank met all the capital adequacy requirements to which they were subject. The summary below compares the actual capital ratios with the minimum quantitative measures established by regulation to ensure capital adequacy: _______________________________________________________________________________ (1) Reflects the capital conservation buffer of 2.5% and 1.875% applicable during 2019 and 2018, respectively. Contractual Obligations In the ordinary course of our operations, we enter into certain contractual obligations. Total contractual obligations at December 31, 2019 were $700.3 million, an increase of $93.1 million, from $607.2 million at December 31, 2018. The increase of $93.1 million was due to increases of $145.0 million in long-term FHLB advances, $29.5 million in subordinated notes net of debt issuance costs, and $2.7 million in operating lease obligations, partially offset by a decrease of $51.8 million in time deposits and $32.3 million in short-term borrowings. The following tables present our contractual obligations as of December 31, 2019 and December 31, 2018. Off-Balance Sheet Arrangements In the normal course of business, the Company offers a variety of financial instruments with off-balance sheet risk to meet the financing needs of its customers. These financial instruments include outstanding commitments to extend credit, credit lines, commercial letters of credit and standby letters of credit. These are agreements to provide credit, as long as conditions established in the contract are met, and usually have expiration dates. Commitments may expire without being used. Off-balance sheet risk to credit loss exists up to the face amount of these instruments, although material losses are not anticipated. The same credit policies used for loans are used to make such commitments, including obtaining collateral at exercise of the commitment. We maintain an allowance to cover probable losses inherent in our financial instruments with off-balance sheet risk. At December 31, 2019, the allowance for off-balance sheet risk was $318 thousand, compared to $38 thousand at December 31, 2018, and was included in "Other liabilities" on our consolidated balance sheets. The increase in the allowance for off-balance sheet risk as compared to December 31, 2018 was due to a change in the assumptions within the calculation for provision of unfunded commitments, which resulted in a better representation of our line of credit utilization. A summary of the contractual amounts of our exposure to off-balance sheet risk is as follows. Of the total unused lines of credit of $316.8 million at December 31, 2019, $49.8 million was comprised of undisbursed construction loan commitments. The Company expects to have sufficient access to liquidity to fund its off-balance sheet commitments. Liquidity Liquidity management is the process by which we manage the flow of funds necessary to meet our financial commitments on a timely basis and at a reasonable cost and to take advantage of earnings enhancement opportunities. These financial commitments include withdrawals by depositors, credit commitments to borrowers, expenses of our operations, and capital expenditures. Liquidity is monitored and closely managed by the Bank's Asset and Liability Committee (ALCO), a group of senior officers from the finance, enterprise risk management, treasury, and lending areas, as well as two board members. It is ALCO's responsibility to ensure we have the necessary level of funds available for normal operations as well as maintain a contingency funding policy to ensure that potential liquidity stress events are planned for and quickly identified, and management has plans in place to respond. ALCO has created policies which establish limits and require measurements to monitor liquidity trends, including modeling and management reporting that identifies the amounts and costs of all available funding sources. In addition, we have implemented modeling software that projects cash flows from the balance sheet under a broad range of potential scenarios, including severe changes in the economic environment. At December 31, 2019, we had liquid assets of $257.5 million, compared to $213.7 million at December 31, 2018. Liquid assets include cash and due from banks, federal funds sold, interest-bearing deposits with banks and unencumbered securities available-for-sale. The Bank is a member of the FHLB, which provides short- and long-term funding to its members through advances collateralized by real estate-related assets and other select collateral, most typically in the form of debt securities. The actual borrowing capacity is contingent on the amount of collateral available to be pledged to the FHLB. As of December 31, 2019, we had $205.0 million of outstanding borrowings from the FHLB, and these advances were secured by a blanket lien on $408.9 million of real estate-related loans. Based on this collateral and the approved policy limits, the Company is eligible to borrow up to an additional $103.7 million from the FHLB. Additionally, the Bank can borrow up to $130.0 million through the unsecured lines of credit it has established with nine other banks, as well as $4.9 million through a secured line with the Federal Reserve Bank. Further, because the Bank is "well capitalized," it can accept wholesale funding up to 40% of total assets, or approximately $633.0 million, based on current policy limits at December 31, 2019. Management believed that as of December 31, 2019, we had adequate resources to fund all of our commitments. The following liquidity ratios compare certain assets and liabilities to total deposits or total assets.

<s>[INST] This discussion and analysis contains forwardlooking statements that involve risks, uncertainties and assumptions. Certain risks, uncertainties and other factors, including but not limited to those set forth under "ForwardLooking Statements," "Risk Factors" and elsewhere in this Form 10K, may cause actual results to differ materially from those projected in the forwardlooking statements. We assume no obligation to update any of these forwardlooking statements. Critical Accounting Policies Our consolidated financial statements are prepared based on the application of accounting policies generally accepted in the United States. Our critical accounting policies require reliance on estimates and assumptions, which are based upon historical experience and on various other assumptions that management believes are reasonable under current circumstances, but may prove to be inaccurate or can be subject to variations. Changes in underlying factors, assumptions, or estimates could have a material impact on our future financial condition and results of operations. The most critical of these significant accounting policies are set forth in Note 1 Basis of Presentation and Summary of Significant Accounting Policies of the Notes to the Consolidated Statements in our consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this Form 10K. Overview Level One Bancorp, Inc. is a financial holding company headquartered in Farmington Hills, Michigan, with its primary branch operations in southeastern and west Michigan. Through our wholly owned subsidiary, Level One Bank, we offer a broad range of loan products to the residential and commercial markets, as well as retail and business banking services. Hamilton Court Insurance Company, a wholly owned subsidiary of the Company, provides property and casualty insurance to the Company and the Bank and reinsurance to ten other thirdparty insurance captives for which insurance may not be currently available or economically feasible in the insurance marketplace. Since 2007, we have grown substantially through organic growth and a series of four acquisitions, all of which have been fully integrated into our operations. We have made significant investments over the last several years in hiring additional staff and upgrading technology and system security. In 2016, we opened our first branch in the Grand Rapids, Michigan market. In the third quarter of 2017, we opened our second location in Bloomfield Township located in Oakland County. In the third quarter of 2018, we doubled the size of our mortgage division with the addition of new mortgage officers and support staff. As of December 31, 2019, the Company had total consolidated assets of $1.58 billion, total consolidated deposits of $1.14 billion and total consolidated shareholders' equity of $170.7 million. Our principal business activity has been lending to and accepting deposits from individuals, businesses, municipalities and other entities. We derive income principally from interest charged on loans and leases and, to a lesser extent, from interest and dividends earned on investment securities. We have also derived income from noninterest sources, such as fees received in connection with various lending and deposit services and originations and sales of residential mortgage loans. Our principal expenses include interest expense on deposits and borrowings, operating expenses, such as salaries and employee benefits, occupancy and equipment expenses, data processing costs, professional fees and other noninterest expenses, provisions for loan losses and income tax expense. Recent Developments Merger with Ann Arbor Bancorp, Inc. On January 2, 2020, the Company completed its previously announced acquisition of Ann Arbor Bancorp, Inc. (“AAB”) and its wholly owned subsidiary, Ann Arbor State Bank. The transaction was completed pursuant to a merger of the Company’s wholly owned merger subsidiary (“Merger Sub”) with and into AAB, pursuant to the Agreement and Plan of Merger, dated as of August 12, 2019, among the Company, Merger Sub and AAB. Level One paid aggregate consideration of approximately $67.9 million in cash. Level One expects to have approximately $1.4 million in expenses related to the acquisition in the first quarter of 2020. As of December 31, 2019, Ann Arbor State Bank [/INST] Positive. </s>

Equitrans Midstream Corp

2019-02-14

2018-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements, and the notes thereto, included in "Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. Executive Overview Net income attributable to Equitrans Midstream was $218.4 million in 2018 compared with net loss attributable to Equitrans Midstream of $27.2 million in 2017. The increase resulted primarily from higher gathering, water and transmission revenues, higher equity income and lower income tax expense, partly offset by higher operating expenses, net interest expense and net income attributable to noncontrolling interests. Net loss attributable to Equitrans Midstream was $27.2 million in 2017 compared with net income attributable to Equitrans Midstream of $65.2 million in 2016. The decrease resulted from higher income tax expense, operating expenses, net income attributable to noncontrolling interests and net interest expense, partly offset by higher gathering, transmission and water revenues and higher equity income. On February 5, 2019, the Board declared a cash dividend for the fourth quarter of 2018 of $0.41 per share payable on February 27, 2019 to shareholders of record at the close of business on February 15, 2019. The following table reconciles the differences between operating income attributable to EQM as reported in EQM's Annual Report on Form 10-K for the years ended December 31, 2018, 2017 and 2016 and operating income attributable to Equitrans Midstream for the same period. Selling, General and Administrative Expense. The Company incurs selling, general and administrative expenses separate from and in addition to similar costs incurred by EQM. In the Predecessor period, these expenses included allocations from EQT for compensation, centralized general and administrative services and auditing, legal and regulatory fees. In the Successor period, these expenses included auditing, legal and regulatory fees and share-based compensation costs. Separation and Other Transaction Costs. Separation and other transaction costs represent selling, general and administrative expenses related to the Rice Merger, the EQM-RMP Mergers, the Drop-Down Transaction, the Separation and the EQGP Buyout and included charges from EQT of $53.3 million and $85.1 million for the years ended December 31, 2018 and 2017, respectively. Separation costs recorded in 2018 also included a one-time charitable contribution of $15.0 million made to the Equitrans Midstream Foundation, a charitable organization established to continue EQT's legacy of charitable giving. Future contributions to the Equitrans Midstream Foundation, if any, will be evaluated from time to time. Depreciation. The Company recorded depreciation expense on corporate assets placed in service in the second half of 2018. During the year ended December 31, 2017, EQM's Transmission business segment recorded a non-cash charge to depreciation of $10.5 million related to the revaluation of differences between regulatory and tax bases in Equitrans, L.P.'s regulated property, plant and equipment. For consolidated reporting at Equitrans Midstream, the $10.5 million is recorded as income tax expense. This difference in presentation is shown as a reduction to depreciation. Impairment of Long-lived Assets. During the year ended December 31, 2016, the Company recorded impairment of long-lived assets of $59.7 million related to certain gathering assets. Using the income approach with Level 3 fair value measurement inputs, these gathering assets were written down to fair value. The impairment was triggered by a reduction in estimated future cash flows caused by a low commodity price environment, which reduced producer drilling activity and related throughput on the gathering assets. The impairment was not recorded by EQM's Gathering business segment as the impairment was recognized by the Company immediately prior to its sale of the gathering assets to EQM. No impairment of any long-lived assets was recorded during the years ended December 31, 2018 and 2017. Business Segment Results Operating segments are revenue-producing components of an enterprise for which separate financial information is produced internally and is subject to evaluation by the chief operating decision maker in deciding how to allocate resources. Other income, net interest expense and income tax expense are managed on a consolidated basis. The Company has presented each segment's operating income, equity income and various operational measures in the following sections. Management believes that the presentation of this information is useful to management and investors regarding the financial condition, results of operations and trends of its segments. The Company has reconciled each segment's operating income to the Company's consolidated operating income and net income in Note 5 to the consolidated financial statements. GATHERING RESULTS OF OPERATIONS Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Gathering operating revenues increased by $487.1 million in 2018 compared to 2017, driven primarily by revenue earned by RMP and the Drop-Down Entities, which came under common control of the Company on November 13, 2017, and production development in the Marcellus and Utica Shales. Firm reservation fee revenues increased primarily as a result of customers contracting for additional firm gathering capacity and higher rates on various wellhead expansion projects in 2018. Volumetric-based fee revenues increased due to increased volumes gathered under interruptible contracts, driven primarily by revenue earned by RMP and the Drop-Down Entities of $238 million and $199 million, respectively, and increased volumes gathered in excess of firm contracted capacity. Gathering operating expenses increased by $432.8 million in 2018 compared to 2017, driven primarily by impairment of goodwill of $261.9 million and expenses incurred by RMP and the Drop-Down Entities of $92.6 million and $71.8 million, respectively. Operating and maintenance expense increased due to the full-year recognition of compressor-related expenses associated with RMP's and the Drop-Down Entities' compression assets of $18.4 million, increased personnel costs related primarily to increased employee headcount of $5.3 million, higher contracted labor of $3.1 million and higher reserves of $2.1 million. Selling, general and administrative expense increased due to increased overhead allocations following the Rice Merger and transaction costs of $7.8 million related to the EQM-RMP Mergers and the Drop-Down Transaction. Depreciation expense increased $48.7 million due to a full year of depreciation incurred on the RMP and Drop-Down assets and from the additional assets placed in service during 2018. Amortization expense increased due to a full year of amortization incurred on the Drop-Down Entities' customer contract intangible asset. See "Outlook" and Note 1 to the consolidated financial statements for discussion of the impairment of goodwill recognized in 2018. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 Gathering operating revenues increased by $112.5 million in 2017 compared to 2016, driven primarily by revenue earned by RMP and the Drop-Down Entities and third-party and EQT production development in the Marcellus Shale. Firm reservation fee revenues increased primarily as a result of third parties and EQT contracting for additional firm gathering capacity, which increased by approximately 475 MMcf per day following the completion of the Range Resources header pipeline project and various EQT wellhead gathering expansion projects in 2017. The increase in volumetric-based fee revenues was driven primarily by revenue earned by RMP and the Drop-Down Entities of $55.4 million, partly offset by lower EQT volumes gathered in excess of firm contracted capacity and lower volumetric-based fee revenues under interruptible contracts due to an increase in contracts for firm gathering capacity. Gathering operating expenses increased by $33.0 million in 2017 compared to 2016, driven primarily by expenses incurred by RMP and the Drop-Down Entities of $20.5 million, higher personnel costs and increased property taxes. Selling, general and administrative expense increased due to expenses associated with the Rice Merger. Depreciation expense increased $8.4 million from the additional assets placed in service, including those associated with the Range Resources header pipeline project and various EQT wellhead gathering expansion projects, and $6.2 million from depreciation expense incurred by RMP and the Drop-Down Entities. Amortization of intangible assets relates to the Drop-Down Entities' customer contract intangible asset. TRANSMISSION RESULTS OF OPERATIONS Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Transmission operating revenues increased by $14.8 million in 2018 compared to 2017. Firm reservation fee revenues increased due to higher contractual rates on existing contracts with customers in 2018 and customers contracting for additional firm transmission capacity. Volumetric-based fee revenues increased due to increased volumes transported under firm contracts. Transmission operating expenses decreased by $3.3 million in 2018 compared to 2017 primarily due to a non-cash charge of $10.5 million recorded in 2017 to depreciation related to the revaluation of differences between the regulatory and tax bases in Equitrans, L.P.'s regulated property, plant and equipment, partially offset by an increase in operating and maintenance expense associated with increased personnel costs, which were primarily associated with the growth of the business. Equity income increased by $39.6 million in 2018 compared to 2017 due to the increase in the MVP Joint Venture's AFUDC on the MVP as a result of continued spending on the project. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 Transmission operating revenues increased by $37.2 million in 2017 compared to 2016. Firm reservation fee revenues increased due to EQT and third parties contracting for additional firm transmission capacity, primarily on the Ohio Valley Connector (OVC), as well as higher contractual rates on existing contracts in 2017. Higher firm transmission capacity on the OVC and reduced throughput on interruptible contracts resulted in lower volumetric-based fee revenues, partly offset by increased storage and parking revenue, which does not have associated pipeline throughput. Transmission operating expenses increased by $28.0 million in 2017 compared to 2016 primarily due to property taxes on the OVC and higher personnel costs. Selling, general and administrative expenses decreased primarily due to lower corporate allocations from EQT as a result of EQT's shift in focus during 2017 from midstream drop-down transactions to upstream asset and corporate acquisition projects. Depreciation expense increased as a result of the OVC project being placed in service in the fourth quarter of 2016 and a non-cash charge of $10.5 million recorded in 2017 to depreciation related to the revaluation of differences between the regulatory and tax bases in Equitrans, L.P.'s regulated property, plant and equipment. The related regulatory liability will be amortized over the estimated useful life of the underlying property of 43 years. Equity income increased by $12.3 million in 2017 compared to 2016 due to the increase in the MVP Joint Venture's AFUDC on the MVP as a result of continued spending on the project. WATER RESULTS OF OPERATIONS Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Water operating revenues increased by $97.6 million in 2018 compared to 2017, as a result of a full year of revenue earned by RMP, which came under control of the Company on November 13, 2017. Water operating expenses increased by $64.1 million in 2018 compared to 2017, as a result of a full year of operating expenses incurred by RMP. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 Water operating revenues increased by $13.6 million in 2017 compared to 2016, consisting of revenue earned by RMP. Water operating expenses increased by $9.5 million in 2017 compared to 2016, consisting of operating expenses incurred by RMP. Operating expenses were composed of customary expenses for a water service business, including water procurement costs. Other Income Statement Items Other Income Other income increased $0.6 million for the year ended December 31, 2018 compared to year ended December 31, 2017 due primarily to increased AFUDC - equity. Other income decreased by $22.7 million for the year ended December 31, 2017 compared to the year ended December 31, 2016 driven primarily by decreased AFUDC - equity of $14.3 million associated with the OVC being placed in service in the fourth quarter of 2016 and distributions from EES of $8.3 million. As discussed in Note 1 to the consolidated financial statements, effective October 1, 2016, the accounting for EQM's investment in EES converted from a cost method investment to a note receivable. Beginning October 1, 2016, distributions received from EES are recorded partly as interest income and partly as a reduction in the note receivable. This change decreased the amount of other income recognized and increased interest income in the year ended December 31, 2017 compared to 2016. Net Interest Expense Net interest expense increased by $80.7 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 due primarily to interest expense of $69.6 million on the EQM $2.5 Billion Senior Notes (defined in Note 10 to the consolidated financial statements), higher interest expense of $21.1 million on credit facility borrowings and higher amortization of debt issuance costs of $4.7 million, partly offset by increased capitalized interest and AFUDC - debt of $8.0 million and interest income earned on cash on hand of $4.4 million. Net interest expense increased by $18.0 million for the year ended December 31, 2017 compared to the year ended December 31, 2016 due primarily to interest expense of $17.4 million on long-term debt issued in November 2016, lower capitalized interest and AFUDC - debt of $5.3 million from decreased spending on capital projects, allocated amortization of debt issuance costs from EQT of $2.9 million related to a bridge financing commitment entered into to support the Rice Merger and higher interest expense on EQM's credit facility borrowings, partly offset by increased interest income recorded on distributions from EES of $5.1 million and higher interest income earned on cash on hand of $4.7 million. See Note 10 to the consolidated financial statements for discussion of debt. Income Taxes The Company's operations had been included in EQT's consolidated income tax return for federal and state tax purposes prior to the Separation. As a result, the financial statements include the income taxes incurred by the Company computed on a separate return basis. EQM and EQGP are limited partnerships for U.S. federal and state income tax purposes and are not subject to U.S. federal or state income taxes. In addition, as of December 31, 2017, Rice Midstream Holdings LLC (Rice Midstream Holdings) was a multi-member LLC and was not subject to U.S. federal or state income taxes. In the fourth quarter of 2018, Rice Midstream Holdings was merged out of existence as part of internal restructurings. On December 22, 2017, the U.S. Congress enacted the Tax Cuts and Jobs Act (the Tax Reform Legislation), which made significant changes to U.S. federal income tax law, including lowering the federal corporate tax rate to 21% from 35% beginning January 1, 2018. The Tax Reform Legislation contains several other provisions, such as limiting the utilization of net operating losses generated after December 31, 2017 that are carried into future years to 80% of taxable income and limitations on the deductibility of interest expense, which are not expected to have a material effect on the Company's results of operations. As of December 31, 2018, the Company completed its accounting for the effects of the Tax Reform Legislation, including accounting for the revaluation of net deferred tax assets and for state income tax effects, and recorded deferred income tax expense of $7.5 million, which is in addition to the $129.3 million of deferred income tax expense recorded during the year ended December 31, 2017. The Company also considered whether existing deferred tax assets will be recovered in future periods under this legislation and noted no significant effect on the deferred tax assets. All of EQGP's and EQM's income is included in the Company's pre-tax income; however, the Company does not record income tax expense on the portions of its income attributable to the noncontrolling limited partners of EQGP and EQM and, for the period prior to May 1, 2018, to Gulfport Midstream. This reduces the Company's effective tax rate in periods when the Company has consolidated pre-tax income. Also, given that Rice Midstream Holdings was a multi-member limited liability company prior to October 22, 2018, the Company was not required to record income tax expense on Rice Midstream Holdings' income in that period. Net Income Attributable to Noncontrolling Interests For the years ended December 31, 2018, 2017 and 2016, the Company's noncontrolling interests comprised third-party ownership interests in EQGP and EQM. For the year ended December 31, 2017 and the periods in 2018 prior to the Company's acquisition of their remaining respective noncontrolling interests, the Company's noncontrolling interests also included the third-party ownership interests in RMP and Gulfport Midstream's 25% ownership interest in Strike Force Midstream. Net income attributable to noncontrolling interests fluctuates based on the amount of net income earned by the entities with noncontrolling interests, the amount of net income allocated to the holder of the IDRs and any changes in the noncontrolling ownership percentages. Net income attributable to noncontrolling interests increased as a result of higher net income as well as additional noncontrolling interests outstanding due to EQM equity issuances. See "Investing Activities" and "Capital Requirements" under "Capital Resources and Liquidity" for discussion of capital expenditures. Outlook The Company's assets overlay core acreage in the prolific Appalachian Basin. The location of the Company's assets allows it to access major demand markets in the U.S. The Company is one of the largest natural gas gatherers in the U.S., and its largest customer, EQT, is the largest natural gas producer in the U.S. based on produced volumes. The Company maintains a stable cash flow profile, with over 50% of its revenue for the year ended December 31, 2018 generated by firm reservation fees. The Company's principal strategy is to leverage its existing and planned growth projects and to seek and execute on strategically-aligned acquisition and joint venture opportunities to achieve the scale and scope of a top-tier midstream company. As part of its approach to organic growth, the Company is focused on building and completing its key gathering and transmission growth projects outlined under "Strategy" in "Item 1. Business," many of which are supported by contracts with firm capacity commitments. Additionally, the Company expects to achieve growth from its water service business and from volumetric gathering opportunities and transmission and storage services. The water service business is complementary to the gathering business, and the Company recognizes an opportunity to expand its existing asset footprint and is actively pursuing solutions for produced water handling. The Company is also focused on optimizing and integrating its Pennsylvania gathering systems to create additional system gathering capacity and provide high- and low-pressure gathering solutions for its customers. The Company's focus on execution of its organic projects, coupled with asset optimization efforts, disciplined capital spending and operating cost control, is complemented by the Company's commitment to seek, evaluate and execute on strategically-aligned acquisition and joint venture opportunities. The Company believes that this approach will enable the Company to achieve its strategic goals. See "EQM IDR Transaction" in "Item 1. Business." For further discussion of key growth projects, see "Strategy" in "Item 1. Business." For further discussion of capital expenditures, see "Capital Requirements." Following the third quarter of 2018 and prior to the Separation, the Company identified impairment indicators in the form of production curtailments announced by a primary customer of the two reporting units to which the Company's goodwill is recorded that could reduce volumetric-based fee revenues of those reporting units. For the year ended December 31, 2018, the Company determined that the carrying value of one of those reporting units (the RMP PA Gas Gathering reporting unit, which comprises the Pennsylvania gathering assets acquired in the Rice Merger) was greater than its fair value. As a result, the Company recognized impairment of goodwill of $261.9 million. As of December 31, 2018, the Company had approximately $1,239 million of goodwill, which will be monitored for future impairment. Management will continue to monitor and evaluate the factors underlying the fair market value of acquired businesses over the course of the year to determine if any interim assessments are necessary and will take any additional impairment charges required. See Note 1 to the consolidated financial statements. Capital Resources and Liquidity The Company's principal liquidity requirements are to finance EQM's operations, fund EQM's capital expenditures, potential acquisitions and other strategic transactions and capital contributions to the MVP Joint Venture, pay cash dividends and distributions to our shareholders and the noncontrolling interests in EQM, respectively, and satisfy indebtedness obligations. The Company's ability to meet these liquidity requirements will depend on the amount and timing of distributions received from EQM, EQM's ability to generate cash in the future and its and EQM's ability to raise capital in banking, capital and other markets. The Company's available sources of liquidity include cash from quarterly cash distributions from EQM, borrowings under its credit facilities, cash on hand, debt offerings and issuances of additional equity interests, including shares of the Company or limited partner interests of EQM. Pursuant to the Tax Matters Agreement (defined in Note 8 to the consolidated financial statements), the Company is subject to certain restrictions related to certain corporate actions, including restrictions related to the issuance of Company and EQM securities beyond certain thresholds as set forth in the Tax Matters Agreement. See "We and EQM may determine to forgo or be required to forgo certain transactions in order to avoid the risk of incurring material tax-related liabilities or indemnification obligations under the tax matters agreement." under "Risk Factors - Risks Related to an Investment in Us" included in "Item 1A. Risk Factors." EQM is not forecasting any public equity issuance for currently anticipated organic growth projects. Operating Activities Net cash flows provided by operating activities were $721.7 million for the year ended December 31, 2018 compared to $669.7 million for the year ended December 31, 2017. The increase was driven primarily by higher operating income, for which contributing factors are discussed in "Executive Overview" and "Business Segment Results." Net cash flows provided by operating activities were $669.7 million for the year ended December 31, 2017 compared to $549.5 million for the year ended December 31, 2016. The increase was driven primarily by higher operating income, for which contributing factors are discussed in "Executive Overview" and "Business Segment Results." Investing Activities Net cash flows used in investing activities were $1,786.0 million for the year ended December 31, 2018 compared to $535.5 million for the year ended December 31, 2017. The increase was attributable primarily to increased capital expenditures, as further described in "Capital Requirements," increased capital contributions to the MVP Joint Venture, consistent with commencement of construction on the MVP, and the purchase of interests in the MVP Southgate project. Net cash flows used in investing activities were $535.5 million for the year ended December 31, 2017 compared to $669.7 million for the year ended December 31, 2016. The decrease was attributable primarily to decreased capital expenditures, as further described in "Capital Requirements," partly offset by increased capital contributions paid to the MVP Joint Venture in 2017 and sales of interests in the MVP Joint Venture in 2016. Financing Activities Net cash flows provided by financing activities were $1,237.4 million for the year ended December 31, 2018 compared to net cash flows used in financing activities of $1,041.1 million for the year ended December 31, 2017. For the year ended December 31, 2018, the primary sources of financing cash flows were proceeds from the issuances of the EQM $2.5 Billion Senior Notes and the Term Loans (each defined in Note 10 to the consolidated financial statements) and net credit facility borrowings, while the primary uses of financing cash flows were net distributions to EQT, distributions paid to noncontrolling interest unitholders, the EQGP Unit Purchases and the Gulfport Transaction. Net cash flows used in financing activities were $1,041.1 million for the year ended December 31, 2017 compared to net cash flows provided by financing activities of $423.5 million for the year ended December 31, 2016. For the year ended December 31, 2017, the primary uses of financing cash flows were net distributions to EQT and distributions to noncontrolling interest unitholders, and the primary source of financing cash flows was net credit facility borrowings. For the year ended December 31, 2016, the primary sources of financing cash flows were proceeds from long-term debt and equity offerings and contributions from EQT, and the primary uses of financing cash flows were net payments of credit facility borrowings and distributions paid to noncontrolling interest unitholders. Capital Requirements The gathering, transmission and storage and water service businesses are capital intensive, requiring significant investment to develop new facilities and to maintain and upgrade existing operations. (a) Expansion capital expenditures do not include capital contributions made to the MVP Joint Venture of $913.2 million, $159.6 million and $98.4 million for the years ended December 31, 2018, 2017 and 2016, respectively. (b) The Company accrues capital expenditures when capital work has been completed but the associated bills have not yet been paid. Accrued capital expenditures are excluded from the statements of consolidated cash flows until they are paid. See Note 5 to the consolidated financial statements. Expansion capital expenditures are expenditures incurred for capital improvements that the Company expects will increase its operating income or operating capacity over the long term. In 2018, expansion capital expenditures related primarily to capital expenditures invested in the assets of RMP and the Drop-Down Entities and in the following projects: the Hammerhead project, the Equitrans, L.P. Expansion project and various wellhead gathering expansion projects, partly offset by decreased spending on the Range Resources header pipeline project. In 2017, expansion capital expenditures related primarily to the following projects: various wellhead gathering expansion projects, the Range Resources header pipeline project and the AVC expansion project. In 2016, expansion capital expenditures related primarily to the following projects: the OVC project, the Range Resources header pipeline project, the Northern West Virginia Marcellus gathering system expansion project and the AVC expansion project. The OVC project was placed in service during the fourth quarter of 2016 and the Range Resources header pipeline project was placed in service in several phases beginning in the fourth quarter of 2016 and ending in the second quarter of 2017. Maintenance capital expenditures are expenditures made to maintain, over the long term, EQM's operating capacity or operating income. Examples of maintenance capital expenditures are expenditures to repair, refurbish and replace pipelines, to connect new wells to maintain throughput, to maintain equipment reliability, integrity and safety and to address environmental laws and regulations. Maintenance capital expenditures increased by $8.6 million in 2018 compared to 2017 and $14.0 million in 2017 compared to 2016 primarily as a result of additional assets in service, including those of the RMP and Drop-Down Entities, and timing of ongoing maintenance projects. In connection with the Separation, the Company assumed all of EQT's obligations to indemnify and reimburse EQM under EQM's omnibus agreement with EQT other than for those losses or expenses relating to or arising from plugging and abandonment obligations. In 2019, EQM expects to make capital contributions to the MVP Joint Venture of approximately $0.9 billion depending on the timing of the construction of the MVP and MVP Southgate projects. Expansion capital expenditures are expected to be approximately $1.1 billion and maintenance capital expenditures are expected to be approximately $60 million. The Company's future capital investments may vary significantly from period to period based on the available investment opportunities and the timing of the construction of the MVP and MVP Southgate projects. Maintenance capital expenditures are also expected to vary quarter to quarter. The Company expects to fund future capital expenditures primarily through cash on hand, cash generated from EQM's operations, borrowings under its credit facilities, debt offerings and issuances of additional equity interests. EQM is not forecasting any public equity issuance for currently anticipated organic growth projects. The Company does not forecast capital expenditures associated with potential projects that are not committed as of the filing of this Annual Report on Form 10-K. Credit Facilities See Note 10 to the consolidated financial statements for discussion of the Company's and EQM's credit facilities. Security Ratings The table below sets forth the credit ratings for debt instruments of the Company and EQM as of December 31, 2018. The Company's and EQM's credit ratings are subject to revision or withdrawal at any time by the assigning rating organization and each rating should be evaluated independently of any other rating. The Company and EQM cannot ensure that a rating will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a credit rating agency if, in its judgment, circumstances so warrant. If any credit rating agency downgrades the Company's or EQM's ratings, the Company's or EQM's access to the capital markets may be limited, borrowing costs could increase, the Company or EQM may be required to provide additional credit assurances in support of commercial agreements such as joint venture agreements and construction contracts, the amount of which may be substantial, and the potential pool of investors and funding sources may decrease. In order to be considered investment grade, a company must be rated Baa3 or higher by Moody's, BBB- or higher by S&P, or BBB- or higher by Fitch. Anything below these ratings, including all of the Company's credit ratings and EQM's current credit rating of Ba1 by Moody's, are considered non-investment grade. Schedule of Contractual Obligations The following represents the Company's, including EQM's, contractual obligations as of December 31, 2018. Purchase obligations exclude EQM's future capital contributions to the MVP Joint Venture and purchase obligations of the MVP Joint Venture. (a) Credit facility borrowings were classified based on the termination date of the underlying credit facility agreements. (b) Interest payments exclude interest related to the credit facility borrowings and the term loan as the interest rates on the credit facility borrowings and the Company's term loan are variable. (c) See Note 13 to the consolidated financial statements. (d) Operating leases are primarily entered into for various office locations and warehouse buildings, as well as lease obligations for compression equipment under existing contracts with third parties. (e) Other liabilities represent commitments for estimated payouts as of December 31, 2018 for various Equitrans Midstream liability award plans. See "Critical Accounting Policies and Estimates" below and Note 9 to the consolidated financial statements for discussion of factors that affect the ultimate amount of the payout of these obligations. Commitments and Contingencies As of February 14, 2019, Equitrans Midstream Corporation was not party to any legal proceedings. In the ordinary course of business, various legal and regulatory claims and proceedings are pending or threatened against EQM and its subsidiaries. While the amounts claimed may be substantial, EQM is unable to predict with certainty the ultimate outcome of such claims and proceedings. EQM accrues legal and other direct costs related to loss contingencies when incurred. EQM establishes reserves whenever it believes it to be appropriate for pending matters. Furthermore, after consultation with counsel and considering available insurance, EQM believes that the ultimate outcome of any matter currently pending against EQM will not materially affect its business, financial condition, results of operations, liquidity or ability to make distributions to EQM unitholders, including the Company. See "The regulatory approval process for the construction of new midstream assets is challenging, and recent decisions by regulatory and judicial authorities in pending proceedings could impact EQM's or the MVP Joint Venture's ability to obtain all approvals and authorizations necessary to complete certain projects on the projected time frame or at all or EQM's ability to achieve the expected investment return on the project" under "Risk Factors - Risks Related to EQM's Business" included in "Item 1A. Risk Factors" and see "Item 3. Legal Proceedings" for discussion of litigation and regulatory proceedings related to the MVP project. See Note 13 to the consolidated financial statements for further discussion of the Company's commitments and contingencies. Off-Balance Sheet Arrangements See Note 7 to the consolidated financial statements for discussion of the MVP Joint Venture guarantees. Recently Issued Accounting Standards See Note 1 to the consolidated financial statements for discussion of recently issued accounting standards. Critical Accounting Policies and Estimates The Company's significant accounting policies are described in Note 1 to the consolidated financial statements. Preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosures of contingent assets and liabilities. The following critical accounting policies, which were reviewed by the Company's Audit Committee, relate to its more significant judgments and estimates used in the preparation of its consolidated financial statements. Actual results could differ from those estimates. Income Taxes. The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the Company's consolidated financial statements or tax returns. The Company has federal and state Net Operating Loss (NOL) carryforwards related to federal and various state jurisdictions. The federal and West Virginia NOL carryforwards have no expiration, but utilization is limited to 80% of taxable income in the year of utilization. Other state NOL carryforwards expire in 2038. The Company believes that it is more likely than not that the benefit from certain federal and state NOL carryforwards will be realized. In addition to the NOL carryforwards, the Company has recorded deferred tax assets principally resulting from its investment in partnerships. No valuation allowances have been established, as it is believed that future sources of taxable income, reversing temporary differences and other tax planning strategies will be sufficient to realize these deferred tax assets. Any determination to change the valuation allowance would impact the Company's income tax expense and net income in the period in which such a determination is made. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not (greater than 50%) that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carry-back periods, future reversals of taxable temporary differences, projections of taxable income and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carry-forward period, including from tax planning strategies, and experience. Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold; otherwise, the tax benefit is recorded when the tax position has been effectively settled, either because the statute of limitations has expired or the appropriate taxing authority has completed its examination. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized. The Company believes that accounting estimates related to income taxes are "critical accounting estimates" because the Company must assess the likelihood that deferred tax assets will be recovered from future taxable income, exercise judgment when evaluating whether or not a valuation allowance must be established on deferred tax assets and exercise judgment regarding the amount of financial statement benefit to record for uncertain tax positions. To the extent that a valuation allowance or an uncertain tax position is established or increased or decreased during a period, the Company includes an expense or benefit within income tax expense on the statements of comprehensive income. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company's assumptions. See Note 11 to the consolidated financial statements for additional information. Property, Plant and Equipment. Determination of depreciation requires judgment regarding the estimated useful lives and salvage values of property, plant and equipment. The Company has not historically experienced material changes in its results of operations from changes in the estimated useful lives or salvage values of its property, plant and equipment; however, these estimates are reviewed periodically, including each time Equitrans, L.P. files with the FERC for a change in transmission and storage rates. Determination of internal costs capitalized requires judgment as to the percent of time spent on capitalized projects for the capitalization of costs such as salaries, benefits and other indirect costs. The Company believes that the accounting estimates related to depreciation and capitalization of internal costs are "critical accounting estimates" because they are susceptible to change. These assumptions affect the gross property, plant and equipment balances and the amount of depreciation and operating expense and, if changed, would have an effect on the results of operations and financial position. See Note 1 to the consolidated financial statements for additional information. Impairments of Long-Lived Assets. Any accounting estimate related to impairment of property, plant and equipment, finite-lived intangible assets or an investment in an unconsolidated entity may require management to make assumptions about future cash flows, discount rates, the fair value of investments and whether losses in the value of its investments are other than temporary. Management's assumptions about future cash flows require significant judgment because actual operating levels have fluctuated in the past and are expected to fluctuate in the future. Additionally, management's assumptions about the fair value of its investment in an unconsolidated entity require significant judgment because the investment is not traded on an active market. During the fourth quarter of 2018, a triggering event occurred as a result of the Company's annual goodwill impairment evaluation, which required the Company to perform a recoverability test on its long-lived assets. No impairment was recorded as a result of the recoverability test. The Company has not historically had indications of impairments; however, the Company believes that the accounting estimates related to impairments are "critical accounting estimates" because they require assumptions that are susceptible to change. Any potential impairment would have an effect on the results of operations and financial position. See Note 1 to the consolidated financial statements for additional information. Allocated General and Administrative Costs. Prior to the Separation, general and administrative costs and operating and maintenance costs were allocated by EQT to the Company based on the nature of the expenses. Costs that were directly related to the Company and its subsidiaries were directly charged to the Company and its subsidiaries. Other costs were allocated based on operational and financial metrics. Allocations are based on estimates and assumptions that management believes are reasonable; however, the Company believes that the accounting estimates related to allocated costs are "critical accounting estimates" because different estimates and assumptions would change the amounts allocated to the Company and its subsidiaries, and those differences could be material. These assumptions affect the amount of general and administrative expense and operating and maintenance expense and would have an effect on the results of operations if changed. See Notes 1 and 8 to the consolidated financial statements for additional information. Regulatory Accounting. Determination and application of regulatory accounting requires judgment regarding probability that certain expenses and income will be allowed in the rate setting process in a period different from the period in which they would have been reflected on the statements of consolidated operations for a non-regulated entity. The Company has not historically experienced material changes in its results of operations from changes in regulatory accounting; however, these estimates are reviewed periodically, including each time Equitrans, L.P. files with the FERC for a change in transmission and storage rates. The Company believes that the accounting estimates related to regulatory accounting are "critical accounting estimates" because they are susceptible to change. These assumptions affect the gross regulatory assets and liabilities and the amount of regulated operating revenues and expenses and would have an effect on the results of operations and financial position if changed. See Note 1 to the consolidated financial statements for additional information. Contingencies. EQM is involved in various regulatory and legal proceedings that arise in the ordinary course of business. A liability is recorded for contingencies based on EQM's assessment that a loss is probable and that the amount of the loss can be reasonably estimated. EQM considers many factors in making these assessments, including the history and specifics of each matter. Estimates are developed in consultation with legal counsel and are based on an analysis of potential results. The Company believes that the accounting estimates related to contingencies are "critical accounting estimates" because the Company must assess the probability and amount of loss related to contingencies. Future results of operations could be materially affected by changes in the assumptions. See Notes 1 and 13 for additional information. Revenue Recognition. Revenue from the gathering, transmission and storage of natural gas is generally recognized when the service is provided. Revenue from water services is generally recognized when water is delivered. Revenue related to services provided but not yet billed is estimated each month. These estimates are generally based on contract data, preliminary throughput and allocation measurements. Final bills for the current month are billed and collected in the following month. See Notes 1 and 3 to the consolidated financial statements for additional information. EQM records a monthly provision for accounts receivable that are considered uncollectible. In order to calculate the appropriate monthly provision, a historical rate of accounts receivable losses as a percentage of total revenue is used. This historical rate is applied to the current revenues on a monthly basis and is updated periodically based on events that may change the rate, such as a significant change to the natural gas industry or to the economy as a whole. Management reviews the adequacy of the allowance on a quarterly basis using the assumptions that apply at that time. While EQM has not historically experienced material bad debt expense, declines in the market price for natural gas combined with the increase in customers on EQM's systems may result in a greater exposure to potential losses than management's current estimates. As of December 31, 2018, EQM had accounts receivable of $255.5 million, net of an allowance for doubtful accounts of $0.1 million. The Company believes that the accounting estimates related to revenue recognition are "critical accounting estimates" because estimated volumes are subject to change based on actual measurements, including prior period adjustments. In addition, the Company believes that the accounting estimates related to the allowance for doubtful accounts receivable are "critical accounting estimates" because the underlying assumptions used for the allowance can change and the actual mix of customers and their ability to pay may vary significantly from management's estimates, which could affect the collectability of customer accounts. These accounting estimates could potentially have a material effect on the results of operations and financial position. Business Combinations - Rice Merger. EQT recorded the Rice Merger using the acquisition method of accounting; accordingly, the value assigned to the assets and liabilities of RMP and the Drop-Down Entities are based on EQT's purchase accounting estimates. Accounting for the acquisition of a business requires a company to record the acquired identifiable assets and liabilities at fair value. The estimated fair value of midstream facilities and equipment, which generally consist of pipeline systems and compression stations, is estimated using the cost approach, which incorporates assumptions about the replacement costs for similar assets, the relative age of the assets and any potential economic or functional obsolescence. The fair values of the intangible assets are estimated using the multi-period excess earnings model, which estimates revenues and cash flows derived from the intangible asset and then deducts portions of cash flow that can be attributed to supporting assets otherwise recognized. Given the time required to obtain pertinent information necessary to finalize the allocation of the purchase price to the acquired net assets, the purchase price allocation may remain preliminary for a period of time before the required fair value estimates are finalized. Accordingly, it is not uncommon for the initial estimates to be subsequently revised. During the fourth quarter of 2018, the Rice Merger purchase price accounting was finalized. See Note 2 to the consolidated financial statements. The Company believes that the accounting estimates related to business combinations are "critical accounting estimates" because in determining the fair value of assets acquired, assumptions must be made about projections regarding the timing and amount of future development and operating costs and projections of replacement cost of and future cash flows from midstream assets and cash flows from customer relationships. Different assumptions may result in materially different values for these assets, which would affect the Company's future results of operations and financial position. Goodwill. Goodwill is the cost of an acquisition less the fair value of the identifiable net assets of the acquired business. As a result of the Rice Merger, on November 13, 2017, Rice Midstream Holdings recorded goodwill to two reporting units within the Gathering segment. Prior to the Rice Merger, the Company had no goodwill. See Note 2 to the consolidated financial statements. Goodwill is evaluated for impairment at least annually or whenever events or changes in circumstances indicate it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The Company uses a combination of an income and market approach to estimate the fair value of a reporting unit. In the fourth quarter of 2018, the Company determined that a goodwill impairment indicator existed prior to its annual assessment date of November 30, 2018. As a result of the Company's goodwill evaluation, which quantitatively considered the production curtailments announced by a primary customer of the Rice Retained Midstream and RMP PA Gas Gathering reporting units, the Company recorded impairment of goodwill. See Note 1 to the consolidated financial statements. The Company believes that the accounting estimates related to goodwill are "critical accounting estimates" because estimating the fair value of reporting units requires considerable judgment. In addition, management's estimate of a reporting unit's future financial results is sensitive to changes in assumptions, such as changes in stock prices, weighted-average cost of capital, terminal growth rates and industry multiples. The Company believes the estimates and assumptions used in estimating its reporting units' fair values are reasonable and appropriate, however, different assumptions and estimates could materially affect the calculated fair value and the resulting conclusion on impairment of goodwill, which could materially affect the Company's results of operations and financial position. Additionally, actual results could differ from these estimates. The Company performed a sensitivity analysis for each reporting unit to quantify the effect of certain changes to assumptions used in the goodwill assessment. While not impaired as of December 31, 2018, it was determined that a 1% increase to the weighted average cost of capital (WACC) and a corresponding 1% decrease to the terminal cash flow growth rate would have resulted in the Company's recognition of approximately $13.8 million of impairment of goodwill associated with the Rice Retained Midstream reporting unit (defined and discussed in Note 1). In addition, a 1% increase to the WACC and a corresponding 1% decrease to the terminal cash flow growth rate would have resulted in the Company's recognition of approximately $114.4 million of additional impairment of goodwill associated with the RMP PA Gas Gathering reporting unit (defined and discussed in Note 1). Share-Based Compensation. The Company awards share-based compensation in connection with specific programs. Awards to employees are typically made in the form of performance-based awards, time-based restricted stock awards, time-based restricted unit awards and stock options. Awards to directors are typically made in the form of phantom units that vest upon grant. Restricted units and performance-based awards expected to be satisfied in cash are treated as liability awards. For liability awards, the Company is required to estimate, on the grant date and on each reporting date thereafter until vesting and payment, the fair value of the ultimate payout based upon the expected performance through, and value of the Company's common stock on, the vesting date. The Company then recognizes a proportionate amount of the expense for each period in the Company's financial statements over the vesting period of the award. The Company reviews its assumptions regarding performance and common stock value on a quarterly basis and adjusts its accrual when changes in these assumptions result in a material change in the fair value of the ultimate payouts. Performance-based awards expected to be satisfied in Company common stock are treated as equity awards. For equity awards, the Company is required to determine the grant date fair value of the awards, which is then recognized as expense in the Company's financial statements over the vesting period of the award. Determination of the grant date fair value of the awards requires judgments and estimates regarding, among other things, the appropriate methodologies to follow in valuing the awards and the related inputs required by those valuation methodologies. Most often, the Company is required to obtain a valuation based upon assumptions regarding risk-free rates of return, dividend yields, expected volatilities and the expected term of the award. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the historical dividend yield of the Company's common stock adjusted for any expected changes and, where applicable, of the common stock of the peer group members at the time of grant. Expected volatilities are based on historical volatility of the Company's common stock and, where applicable, the common stock of the peer group members at the time of grant. The expected term represents the period of time elapsing during the applicable performance period. For time-based restricted stock awards, the grant date fair value of the awards is recognized as expense in the Company's financial statements over the vesting period, typically three years. For director phantom units (which vest on the date of grant) expected to be satisfied in equity, the grant date fair value of the awards is recognized as an expense in the Company's financial statements in the year of grant. The grant date fair value, in both cases, is determined based upon the closing price of the Company's common stock on the date of the grant. For non-qualified stock options, the grant date fair value is recognized as expense in the Company's financial statements over the vesting period, typically three years. The Company utilizes the Black-Scholes option pricing model to measure the fair value of stock options, which includes assumptions for a risk-free interest rate, dividend yield, volatility factor and expected term. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the dividend yield of the Company's common stock at the time of grant. The expected volatility is based on historical volatility of the Company's common stock at the time of grant. The expected term represents the period of time that options granted are expected to be outstanding based on historical option exercise experience at the time of grant. The Company believes that the accounting estimates related to share-based compensation are "critical accounting estimates" because they may change from period to period based on changes in assumptions about factors affecting the ultimate payout of awards, including the number of awards to ultimately vest and the market price and volatility of the Company's common stock. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company's assumptions. See Note 9 to the consolidated financial statements for additional information.

<s>[INST] Executive Overview Net income attributable to Equitrans Midstream was $218.4 million in 2018 compared with net loss attributable to Equitrans Midstream of $27.2 million in 2017. The increase resulted primarily from higher gathering, water and transmission revenues, higher equity income and lower income tax expense, partly offset by higher operating expenses, net interest expense and net income attributable to noncontrolling interests. Net loss attributable to Equitrans Midstream was $27.2 million in 2017 compared with net income attributable to Equitrans Midstream of $65.2 million in 2016. The decrease resulted from higher income tax expense, operating expenses, net income attributable to noncontrolling interests and net interest expense, partly offset by higher gathering, transmission and water revenues and higher equity income. On February 5, 2019, the Board declared a cash dividend for the fourth quarter of 2018 of $0.41 per share payable on February 27, 2019 to shareholders of record at the close of business on February 15, 2019. The following table reconciles the differences between operating income attributable to EQM as reported in EQM's Annual Report on Form 10K for the years ended December 31, 2018, 2017 and 2016 and operating income attributable to Equitrans Midstream for the same period. Selling, General and Administrative Expense. The Company incurs selling, general and administrative expenses separate from and in addition to similar costs incurred by EQM. In the Predecessor period, these expenses included allocations from EQT for compensation, centralized general and administrative services and auditing, legal and regulatory fees. In the Successor period, these expenses included auditing, legal and regulatory fees and sharebased compensation costs. Separation and Other Transaction Costs. Separation and other transaction costs represent selling, general and administrative expenses related to the Rice Merger, the EQMRMP Mergers, the DropDown Transaction, the Separation and the EQGP Buyout and included charges from EQT of $53.3 million and $85.1 million for the years ended December 31, 2018 and 2017, respectively. Separation costs recorded in 2018 also included a onetime charitable contribution of $15.0 million made to the Equitrans Midstream Foundation, a charitable organization established to continue EQT's legacy of charitable giving. Future contributions to the Equitrans Midstream Foundation, if any, will be evaluated from time to time. Depreciation. The Company recorded depreciation expense on corporate assets placed in service in the second half of 2018. During the year ended December 31, 2017, EQM's Transmission business segment recorded a noncash charge to depreciation of $10.5 million related to the revaluation of differences between regulatory and tax bases in Equitrans, L.P.'s regulated property, plant and equipment. For consolidated reporting at Equitrans Midstream, the $10.5 million is recorded as income tax expense. This difference in presentation is shown as a reduction to depreciation. Impairment of Longlived Assets. During the year ended December 31, 2016, the Company recorded impairment of longlived assets of $59.7 million related to certain gathering assets. Using the income approach with Level 3 fair value measurement inputs, these gathering assets were written down to fair value. The impairment was triggered by a reduction in estimated future cash flows caused by a low commodity price environment, which reduced producer drilling activity and related throughput on the gathering assets. The impairment was not recorded by EQM's Gathering business segment as the impairment was recognized by the Company immediately prior to its sale of the gathering assets to EQM. No impairment of any longlived assets was recorded during the years ended December 31, 2018 and 2017. Business Segment Results Operating segments are revenueproducing components of [/INST] Positive. </s>

Equitrans Midstream Corp

2020-02-27

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of financial condition and results of operations should be read in conjunction with the consolidated financial statements, and the notes thereto, included in "Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. The Company has applied the FAST Act Modernization and Simplification of Regulation S-K that was adopted by the SEC on March 20, 2019, which allows registrants providing financial statements covering three years in a filing to exclude discussion of the earliest of the three years in "Management's Discussion and Analysis of Financial Condition and Results of Operations". The information covered here provides a comparison of material changes in the consolidated financial statements for fiscal year 2019 and fiscal year 2018. For the comparison of fiscal year 2018 and fiscal year 2017, see Part II, "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Company's Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on February 14, 2019. Executive Overview Net loss attributable to Equitrans Midstream was $203.7 million in 2019 compared with net income attributable to Equitrans Midstream of $218.4 million in 2018. The decrease resulted primarily from increased impairments to long-lived assets (as discussed in Note 3), higher net interest expense associated with increased long-term debt outstanding, higher other operating expenses and lower net income attributable to noncontrolling interests partly offset by higher gathering revenues primarily associated with the operating entities acquired with the Bolt-on Acquisition, higher equity income from EQM's investment in the MVP Joint Venture and lower income tax expense. On January 15, 2020, the Board declared a cash dividend for the fourth quarter of 2019 of $0.45 per share payable on February 21, 2020 to shareholders of record at the close of business on February 11, 2020. The following table reconciles the differences between operating income attributable to EQM as reported in EQM's Annual Report on Form 10-K for the years ended December 31, 2019 and 2018 and operating income attributable to Equitrans Midstream for the same periods. Separation and Other Transaction Costs. Separation and other transaction costs primarily represented expenses related to the EQGP Buyout, the EQM IDR Transaction and the Separation for the year ended December 31, 2019. Separation and other transaction costs for the year ended December 31, 2018, primarily related to the Rice Merger, the EQM-RMP Mergers, the Drop-Down Transaction, the Separation, the EQGP Buyout and the EQM IDR Transaction (which included charges from EQT). Separation costs recorded in 2018 also included a one-time charitable contribution of $15.0 million made to the Equitrans Midstream Foundation, a charitable organization established to continue EQT's legacy of charitable giving. Future contributions to the Equitrans Midstream Foundation, if any, will be evaluated from time to time. Impairment of Long-lived Assets. The Company recognized $115.0 million of additional goodwill impairment primarily related to the Rice Retained Midstream reporting unit (see Note 3). Additional Expenses, Net. As a result of being a publicly traded company, the Company incurs additional operating expenses separate from and in addition to similar costs incurred by EQM. Business Segment Results Operating segments are revenue-producing components of an enterprise for which separate financial information is produced internally and is subject to evaluation by the chief operating decision maker in deciding how to allocate resources. Other income, net interest expense and income tax expense are managed on a consolidated basis. The Company has presented each segment's operating income, equity income and various operational measures in the following sections. Management believes that the presentation of this information is useful to management and investors regarding the financial condition, results of operations and trends of its segments. The Company has reconciled each segment's operating income to the Company's consolidated operating income and net income in Note 6. GATHERING RESULTS OF OPERATIONS (a) Includes the pre-acquisition results of the Drop-Down Transaction and the EQM-RMP Mergers, which were effective May 1, 2018 and July 23, 2018, respectively. The recasts are for the period the acquired businesses were under the common control of EQT, which began on November 13, 2017 as a result of the Rice Merger. (b) Includes approximately $25.9 million of capital expenditures related to noncontrolling interests in Eureka Midstream for the year ended December 31, 2019. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Gathering operating revenues increased by $162.9 million in 2019 compared to 2018, driven primarily as a result of revenues generated by the entities acquired in the Bolt-on Acquisition, as well as production development in the Marcellus and Utica Shales in 2019. Firm reservation fee revenues increased approximately $133.8 million primarily as a result of increased revenues generated under agreements with MVCs and revenues generated by the entities acquired in the Bolt-on Acquisition, as well as higher rates on various wellhead expansion projects in 2019. Volumetric-based fee revenues increased approximately $29.1 million due to revenues generated by the entities acquired in the Bolt-on Acquisition. Gathering operating expenses increased by $675.1 million in 2019 compared to 2018, primarily as a result of approximately $854.3 million in impairment charges in 2019, of which $736.8 million related to impairments of goodwill, $81.0 million was associated with an impairment to certain low-pressure gathering assets and $36.4 million related to an impairment of intangible assets (as discussed in Note 3), an approximate $45.6 million increase in depreciation expense as a result of additional assets placed in-service, as well as depreciation on assets acquired in the Bolt-on Acquisition and the Shared Assets Transaction, and an approximate $17.0 million increase in operating and maintenance expense primarily associated with the operations of entities acquired in the Bolt-on Acquisition and increased personnel costs, partly offset by a decrease to repairs and maintenance expense. In addition, EQM recognized an increase to separation and other transaction costs of approximately $11.6 million primarily associated with the Bolt-on Acquisition. Selling, general and administrative expenses decreased approximately $3.2 million primarily due to lower corporate overhead and personnel costs, partly offset by an increase in information technology related expenses and an increase in expenses associated with the entities acquired in the Bolt-on Acquisition. See "Outlook" and Note 3 for further discussion of the impairment of long-lived assets. See also “Outlook” and Note 18 for a discussion of the EQT Global GGA with EQT and the Credit Letter Agreement, and the transactions related thereto, including the potential cash fee relief related to the MVP in-service date. The Company expects that the revenues resulting from the MVCs provided in the EQT Global GGA will increase the proportion of the Company’s total operating revenues that are firm reservation fee revenues in future periods. TRANSMISSION RESULTS OF OPERATIONS (a) Transmission capital expenditures do not include capital contributions made to the MVP Joint Venture for the MVP and MVP Southgate projects of approximately $774.6 million, $913.2 million and $159.6 million for the years ended December 31, 2019, 2018 and 2017, respectively. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Transmission operating revenues increased by approximately $3.7 million in 2019 compared to 2018 primarily due to increased volumetric-based fee revenues due to an increase in pipeline throughput. Transmission operating expenses decreased by approximately $8.4 million in 2019 compared to 2018. Operating and maintenance expense decreased approximately $5.6 million primarily resulting from lower personnel costs and a decrease in repairs and maintenance expense. Selling, general and administrative expense decreased approximately $5.1 million resulting from lower corporate overhead and personnel costs. The decrease in operating and maintenance expense and selling, general and administrative expense was partly offset by an increase in depreciation expense due to additional assets placed in service. Equity income increased by $101.5 million in 2019 compared to 2018 due to the increase in the MVP Joint Venture's AFUDC on the MVP as a result of continued spending on the project. WATER RESULTS OF OPERATIONS (a) Includes the pre-acquisition results of the EQM-RMP Mergers, which were effective July 23, 2018. The recast is for the period the acquired businesses were under the common control of EQT, which began on November 13, 2017 as a result of the Rice Merger. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 Water operating revenues decreased by $31.4 million in 2019 compared to 2018, primarily due to a reduction in fresh water distribution fees as the fee EQM charges per gallon of water is tiered and thus is lower on a per gallon basis once certain volumetric thresholds are met and a 13.4% decrease in fresh water distribution volumes associated with lower customer activity. Water operating expenses decreased by $9.1 million in 2019 compared to 2018, primarily as a result of decreased operating and maintenance expense associated with reduced operating activity and water procurement costs and decreased selling, general and administrative expense associated with lower corporate overhead and personnel costs, partly offset by increased depreciation expense as a result of additional assets placed in-service. Other Income Statement Items Other Income Other income decreased $2.4 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the net settlement of incentive compensation. Net Interest Expense Net interest expense increased by $140.7 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 due primarily to higher interest expense of $64.8 million on the EQM $2.5 Billion Senior Notes (defined in Note 11), higher interest expense of $58.2 million associated with increased outstanding debt related to the ETRN Term Loan Credit Agreement (defined in Note 11) and the 2019 EQM Term Loan Agreement (defined in Note 11), higher interest expense of $18.6 million on net credit facility borrowings (including borrowings under the Eureka Credit Facility (defined in Note 11)), a decrease in interest income earned on cash on hand of $12.1 million and higher amortization of debt issuance costs of $6.9 million, partly offset by increased capitalized interest and AFUDC - debt of $18.0 million. See Notes 11 and 18 for discussion of the Company's, EQM's and Eureka Midstream's debt, as applicable. Income Taxes See Note 12 for an explanation of the decrease in income taxes for the year ended December 31, 2019 compared to the year ended December 31, 2018. The Company's operations had been included in EQT's consolidated income tax return for federal and state tax purposes prior to the Separation. As a result, the financial statements include the income taxes incurred by the Company computed on a separate return basis. EQM, Eureka Midstream and EQGP are limited partnerships for U.S. federal and state income tax purposes and are not subject to U.S. federal or state income taxes. In addition, as of December 31, 2017, Rice Midstream Holdings LLC (Rice Midstream Holdings) was a multi-member LLC and was not subject to U.S. federal or state income taxes. In the fourth quarter of 2018, prior to the Separation, Rice Midstream Holdings was merged out of existence as part of internal restructurings. On December 22, 2017, the U.S. Congress enacted the Tax Cuts and Jobs Act (the Tax Reform Legislation), which made significant changes to U.S. federal income tax law, including lowering the federal corporate tax rate to 21% from 35% beginning January 1, 2018. The Tax Reform Legislation contains several other provisions, such as limiting the utilization of net operating losses generated after December 31, 2017 that are carried into future years to 80% of taxable income and limitations on the deductibility of interest expense, which are not expected to have a material effect on the Company's results of operations. As of December 31, 2018, the Company completed its accounting for the effects of the Tax Reform Legislation, including accounting for the revaluation of net deferred tax assets and for state income tax effects, and recorded deferred income tax expense of $7.4 million, which is in addition to the $129.3 million of deferred income tax expense recorded during the year ended December 31, 2017. The Company also considered whether existing deferred tax assets will be recovered in future periods under this legislation and noted no significant effect on the deferred tax assets. All of EQM, Eureka Midstream and, for the period prior to the EQGP Buyout, EQGP income is included in the Company's pre-tax income; however, the Company does not record income tax expense on the portions of its income attributable to the noncontrolling limited partners of EQM, the noncontrolling members of Eureka Midstream, the noncontrolling limited partners of EQGP (for the period prior to the EQGP Buyout) and, for the period prior to May 1, 2018, the noncontrolling member of Strike Force Midstream. This reduces the Company's effective tax rate in periods when the Company has consolidated pre-tax income. Also, given that Rice Midstream Holdings was a multi-member limited liability company prior to October 22, 2018, the Company was not required to record income tax expense on Rice Midstream Holdings' income during such prior periods. Net Income Attributable to Noncontrolling Interests For the years ended December 31, 2019 and 2018, the Company's noncontrolling interests included the third-party ownership interests in EQM. For the year ended December 31, 2019 and specifically for the period from April 10, 2019 to December 31, 2019, the Company's noncontrolling interests also included third-party ownership interests in Eureka Midstream, as well as the Series A Preferred Unit interests in EQM's net income. For the period beginning January 1, 2019 and ending January 10, 2019 and for the year ended December 31, 2018, the Company's noncontrolling interests included third-party ownership interests in EQGP. For the periods in 2018 prior to the Company's acquisition of their remaining respective noncontrolling interests, the Company's noncontrolling interests also included the third-party ownership interests in RMP and Gulfport Midstream's 25% ownership interest in Strike Force Midstream. The noncontrolling interests described above resulted in net income allocations to noncontrolling interests in the statements of consolidated comprehensive income. Net income attributable to noncontrolling interests fluctuates based on the amount of net income earned by the entities with noncontrolling interests, the amount of net income allocated to EQM's IDRs prior to the EQM IDR Transaction, the amount of net income allocated to the Class B units subsequent to the EQM IDR Transaction, the amount of net income attributable to the noncontrolling interest related to the third-party ownership interests in Eureka Midstream, the amount of net income attributable to the Series A Preferred Units and any changes in the noncontrolling ownership percentages. See "Investing Activities" and "Capital Requirements" under "Capital Resources and Liquidity" for discussion of capital expenditures. Outlook The Company's assets overlay core acreage in the Appalachian Basin. The location of the Company's assets allows it to access major demand markets in the U.S. The Company is one of the largest natural gas gatherers in the U.S., and its largest customer, EQT, is the largest natural gas producer in the U.S. based on produced volumes. The Company maintains a stable cash flow profile, with approximately 58% of its revenue for the year ended December 31, 2019 generated by firm reservation fees and MVCs. Further, the percentage of the Company’s revenues that are generated by firm reservation fees and MVCs is expected to increase in future years as a result of the EQT Global GGA, which includes an MVC effective on February 26, 2020 of 3.0 Bcf per day, which ramps up to 4.0 Bcf per day in future periods following the in-service date of the MVP project. The Company's principal strategy is to achieve the scale and scope of a top-tier midstream company by leveraging its existing assets, executing on its growth projects and, where appropriate, seeking and executing on strategically-aligned acquisition and joint venture opportunities, while strengthening its balance sheet through (i) highly predictable cash flows backed by MVCs and firm reservation fees, (ii) actions to delever its balance sheet, (iii) disciplined capital spending, (iv) operating cost control and (v) an appropriate distribution policy. As part of its approach to organic growth, the Company is focused on building and completing its key transmission and gathering growth projects outlined under "Strategy" in "Item 1. Business," many of which are supported by contracts with firm capacity commitments. Additionally, the Company is targeting growth from volumetric gathering and transmission opportunities and from its water services business, which is complementary to its gathering business. On February 27, 2020, the Company and EQM announced the EQT Global GGA with EQT, which is a 15-year contract that includes, among other things, a 3.0 Bcf per day MVC (which gradually steps up to 4.0 Bcf per day for several years following the in-service date of the MVP project) and the dedication of a substantial majority of EQT’s core acreage in Pennsylvania and West Virginia to the Company, and EQT received certain gathering fee relief over a period of three years following the in-service date of the MVP. The EQT Global GGA replaced 14 previous gathering agreements between affiliates of EQT and the Company. In addition, on February 27, 2020, the Company and EQM announced a definitive merger agreement between the Company, EQM and certain of their affiliates related to the EQM Merger, pursuant to which, among other things, the Company will acquire all of the issued and outstanding EQM common units (other than EQM common units held by the Company and its subsidiaries). Following the EQM Merger, which is subject to customary closing conditions, including approvals of EQM’s limited partners and the Company’s shareholders, EQM will be a wholly-owned subsidiary of the Company and will no longer be a public entity. The Company expects the EQM Merger to close in mid-2020. See Note 18 for additional information regarding the EQT Global GGA, the EQM Merger and the transactions related thereto. For further discussion of key growth projects, see "Strategy" in "Item 1. Business." For further discussion of capital expenditures, see "Capital Requirements." Commodity Prices. The Company’s business is dependent on continued natural gas production and the availability and development of reserves in its areas of operation. Low prices for natural gas and natural gas liquids have adversely affected development of additional reserves and production that is accessible by EQM’s pipeline and storage assets, which also negatively affects EQM’s water services business. The Henry Hub natural gas price ranged from $2.02 per MMbtu to $4.25 per MMbtu between January 1, 2019 and December 31, 2019, and the natural gas forward strip price trended downwards during 2019 and in early 2020, and is expected to remain depressed for several years. Further, market prices for natural gas in the Appalachian Basin continue to be lower than Henry Hub natural gas prices. Lower natural gas prices have caused producers to determine to reduce their rig count or otherwise take actions to slow production growth and/or reduce production, which in turn reduces the demand for, and usage of, EQM’s services. A sustained period of depressed natural gas production and prices could cause producers in EQM's areas of operation to take further actions to reduce natural gas production and supply in the future. EQM’s customers, including EQT, have announced reductions in their capital spending and may continue to lower capital spending in the future based on commodity prices, access to capital, investor expectations for positive free cash flow, a desire to reduce leverage or other factors. On January 13, 2020, EQT publicly announced a 2020 capital expenditure forecast of $1.25 billion to $1.35 billion, compared to 2019 capital expenditures of $1.85 billion to $1.95 billion, which represents an approximate 30% decrease in capital expenditures compared to EQT’s projected 2019 capital expenditures. Longer-term price declines could continue to have an adverse effect on customers' creditworthiness and related ability to pay firm reservation fees under long-term contracts and/or affect activity levels and, accordingly, volumetric-based fees which could affect the Company's results of operations, liquidity or financial position. For example, on February 3, 2020, S&P took negative rating actions on nine Appalachian exploration and production companies citing lower natural gas price assumptions. Many of EQM’s customers, including EQT, have entered into long-term firm reservation transmission and gathering contracts or contracts with MVCs on EQM's systems. However, approximately 49.9% of EQM’s gathering revenues and 8.7% of EQM’s transmission revenues for the year ended December 31, 2019 were from volumetric-based fee revenues. Additionally, EQM’s water service agreements are primarily volumetric in nature. For more information see "Decreases in production of natural gas in EQM's areas of operation have adversely affected, and future decreases could further adversely affect, its business and operating results and reduce its cash available to make distributions to its unitholders, including us" included in "Item 1A. Risk Factors - Risks Related to EQM's Business." Potential Future Impairments. During 2019, the Company recognized an impairment to goodwill of approximately $851.8 million, including $602.1 million, $150.5 million, and $99.2 million associated with its RMP PA Gas Gathering, Rice Retained Midstream and Eureka/Hornet reporting units, respectively. In addition, the Company recognized a $36.4 million impairment related to certain Hornet Midstream-related intangible assets during the third quarter of 2019. See Note 3 for additional information. On January 13, 2020, EQT publicly announced an approximately 30% decrease in capital expenditures for 2020 compared to 2019 capital expenditures. In connection with the execution of the EQT Global GGA, management will reevaluate the Company’s reporting units. In connection with the execution of the EQT Global GGA, management may be required to reevaluate the Company's reporting units under the provisions in ASC 350. If, as a result of this reevaluation, management identifies that a change to the current reporting units is warranted, management will assess the goodwill for impairment before and after the change in the reporting units. Depending on the location and timing of EQT’s 2020 drilling activity, EQT’s planned reductions in its drilling and completions activity, as well as reductions in drilling and completions activity by other producers, the Company may recognize additional goodwill and long-lived asset impairment charges in future periods. The Company continues to receive and evaluate drilling plan information from EQT and other producers for 2020 and future years. As of the filing of this Annual Report on Form 10-K, the Company cannot predict the likelihood or magnitude of any future impairment. See also "Reviews of our goodwill and intangible and other long-lived assets have resulted in and could result in future significant impairment charges" included in "Item 1A, Risk Factors - Risks Related to EQM's Business" and the Company's discussion on "Critical Accounting Policies and Estimates" under "Outlook" included in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operation." Capital Resources and Liquidity The Company's liquidity requirements are to finance EQM's operations, EQM's capital expenditures, potential acquisitions and other strategic transactions and capital contributions to joint ventures, including the MVP Joint Venture, pay cash dividends and distributions and satisfy any indebtedness obligations. The Company's ability to meet these liquidity requirements depends on the cash flow from operations (through EQM operations) and the Company's and EQM's ability to raise capital in banking, capital and other markets. The Company's available sources of liquidity include cash from operations (as distributed to the Company by EQM), incremental borrowings under revolving credit facilities, cash on hand and issuances of additional debt or equity securities by the Company or EQM. Pursuant to the Tax Matters Agreement (defined in Note 9), the Company is subject to certain restrictions related to certain corporate actions, including restrictions related to the issuance of the Company and EQM securities beyond certain thresholds as set forth in the Tax Matters Agreement for a two-year period following the Separation and Distribution. See "We and EQM may determine to forgo or be required to forgo certain transactions in order to avoid the risk of incurring material tax-related liabilities or indemnification obligations under the tax matters agreement." under "Risk Factors - Risks Related to the Separation" included in Item 1A, "Risk Factors." EQM is not forecasting any public equity issuance for currently anticipated organic growth projects. In February 2020, S&P and Fitch downgraded EQM's credit ratings to non-investment grade and further downgraded the Company's credit ratings. As a result of the downgrades, each of Moody's, S&P and Fitch have assigned non-investment grade credit ratings to the Company and EQM. The non-investment grade ratings have caused EQM to incur higher borrowing costs under the EQM Credit Facility and 2019 EQM Term Loan Agreement. In addition, as a result of the downgrades, EQM was obligated to deliver additional credit support to the MVP Joint Venture, which included letters of credit in the amounts of approximately $220.2 million and $14.2 million with respect to the MVP project and MVP Southgate project, respectively. See "A further downgrade of EQM's credit ratings, including in connection with the MVP project or changes in the credit ratings of EQT, which are determined by independent third parties, could impact EQM's liquidity, access to capital, and costs of doing business." and "The credit and risk profile of EQM affect our credit ratings and risk profile, and any adverse changes in EQM's credit and risk profile could increase our borrowing costs or hinder our ability to raise capital." under "Item 1A. Risk Factors." Operating Activities Net cash flows provided by operating activities were $976.5 million for the year ended December 31, 2019 compared to $721.7 million for the year ended December 31, 2018. The increase was driven primarily by the timing of payments from working capital. Investing Activities Net cash flows used in investing activities were $2,574.5 million for the year ended December 31, 2019 compared to $1,786.0 million for the year ended December 31, 2018. The increase in cash used was primarily attributable to the cost of the Bolt-on Acquisition in 2019 and increased capital expenditures in 2019 relative to 2018 as further described in "Capital Requirements," partly offset by decreased capital contributions to the MVP Joint Venture consistent with the timing of construction for the MVP and MVP Southgate projects in 2019 relative to 2018. Financing Activities Net cash flows provided by financing activities were $1,392.2 million for the year ended December 31, 2019 compared to $1,237.4 million for the year ended December 31, 2018. For the year ended December 31, 2019, the primary sources of financing cash flows were borrowings on the Company's and EQM's credit facilities, proceeds from the issuance of the term loans under the 2019 EQM Term Loan Agreement (defined in Note 11), which were used primarily to pay down borrowings under the EQM Credit Facility, and the net proceeds from the issuance of the Series A Preferred Units, which were used in part to fund the purchase price of the Bolt-on Acquisition and to pay certain fees and expenses related to the Bolt-on Acquisition, while the primary uses of financing cash flows were payments on the Company's and EQM's credit facility borrowings, the payment of dividends, the payments of distributions to noncontrolling interest unitholders, the Company's purchase of EQGP common units and the payment of distributions to Series A Preferred unitholders. For the year ended December 31, 2018, the primary sources of financing cash flows were proceeds from the issuance of the EQM $2.5 Billion Senior Notes and the Term Loans (defined in Note 11) and net credit facility borrowings, while the primary uses of financing cash flows were net distributions to EQT, distributions paid to noncontrolling interest unitholders, the EQGP Unit Purchases (defined in Note 7) and the Gulfport Transaction (defined in Note 1). Capital Requirements The gathering, transmission and storage and water service businesses are capital intensive, requiring significant investment to develop new facilities and to maintain and upgrade existing operations. (a) Expansion capital expenditures do not include capital contributions made to the MVP Joint Venture of $774.6 million, $913.2 million and $159.6 million related to the MVP and MVP Southgate projects for the years ended December 31, 2019, 2018 and 2017, respectively. (b) Includes approximately $22.5 million of expansion capital expenditures and $3.4 million of maintenance capital expenditures related to noncontrolling interests in Eureka Midstream for the year ended December 31, 2019. (c) The Company accrues capital expenditures when capital work has been completed but the associated bills have not been paid. Accrued capital expenditures are excluded from the statements of consolidated cash flows until they are paid. See Note 6. Expansion capital expenditures are expenditures incurred for capital improvements that the Company expects will increase its operating income or operating capacity over the long term. In 2019, expansion capital expenditures reflected investments in the assets acquired in the Bolt-on Acquisition, the EQM-RMP Mergers and the Drop-Down Transaction, as well as the Hammerhead project and various wellhead gathering expansion projects, partly offset by decreased spending on the Equitrans, L.P. Expansion project. In 2018, expansion capital expenditures reflected primarily investments in the assets acquired in the EQM-RMP Mergers and the Drop-Down Transaction and in the following projects: the Hammerhead project, the Equitrans L.P. Expansion project, various wellhead gathering expansion projects and the Range Resources header pipeline project. Maintenance capital expenditures are expenditures made to maintain, over the long term, EQM's operating capacity or operating income. Examples of maintenance capital expenditures are expenditures to repair, refurbish and replace pipelines, to connect new wells to maintain throughput, to maintain equipment reliability, integrity and safety and to address environmental laws and regulations. Maintenance capital expenditures increased by $13.3 million in 2019 compared to 2018 primarily as a result of maintenance associated with the assets acquired in the Bolt-on Acquisition, additional assets placed in service and the timing of ongoing maintenance projects. In connection with the Separation, the Company assumed all of EQT’s obligations to indemnify and reimburse EQM under EQM's omnibus agreement with EQT other than for those losses or expenses relating to or arising from plugging and abandonment obligations. During 2019, the Company reimbursed EQM approximately $0.7 million associated with bare steel replacement capital expenditures. As of December 31, 2019, the Company's reimbursement obligations associated with bare steel replacement capital expenditures had been capped. Please read "Item 13. Certain Relationships and Related Transactions, and Director Independence-Agreements with EQT-Omnibus Agreement." In 2020, EQM expects to make capital contributions to the MVP Joint Venture of $650 million to $700 million depending on the timing of the construction of the MVP project and approximately $50 million for the MVP Southgate project. Expansion capital expenditures are expected to be approximately $525 million (exclusive of approximately $40 million attributable to the noncontrolling interest in Eureka Midstream) and maintenance capital expenditures are expected to be approximately $55 million (exclusive of approximately $5 million attributable to the noncontrolling interest in Eureka Midstream), net of expected reimbursements. Future capital investments may vary significantly from period to period based on the available investment opportunities and the timing of the construction of the MVP, MVP Southgate and other projects. Maintenance capital expenditures are also expected to vary quarter to quarter. EQM expects to fund future capital expenditures primarily through cash on hand, cash generated from operations, borrowings under its and its subsidiaries' respective credit facilities (including term loan agreements), debt transactions and issuances of additional EQM partnership units. EQM is not forecasting any public equity issuance for currently anticipated organic growth projects. Credit Facilities See Note 11 for discussion of the Company's and its subsidiaries' credit facilities. See Note 18 for additional information on the proposed Intercompany Loan and the anticipated termination of the ETRN Term Loan Credit Agreement. Security Ratings The table below sets forth the credit ratings for debt instruments of the Company and EQM at December 31, 2019. On January 31, 2020, Moody’s affirmed the Company’s Ba3 and EQM’s Ba1 credit ratings but changed its outlook from stable to negative, citing uncertainty around the MVP project and EQT’s weakening credit profile. On February 4, 2020, S&P downgraded the Company's credit rating to a BB- rating, with a negative outlook, from a BB rating. S&P also downgraded EQM's credit to a BB+ rating, with a negative outlook, from a BBB- rating. On February 27, 2020, S&P further downgraded EQM's credit to a BB rating, with a stable outlook, but upgraded the Company's credit rating to BB, with a stable outlook. Further, on February 18, 2020, Fitch downgraded EQM to a BB rating, with a negative outlook, from a BBB- rating, citing a downgrade of EQT’s credit rating from BBB- to BB, with a negative outlook, on February 14, 2020, as well as uncertainty around the MVP project, as the principal reasons for the ratings action. Additionally, on February 18, 2020, Fitch downgraded the Company’s credit rating from BB to B+ with a negative outlook credit rating and the credit rating specific to the Company’s term loan B from BB to B with a negative outlook. The Company's and EQM's credit ratings are subject to further revision or withdrawal at any time by the assigning rating organization and each rating should be evaluated independently of any other rating. The Company and EQM cannot ensure that a rating will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a credit rating agency if, in its judgment, circumstances so warrant, including in connection with the MVP project or the creditworthiness of EQM's customers, including EQT. As of December 31, 2019, EQT's public debt had an investment grade rating, but was on negative outlook with Moody's, S&P and Fitch. On January 13, 2020, Moody's downgraded EQT's senior unsecured rating to Ba1 with a negative outlook, from Baa3 with a negative outlook. On February 3, 2020, S&P downgraded EQT's senior unsecured rating to BB+ with a negative outlook, from BBB- with a negative outlook. Further, on February 14, 2020, Fitch downgraded EQT's senior unsecured rating to BB with a negative outlook, from BBB-. If any credit rating agency further downgrades the Company's or EQM's ratings, the Company's and EQM's access to the capital markets may be limited, borrowing costs could increase, EQM may be required to provide additional credit assurances in support of commercial agreements such as joint venture agreements and, if applicable, construction contracts, and the potential pool of investors and funding sources may decrease. In order to be considered investment grade, a company must be rated Baa3 or higher by Moody's, BBB- or higher by S&P, or BBB- or higher by Fitch. Anything below these ratings, including all of the Company's and EQM's credit ratings are considered non-investment grade. Schedule of Contractual Obligations The following represents the Company's contractual obligations as of December 31, 2019. Purchase obligations exclude future capital contributions to the MVP Joint Venture and purchase obligations of the MVP Joint Venture. In addition, the following contractual obligations exclude distributions associated with the Series A Preferred Units. (a) Includes $3.5 billion in aggregate principal amount of EQM's senior notes and $1.4 billion associated with the term loans issued pursuant to the 2019 EQM Term Loan Agreement as of December 31, 2019. See Note 11 for further information. (b) Credit facility borrowings were classified based on the termination date of the credit facility agreements. As of December 31, 2019, the Company had aggregate credit facility borrowings outstanding of approximately $610 million and $293 million under the EQM Credit Facility and the Eureka Credit Facility, respectively. See Note 11 for further information. (c) Interest payments exclude interest related to the EQM Credit Facility, Eureka Credit Facility and term loans issued under the 2019 EQM Term Loan and ETRN Term Loan as the interest rates on the credit facility borrowings and the term loans are variable. (d) Purchase obligations represent agreements to purchase goods or services that are enforceable, legally binding and specify all significant terms, including the approximate timing of the transaction. As of December 31, 2019, the Company's purchase obligations included commitments for capital expenditures, operating expenses and service contracts. (e) Operating leases are primarily entered into for various office locations and warehouse buildings, as well as lease obligations for compression equipment under existing contracts with third parties. (f) Other liabilities represent commitments for estimated payouts as of December 31, 2019 for various Equitrans Midstream liability award plans. See "Critical Accounting Policies and Estimates" below and Note 10 for discussion of factors that affect the ultimate amount of the payout of these obligations. See Note 18 for additional information on the proposed Intercompany Loan and the anticipated termination of the ETRN Term Loan Credit Agreement. Commitments and Contingencies In the ordinary course of business, various legal and regulatory claims and proceedings are pending or threatened against the Company and its subsidiaries, including EQM. While the amounts claimed may be substantial, the Company and EQM are unable to predict with certainty the ultimate outcome of such claims and proceedings. The Company and EQM accrue legal and other direct costs related to loss contingencies when incurred. Each of the Company and EQM, as applicable, establishes reserves whenever it believes it to be appropriate for pending matters. Furthermore, after consultation with counsel and considering available insurance, the Company believes that the ultimate outcome of any matter currently pending against it, EQM or any of their respective subsidiaries will not materially affect its business, financial condition, results of operations, liquidity or ability to pay dividends to its shareholders. See "The regulatory approval process for the construction of new midstream assets is challenging, and recent decisions by regulatory and judicial authorities in pending proceedings could impact EQM's or the MVP Joint Venture's ability to obtain all approvals and authorizations necessary to complete certain projects on the projected time frame or at all or EQM's ability to achieve the expected investment return on the projects." under "Risk Factors - Risks Related to EQM's Business" included in "Item 1A. Risk Factors," and see "Item 3. Legal Proceedings" for discussion of litigation and regulatory proceedings related to the MVP project. See Note 14 for further discussion of the Company's commitments and contingencies. Off-Balance Sheet Arrangements See Note 8 for discussion of the MVP Joint Venture guarantees. Recently Issued Accounting Standards Recently issued accounting standards relevant to the Company are described in Note 1. Critical Accounting Policies and Estimates The Company's significant accounting policies are described in Note 1. Preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosures of contingent assets and liabilities. The following critical accounting policies, which were reviewed by the Company's Audit Committee, relate to its more significant judgments and estimates used in the preparation of its consolidated financial statements. Actual results could differ from those estimates. Income Taxes. The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the Company's consolidated financial statements or tax returns. The Company has federal and state net operating loss (NOL) carryforwards related to federal and various state jurisdictions. The federal and states of Virginia and West Virginia NOL carryforwards have no expiration, but utilization is limited to 80% of taxable income in the year of utilization. The Company's Pennsylvania NOL carryforwards expire in 2039. The Company believes that it is more likely than not that the benefit from certain federal and state NOL carryforwards will be realized. In addition to the NOL carryforwards, the Company has recorded deferred tax assets principally resulting from its investments in partnerships. No valuation allowances have been established because the Company believes that future sources of taxable income, reversing temporary differences and other tax planning strategies will be sufficient to realize these deferred tax assets. Any determination to change the valuation allowance would impact the Company's income tax expense and net income in the period in which such a determination is made. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not (greater than 50%) that a tax benefit will not be realized. In evaluating the need for a valuation allowance, management considers all potential sources of taxable income, including income available in carry-back periods, future reversals of taxable temporary differences, projections of taxable income and income from tax planning strategies, as well as all available positive and negative evidence. Positive evidence includes factors such as a history of profitable operations, projections of future profitability within the carry-forward period, including from tax planning strategies, and experience. The Company has not noted any significant negative evidence. Deferred tax assets for which no valuation allowance is recorded may not be realized, and changes in facts and circumstances may result in the establishment of a valuation allowance. Existing valuation allowances are re-examined under the same standards of positive and negative evidence that apply to valuation allowance establishment. If the Company determines that it is more likely than not that a deferred tax asset for which a valuation is recorded will be realized, all or a portion of the valuation allowance may be released. Deferred tax assets and liabilities are also re-measured to reflect changes in underlying tax rates from law changes. Tax benefits related to uncertain tax positions taken or expected to be taken on a tax return are recorded when such benefits meet a more likely than not threshold; otherwise, the tax benefit is recorded when the tax position has been effectively settled, either because the statute of limitations has expired or the appropriate taxing authority has completed its examination. Interest and penalties related to uncertain tax positions are recognized as part of the provision for income taxes and are accrued beginning in the period that such interest and penalties would be applicable under relevant tax law until such time that the related tax benefits are recognized. The Company believes that accounting estimates related to income taxes are "critical accounting estimates" because the Company must assess the likelihood that deferred tax assets will be recovered from future taxable income, exercise judgment when evaluating whether or not a valuation allowance must be established on deferred tax assets and exercise judgment regarding the amount of financial statement benefit to record for uncertain tax positions. To the extent that a valuation allowance or an uncertain tax position is established or increased or decreased during a period, the Company includes an expense or benefit within income tax expense on the statements of comprehensive income. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company's assumptions. See Note 12 for additional information. Property, Plant and Equipment. Determination of depreciation requires judgment regarding the estimated useful lives and salvage values of property, plant and equipment. The Company has not historically experienced material changes in its results of operations from changes in the estimated useful lives or salvage values of its property, plant and equipment; however, these estimates are reviewed periodically, including each time Equitrans, L.P. files with the FERC for a change in its transmission, storage and gathering rates. The Company believes that the accounting estimate related to depreciation is a "critical accounting estimate" because it is susceptible to change. These assumptions affect depreciation expense and, if changed, would have an effect on the Company's results of operations and financial position. See Note 1 for additional information. Impairments of Long-Lived Assets, Including Intangible Assets and Goodwill. Any accounting estimate related to impairment of property, plant and equipment, finite-lived intangible assets, goodwill or an investment in an unconsolidated entity may require the Company's management to make assumptions about future cash flows, discount rates, the fair value of investments and whether losses in the value of its investments are other than temporary. Management's assumptions about future cash flows require significant judgment because actual operating levels have fluctuated in the past and are expected to fluctuate in the future. Goodwill is the cost of an acquisition less the fair value of the identifiable net assets of the acquired business. Goodwill is evaluated for impairment at least annually or whenever events or changes in circumstances indicate it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The Company uses a combination of an income and market approach to estimate the fair value of a reporting unit. See Notes 1 and 3 for additional information. The Company believes that the accounting estimates related to impairments are "critical accounting estimates" because they require assumptions that are susceptible to change, including estimating fair value which requires considerable judgment. For goodwill, management’s estimate of a reporting unit’s future financial results is sensitive to changes in assumptions, such as changes in stock prices, weighted-average cost of capital, terminal growth rates and industry multiples. The Company believes the estimates and assumptions used in estimating its reporting units’ fair values are reasonable and appropriate, however, different assumptions and estimates could materially affect the calculated fair value and the resulting conclusion on impairment of goodwill, which could materially affect the Company’s results of operations and financial position. Additionally, actual results could differ from these estimates. The Company performed a sensitivity analysis for the RMP PA Gas Gathering reporting unit (defined and discussed in Note 1), which is the only reporting unit with goodwill as of December 31, 2019, to quantify the effect of certain changes to assumptions used in the goodwill assessment. It was determined that a 1% increase to the weighted average cost of capital and a corresponding 1% decrease to the terminal cash flow growth rate would have resulted in the Company’s recognition of approximately $81.3 million of additional impairment of goodwill as of December 31, 2019. The Company’s investments in unconsolidated entities also require considerable judgment to estimate fair value because the Company’s investments are not traded on an active market. Additionally, investments in unconsolidated entities are susceptible to impairment risk from further adverse macroeconomic conditions or other adverse factors such as permit and litigation matters impacting the MVP project. Such matters could cause further significant delays in the timing and costs of the MVP project which could result in a decline in fair value that could trigger future impairment charges relating to the Company’s investments in unconsolidated entities. Any potential impairment would have an effect on the Company's results of operations and financial position. See Notes 1 and 3 for additional information. Revenue Recognition. Revenue from the gathering, transmission and storage of natural gas is generally recognized when the service is provided. Revenue from water services is generally recognized when water is delivered. For all contracts, EQM allocates the transaction price to each performance obligation based on the judgmentally determined relative standalone selling price. When applicable, the excess of consideration received over revenue recognized results in the deferral of those amounts until future periods based on a units of production or straight-line methodology as these methods appropriately match the consumption of services provided to the customer. The units of production methodology requires the use of production estimates that are uncertain and the use of judgment when developing estimates of future production volumes, thus impacting the rate of revenue recognition. Production estimates are monitored as circumstances and events warrant. Certain of our gas gathering and water agreements have MVCs. If a customer under such an agreement fails to meet its MVC for a specified period (thus not exercising all the contractual rights to gathering and water services within the specified period, herein referred to as “breakage”), it is obligated to pay a contractually determined fee based upon the shortfall between the actual gathered or water volumes and the MVC for the period contained in the contract. Based on management’s judgment, it is probable that the customer will not exercise all or a portion of its remaining rights, we recognize revenue associated with such breakage amount in proportion to the pattern of exercised rights within the respective MVC period. Revenue related to services provided but not yet billed is estimated each month. These estimates are generally based on contract data, preliminary throughput and allocation measurements. Final bills for the current month are billed and collected in the following month. See Note 4 for additional information. EQM records a provision for accounts receivable that are estimated to be uncollectible. In order to calculate the appropriate provision, an estimated loss rate of accounts receivable as a percentage of total revenue is used. This estimated loss rate is applied to the outstanding accounts receivable and is updated periodically based on a customer's credit rating or other events that could impact the estimated loss rate, such as a significant change to the natural gas industry or to the economy as a whole. Management reviews the adequacy of the allowance on a quarterly basis using the assumptions that apply at that time. While EQM has not historically experienced material bad debt expense, declines in the market price for natural gas affecting producer activity combined with the increase in customers on EQM's systems may result in a greater exposure to potential losses than management's current estimates. The Company believes that the accounting estimates related to revenue recognition are "critical accounting estimates" because estimated volumes are subject to change based on actual measurements, including prior period adjustments. In addition, the Company believes that the accounting estimates related to the allowance for doubtful accounts receivable are "critical accounting estimates" because the underlying assumptions used for the allowance can change and the actual mix of customers and their ability to pay may vary significantly from management's estimates, which could affect the collectability of customer accounts. These accounting estimates could potentially have a material effect on the Company's results of operations and financial position. Business Combinations. During the second quarter of 2019, EQM recorded the Bolt-on Acquisition using the acquisition method of accounting; accordingly, the values assigned to the assets and liabilities are based on EQM's purchase price accounting estimates. Accounting for the acquisition of a business requires a company to record the acquired identifiable assets and liabilities at fair value. The estimated fair value of midstream facilities and equipment, which generally consist of pipeline systems and compression stations, was estimated using the cost approach. Significant unobservable inputs in the estimate of fair value include management's assumptions about the replacement costs for similar assets, the relative age of the acquired assets and any potential economic or functional obsolescence associated with the acquired assets. The fair value of intangible assets was determined using the income approach, which requires a forecast of the expected future cash flows generated and an estimated market-based weighted average cost of capital. Significant unobservable inputs in the determination of fair value include future revenue estimates, future cost assumptions and estimated customer retention rates. Given the time required to obtain pertinent information necessary to finalize the allocation of the purchase price to the acquired net assets, the purchase price allocation remained preliminary for a period of time before the required fair value estimates were finalized. It is not uncommon for the initial estimates to be subsequently revised. During the fourth quarter of 2019, the Bolt-on Acquisition purchase price accounting was finalized. See Note 2 for further information. The Company believes that the accounting estimates related to business combinations are "critical accounting estimates" because in determining the fair value of assets acquired, assumptions must be made about projections regarding the timing and amount of future development and operating costs and projections of replacement costs of and future cash flows from midstream assets and cash flows from customer relationships. Different assumptions may result in materially different values for these assets, which would affect the Company's future results of operations and financial position. Share-Based Compensation. The Company awards share-based compensation in connection with specific programs. Awards to employees are typically made in the form of performance-based awards, time-based restricted stock awards and time-based restricted unit awards; and certain former employees were awarded stock options in the past. Awards to directors are typically made in the form of phantom units that vest upon grant. Restricted units and performance-based awards expected to be satisfied in cash are treated as liability awards. For liability awards, the Company is required to estimate, on the grant date and on each reporting date thereafter until vesting and payment, the fair value of the ultimate payout based upon the expected performance through, and value of the Company's common stock on, the vesting date. The Company then recognizes a proportionate amount of the expense for each period in the Company's financial statements over the vesting period of the award. The Company reviews its assumptions regarding performance and common stock value on a quarterly basis and adjusts its accrual when changes in these assumptions result in a material change in the fair value of the ultimate payouts. Performance-based awards expected to be satisfied in Company common stock are treated as equity awards. For equity awards, the Company is required to determine the grant date fair value of the awards, which is then recognized as expense in the Company's financial statements over the vesting period of the award. Determination of the grant date fair value of the awards requires judgments and estimates regarding, among other things, the appropriate methodologies to follow in valuing the awards and the related inputs required by those valuation methodologies. Most often, the Company is required to obtain a valuation based upon assumptions regarding risk-free rates of return, dividend yields, expected volatilities and the expected term of the award. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the historical dividend yield of the Company's common stock adjusted for any expected changes and, where applicable, of the common stock of the peer group members at the time of grant. Expected volatilities are based on historical volatility of the Company's common stock and, where applicable, the common stock of the peer group members at the time of grant. The expected term represents the period of time elapsing during the applicable performance period. For time-based restricted stock awards, the grant date fair value of the awards is recognized as expense in the Company's financial statements over the vesting period, typically three years. For director phantom units (which vest on the date of grant) expected to be satisfied in equity, the grant date fair value of the awards is recognized as an expense in the Company's financial statements in the year of grant. The grant date fair value, in both cases, is determined based upon the closing price of the Company's common stock on the day before the grant date. The Company believes that the accounting estimates related to share-based compensation are "critical accounting estimates" because they may change from period to period based on changes in assumptions about factors affecting the ultimate payout of awards, including the number of awards to ultimately vest and the market price and volatility of the Company's common stock. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company's assumptions. See Note 10 for additional information.

<s>[INST] The Company has applied the FAST Act Modernization and Simplification of Regulation SK that was adopted by the SEC on March 20, 2019, which allows registrants providing financial statements covering three years in a filing to exclude discussion of the earliest of the three years in "Management's Discussion and Analysis of Financial Condition and Results of Operations". The information covered here provides a comparison of material changes in the consolidated financial statements for fiscal year 2019 and fiscal year 2018. For the comparison of fiscal year 2018 and fiscal year 2017, see Part II, "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" of the Company's Annual Report on Form 10K for the year ended December 31, 2018, filed with the SEC on February 14, 2019. Executive Overview Net loss attributable to Equitrans Midstream was $203.7 million in 2019 compared with net income attributable to Equitrans Midstream of $218.4 million in 2018. The decrease resulted primarily from increased impairments to longlived assets (as discussed in Note 3), higher net interest expense associated with increased longterm debt outstanding, higher other operating expenses and lower net income attributable to noncontrolling interests partly offset by higher gathering revenues primarily associated with the operating entities acquired with the Bolton Acquisition, higher equity income from EQM's investment in the MVP Joint Venture and lower income tax expense. On January 15, 2020, the Board declared a cash dividend for the fourth quarter of 2019 of $0.45 per share payable on February 21, 2020 to shareholders of record at the close of business on February 11, 2020. The following table reconciles the differences between operating income attributable to EQM as reported in EQM's Annual Report on Form 10K for the years ended December 31, 2019 and 2018 and operating income attributable to Equitrans Midstream for the same periods. Separation and Other Transaction Costs. Separation and other transaction costs primarily represented expenses related to the EQGP Buyout, the EQM IDR Transaction and the Separation for the year ended December 31, 2019. Separation and other transaction costs for the year ended December 31, 2018, primarily related to the Rice Merger, the EQMRMP Mergers, the DropDown Transaction, the Separation, the EQGP Buyout and the EQM IDR Transaction (which included charges from EQT). Separation costs recorded in 2018 also included a onetime charitable contribution of $15.0 million made to the Equitrans Midstream Foundation, a charitable organization established to continue EQT's legacy of charitable giving. Future contributions to the Equitrans Midstream Foundation, if any, will be evaluated from time to time. Impairment of Longlived Assets. The Company recognized $115.0 million of additional goodwill impairment primarily related to the Rice Retained Midstream reporting unit (see Note 3). Additional Expenses, Net. As a result of being a publicly traded company, the Company incurs additional operating expenses separate from and in addition to similar costs incurred by EQM. Business Segment Results Operating segments are revenueproducing components of an enterprise for which separate financial information is produced internally and is subject to evaluation by the chief operating decision maker in deciding how to allocate resources. Other income, net interest expense and income tax expense are managed on a consolidated basis. The Company has presented each segment's operating income, equity income and various operational measures in the following sections. Management believes that the presentation of this information is useful to management and investors regarding the financial condition, results of operations and trends of its segments. The Company has reconciled each segment's operating income to the Company's consolidated operating income and net income in Note 6. GATHERING RESULTS OF OPERATIONS (a) Includes the [/INST] Negative. </s>

WYNDHAM HOTELS & RESORTS, INC.

2019-02-14

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. (Unless otherwise noted, all amounts are in millions, except share and per share amounts) References herein to “Wyndham Hotels,” the “Company,” “we,” “our” and “us” refer to both (i) Wyndham Hotels & Resorts, Inc. and its consolidated subsidiaries for time periods following the consummation of the spin-off and (ii) the Wyndham Hotels & Resorts businesses for time periods prior to the consummation of our spin-off from Wyndham Worldwide. Unless the context otherwise suggests, references herein to “Wyndham Worldwide,” “Wyndham Destinations” and “former Parent” refer to Wyndham Worldwide Corporation and its consolidated subsidiaries. BUSINESS AND OVERVIEW Wyndham Hotels & Resorts is a leading global hotel franchisor, licensing its renowned hotel brands to hotel owners in more than 80 countries around the world. Wyndham Hotels operates in the following segments: • Hotel franchising - licenses our lodging brands and provides related services to third-party hotel owners and others. • Hotel management - provides hotel management services for full-service and limited-service hotels as well as two hotels that are owned by Wyndham Hotels. The Consolidated and Combined Financial Statements presented herein have been prepared on a stand-alone basis and prior to May 31, 2018 are derived from the consolidated financial statements and accounting records of Wyndham Worldwide. The Consolidated and Combined Financial Statements include Wyndham Hotels’ assets, liabilities, revenues, expenses and cash flows and all entities in which Wyndham Hotels has a controlling financial interest. RESULTS OF OPERATIONS Discussed below are our key operating statistics, combined results of operations and the results of operations for each of our reportable segments. The reportable segments presented below represent our operating segments for which discrete financial information is available and used on a regular basis by our chief operating decision maker to assess performance and to allocate resources. In identifying our reportable segments, we also consider the nature of services provided by our operating segments. Management evaluates the operating results of each of our reportable segments based upon net revenues and Adjusted EBITDA. Beginning with the third quarter of 2018, our calculation of Adjusted EBITDA excludes the currency effects of highly inflationary countries. Adjusted EBITDA is defined as net income excluding interest expense, depreciation and amortization, impairment charges, restructuring and related charges, contract termination costs, transaction-related expenses (acquisition-, disposition- or separation-related), foreign currency impacts of highly inflationary countries, stock-based compensation expense, early extinguishment of debt costs and income taxes. We believe that Adjusted EBITDA is a useful measure of performance for our segments and, when considered with U.S. GAAP measures, gives a more complete understanding of our operating performance. Adjusted EBITDA is not a recognized term under U.S. GAAP and should not be considered as an alternative to net income or other measures of financial performance or liquidity derived in accordance with U.S. GAAP. Our presentation of Adjusted EBITDA may not be comparable to similarly-titled measures used by other companies. We generate royalties and franchise fees, management fees and other revenues from hotel franchising and hotel management activities, as well as fees from licensing our “Wyndham” trademark, certain other trademarks and intellectual property. In addition, pursuant to our franchise and management contracts with third-party hotel owners, we generate marketing, reservation and loyalty fee revenues and cost reimbursement revenues that over time are offset, respectively, by the marketing, reservation and loyalty costs and property operating costs that we incur. OPERATING STATISTICS - 2018 VS. 2017 The table below presents our operating statistics for the years ended December 31, 2018 and 2017. “Rooms” represent the number of hotel rooms in our brand systems as of the last date of the period. “RevPAR” represents the room rental revenues generated by our franchisees divided by the number of available room-nights in the period. These operating statistics are drivers of our revenues and therefore provide an enhanced understanding of our business. Refer to the section below for a discussion as to how these operating statistics affected our business for the periods presented. ______________________ (a) Includes the impact of acquisitions and dispositions from their respective dates forward. (b) Excluding currency effects for the year ended December 31, 2018, international RevPAR increased 4% and total RevPAR increased 9%. YEAR ENDED DECEMBER 31, 2018 VS. YEAR ENDED DECEMBER 31, 2017 During 2018, net revenues increased 46% compared with the prior-year, which was driven by $513 million of incremental revenues from the La Quinta acquisition, which included $324 million of cost reimbursement revenues. Excluding the La Quinta acquisition, net revenues increased 6% primarily due to higher license and other fees and higher royalties. During 2018, total expenses increased 54%, which included $443 million of incremental expenses associated with the La Quinta acquisition, $77 million of separation-related costs and $36 million of net transaction-related costs that were primarily associated with the La Quinta acquisition. During 2018: • Marketing, reservation and loyalty expenses decreased to 26.0% of revenues from 29.1% during 2017, primarily due to higher cost reimbursement revenues. Excluding La Quinta, marketing, reservation and loyalty expenses increased to 29.9% of revenues from 29.1% primarily due to higher marketing, reservation and loyalty expenses resulting from the increase in marketing and reservation fee revenues from franchisees; • Operating expenses decreased to 9.7% of revenues from 14.3% during 2017, primarily as a result of the increase in cost reimbursement revenues and reduced expenses at our owned hotel in Puerto Rico resulting from insurance recoveries received in 2018 related to hurricanes that occurred in 2017; and • General and administrative expenses decreased to 6.4% of revenues from 6.9% during 2017, primarily due to higher cost reimbursement revenues, partially offset by higher employee-related and information technology costs, principally related to operating as a stand-alone public company. Marketing, reservation and loyalty revenues exceeded marketing, reservation and loyalty expenses by $5 million. Excluding La Quinta, marketing, reservation and loyalty expenses exceeded marketing, reservation and loyalty revenues by $9 million. Marketing, reservation and loyalty expenses exceeded marketing, reservation and loyalty revenues by $2 million during 2017. During 2018, net interest expense increased $54 million primarily due to the borrowings used to fund the La Quinta acquisition. Our effective tax rates were 27.4% and 5.3% for 2018 and 2017, respectively. The increase was principally due to the net tax benefit of $85 million recorded from the enactment of the U.S. Tax Cuts and Jobs Act in 2017. As a result of these items, principally driven by the net income tax benefit in 2017, separation-related and transaction-related expenses in 2018 and higher interest expense in 2018, net income decreased $68 million compared with 2017. Reconciliation of Net Income to Adjusted EBITDA For 2018, we reported net income of $162 million, which included after-tax charges of $58 million related to our separation from Wyndham Destinations, $29 million for net transaction-related costs primarily related to acquisitions and dispositions and $3 million related to the foreign currency impact of the highly inflationary economy in Argentina. For 2017, we reported net income of $230 million, which included after-tax charges of $25 million for impairments, $4 million for separation- and transaction-related costs and $1 million for restructuring activities. Following is a discussion of the results of each of our segments and Corporate and Other for 2018 compared to 2017: Hotel Franchising ______________________ (a) Includes the impact of acquisitions and dispositions from the acquisition and disposition dates forward. (b) Excluding currency effects, international RevPAR increased 4% and total RevPAR increased 8%. Net revenues increased 27% during 2018 primarily due to the acquisition of La Quinta, which contributed to 6% total hotel franchising system growth and 7% higher RevPAR. Excluding the La Quinta acquisition, net revenues increased 8% primarily due to higher license fees, an increase in marketing, reservation and loyalty fees and higher royalties and franchise fees. Adjusted EBITDA increased 28% during 2018 primarily due to higher revenues. Excluding the La Quinta acquisition, Adjusted EBITDA increased 9% primarily due to higher revenues. During 2018: • Marketing, reservation and loyalty expenses increased to 41.2% of revenues from 40.6% during the prior year primarily due to the La Quinta acquisition; • Operating expenses decreased to 9.6% of revenue compared to 10.4% during the prior year primarily due to the La Quinta acquisition; and • General and administrative expenses decreased to 3.8% of revenues from 4.2% during the prior year, primarily due to lower employee-related expenses coupled with higher net revenues. Marketing, reservation and loyalty revenues exceeded marketing, reservation and loyalty expenses by $21 million and $6 million during 2018 and 2017, respectively. Excluding La Quinta, marketing, reservation and loyalty expenses exceeded marketing, reservation and loyalty revenues by $1 million during 2018. Hotel Management ______________________ (a) Includes the impact of acquisitions and disposition from their respective dates forward. (b) Excluding currency effects, International RevPAR increased 5% and total RevPAR decreased 11%. Net revenues increased 90% during 2018 primarily due to $351 million of incremental revenues from the La Quinta acquisition (including $324 million of cost reimbursement revenues). Excluding La Quinta, net revenues decreased 2% due primarily to certain management contracts being transferred to our former Parent upon our spin-off. Adjusted EBITDA increased 124% in 2018 including approximately $14 million of Adjusted EBITDA from La Quinta. Excluding La Quinta, Adjusted EBITDA increased 57% due to reduced expenses at our owned hotel in Puerto Rico due to insurance recoveries in 2018 related to hurricanes that occurred in 2017. Cost reimbursement revenue was equal to reimbursable expenses in both 2018 and 2017. Marketing, reservation and loyalty expenses exceeded marketing, reservation and loyalty revenues by $16 million ($9 million excluding La Quinta) in 2018 and by $7 million in 2017. Corporate and Other Revenues increased $7 million during 2018, which represents fees earned under a transition services agreement with our former Parent. Adjusted EBITDA decreased $15 million during 2018 compared to the prior year, primarily due to an increase in general overhead expenses in connection with operating as a stand-alone public company, partially offset by higher revenues. OPERATING STATISTICS - 2017 VS. 2016 The table below presents our operating statistics for the years ended December 31, 2017 and 2016. “Rooms” represent the number of hotel rooms in our brand systems as of the last date of the period. “RevPAR” represents the room rental revenues generated by our franchisees divided by the number of available room-nights in the period. These operating statistics are drivers of our revenues and therefore provide an enhanced understanding of our business. Refer to the section below for a discussion as to how these operating statistics affected our business for the periods presented. ______________________ (a) Includes the impact of acquisitions from their respective dates forward. (b) Excluding currency effects for the year ended December 31, 2017, international and total RevPAR increased 3%. YEAR ENDED DECEMBER 31, 2017 VS. YEAR ENDED DECEMBER 31, 2016 During 2017, net revenues increased 1% compared with the prior-year, primarily due to higher royalties and franchise fees from global system growth, higher RevPAR and an increase in license and other fees, partially offset by lower cost reimbursements revenues. During 2017, total expenses increased 6% and include $41 million of non-cash impairment charges. During 2017: • Marketing, reservation and loyalty expenses decreased to 29.1% of revenues from 29.6% during 2016, due to an overall increase in net revenues; • Operating expenses increased to 14.3% of revenues from 13.2% during 2016, primarily as a result of higher employee-related costs and higher expenses at our owned hotel in Puerto Rico due to the impact of the hurricanes during 2017; and • General and administrative expenses increased to 6.9% of revenues from 6.5% during 2016, primarily due to higher employee-related and legal costs. Marketing, reservation and loyalty expenses exceeded marketing, reservation and loyalty revenue by $2 million and $1 million during 2017 and 2016, respectively. Our effective tax rate was 5.3% for 2017, primarily due to an $85 million net tax benefit from the impact of the enactment of the U.S. Tax Cuts and Jobs Act during the year. Our effective tax rate was 40.1% in 2016. As a result of the foregoing, net income increased by $54 million, or 31%, from 2016. Reconciliation of Net Income to Adjusted EBITDA For 2017, we reported net income of $230 million, which included after-tax charges of (i) $25 million for impairments, (ii) $2 million for transaction-related costs for acquisitions, (iii) $2 million related to our planned separation from Wyndham Worldwide and (iv) $1 million for restructuring activities. In 2016, we reported net income of $176 million, which included after-tax charges of (i) $5 million for termination of a management contract, (ii) $1 million for transaction-related costs and (iii) $1 million for restructuring activities. Following is a discussion of the results of each of our segments and Corporate and Other for 2017 compared to 2016: Hotel Franchising ______________________ (a) Includes the impact of acquisitions from their respective dates forward. (b) Excluding currency effects, international and total RevPAR increased 3%. Net revenues increased 2% during 2017 compared with 2016 primarily due to 4% total hotel franchising system growth and 3% higher RevPAR. Adjusted EBITDA increased 1% during 2017 primarily due to higher revenues. Foreign currency translation unfavorably impacted Adjusted EBITDA by $1 million. During 2017: • Marketing, reservation and loyalty expenses decreased to 40.6% of revenues from 41.9% during 2016 due primarily to an increase in total net revenues; • Operating expenses increased to 10.4% of revenue from 8.8% during 2016 due to higher employee-related costs; and • General and administrative expenses increased to 4.2% of revenues from 3.9% during 2016 primarily due to higher legal costs. Marketing, reservation and loyalty revenues exceeded marketing, reservation and loyalty expenses by $6 million and $4 million in 2017 and 2016, respectively. Hotel Management ______________________ (a) Includes the impact of acquisitions from their respective dates forward. (b) Excluding currency effects, international RevPAR decreased 6% and total RevPAR decreased 5%. Net revenues declined $5 million during 2017 compared with 2016, primarily as a result of a $7 million reduction in cost reimbursement revenues. Adjusted EBITDA decreased by $5 million during 2017 compared with 2016 as a result of the unfavorable impact the 2017 hurricanes had on our owned hotel in Puerto Rico. During 2017: • Cost reimbursements decreased to 68.9% of revenues from 69.8% during 2016; • Operating expenses increased to 22.7% of revenues from 20.6% in 2016, primarily as a result of higher operating expenses at our owned hotel in Puerto Rico due to the impact of the hurricanes during 2017 and higher expenses associated with hotel management guarantees; • Marketing, reservation and loyalty expenses increased to 2.3% of revenues from 1.9% during 2016; and • General and administrative expenses decreased to 0.7% of revenues from 0.9% during 2016. Cost reimbursement revenue was equal to reimbursable expenses in both 2017 and 2016. Marketing, reservation and loyalty expenses exceeded marketing, reservation and loyalty revenues by $7 million and $5 million in 2017 and 2016, respectively. Corporate and Other Corporate expenses increased $2 million during 2017 compared to 2016. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES FINANCIAL CONDITION Total assets increased $2.8 billion from December 31, 2017 to December 31, 2018 primarily due to (i) the La Quinta acquisition, (ii) increased cash from borrowings and (iii) the contribution of assets from our former Parent upon our separation. Total liabilities increased $2.7 billion primarily due to (i) an increase in debt and other liabilities related to the La Quinta acquisition and (ii) the contribution of liabilities from our former Parent upon our separation. Total equity increased $156 million from December 31, 2017 to December 31, 2018 primarily due to contributions from our former Parent upon our separation. LIQUIDITY AND CAPITAL RESOURCES We intend to use the cash flow generated by our operations to create value for stockholders. Our asset-light business model, with low fixed costs and stable, recurring franchise fee revenue, generates attractive margins and cash flow. In addition to investments in the business, including acquisitions of brands and businesses that would expand our presence and capabilities in the lodging industry, we expect to return capital to our stockholders through dividends and/or share repurchases. We expect to pay a regular dividend and use excess cash to repurchase shares. Historically, our net cash was transferred to Wyndham Worldwide, where it was centrally managed. Following the spin-off, we no longer participate in cash management and intercompany funding arrangements with Wyndham Worldwide. Our principal sources of liquidity following the spin-off are our cash on hand and our ability to generate cash through operations and financing activities, as well as any available funding arrangements we have entered into. In April 2018, we issued $500 million of senior unsecured notes, which mature in 2026 and bear interest at a rate of 5.375% per year. In addition to the notes offering, in May 2018, we entered into new Senior Secured Credit Facilities (the “Credit Facilities”) in an aggregate principal amount of $2.35 billion, consisting of a Term Loan in an aggregate principal amount of $1.6 billion maturing in 2025 and a revolving credit facility in an aggregate principal amount of $750 million maturing in 2023, which was undrawn at closing and at December 31, 2018. The proceeds from the notes offering and the term loan were used primarily to finance the cash consideration for the La Quinta acquisition, as well as to pay related fees and expenses and for general corporate purposes. See Note 5 - Acquisitions and Note 12 - Long-term Debt and Borrowing Arrangements to the Consolidated and Combined Financial Statements contained in Part IV of this report for a discussion of the La Quinta acquisition, the Credit Facilities and the notes offering. The interest rate per annum applicable to our Term Loan is equal to, at Wyndham Hotels’ option, either a base rate plus a margin of 0.75% or LIBOR plus a margin of 1.75%. The revolving credit facility is subject to an interest rate per annum equal to, at Wyndham Hotels’ option, either a base rate plus a margin ranging from 0.50% to 1.00% or LIBOR plus a margin ranging from 1.50% to 2.00%, in either case based upon the total leverage ratio of the Company and its restricted subsidiaries. The Federal Reserve has established the Alternative Reference Rates Committee to identify alternative reference rates in the event that LIBOR ceases to exist after 2021. Our credit facility, which includes its revolving credit facility and term loan, gives the option to use LIBOR as a base rate and our interest rate swaps are based on the one-month U.S. dollar LIBOR rate. In the event that LIBOR is no longer published, the credit facility allows us and the administrative agent of the facility to replace LIBOR with an alternative benchmark rate, subject to the approval of majority of lenders. The International Swaps and Derivatives Association is expected to issue protocols to allow swap parties to amend their existing contracts. Our liquidity and access to capital may be impacted by our credit ratings, financial performance and global credit market conditions. We believe that our existing cash, cash equivalents, cash generated through operations and our expected access to financing facilities, together with funding through our revolving credit facility, will be sufficient to fund our operating activities, anticipated capital expenditures and growth needs. CASH FLOW The following table summarizes the changes in cash, cash equivalents and restricted cash during the years ended December 31, 2018, 2017 and 2016: During 2018, net cash provided by operating activities decreased $47 million compared to the prior year primarily due to lower net income resulting from separation-related and transaction-related costs and $35 million of tax payments assumed with the La Quinta acquisition. Net cash used in investing activities increased $1.5 billion compared to the prior year, primarily due to the purchase price for our acquisition of La Quinta. Net cash provided by financing activities increased $1.9 billion compared to the prior year, primarily reflecting the proceeds from the borrowings used to fund the La Quinta acquisition. During 2017, net cash provided by operating activities increased $14 million primarily due to increased cash from working capital. Net cash used in investing activities increased $83 million primarily due to our acquisition of AmericInn. Net cash used in financing activities decreased $110 million compared to 2016, primarily reflecting a $180 million reduction in transfers to Wyndham Worldwide under the cash pooling program partially offset by lower borrowings from Wyndham Worldwide. Capital Deployment We focus on optimizing cash flow and deploying capital to generate attractive risk-adjusted returns in ways that are consistent with, and further, our strategic objectives. We intend to continue to invest in select capital and technological improvements across our business. We may also seek to obtain additional franchise agreements and hotel management contracts on a strategic and selective basis as well as grow our business through acquisitions. In addition, we expect to return cash to stockholders through the payment of dividends and the repurchase of common stock. During 2018, we spent $73 million on capital expenditures primarily for information technology enhancement projects as well as renovations at our Rio Mar property (which costs were funded primarily by previously received insurance proceeds). Our 2018 expenditures also included $7 million associated with our separation from Wyndham Worldwide. During 2019, we anticipate spending $60 to $65 million on capital expenditures, including expenditures of $10 to $15 million to integrate La Quinta. In addition, during 2018, we spent $27 million ($13 million net of repayments) on development advance notes to acquire new franchise and management agreements. In an effort to support growth in our business, we intend to continue to provide development advance notes, which may include agreements with multi-unit owners, from time to time. We may also continue to provide other forms of financial support. We expect that the majority of the expenditures that will be required to pursue our capital spending programs and strategic investments (other than any significant acquisitions) will be financed with cash flow generated through operations. Additional expenditures will be financed with general unsecured corporate borrowings. Stock Repurchase Program In May 2018, our Board of Directors approved a share repurchase plan, effective immediately following our spin-off, pursuant to which we have been authorized to purchase up to $300 million of Wyndham Hotels common stock. Under the plan, we may, from time to time, purchase our common stock through various means, including, without limitation, open market transactions, privately negotiated transactions or tender offers, subject to the terms of the tax matters agreement entered into in connection with our spin-off. Under our stock repurchase program, we repurchased approximately 2.3 million shares at an average price of $52.51 for a cost of $119 million during 2018. We had $181 million of remaining availability under our program as of December 31, 2018. Dividend Policy During each of the quarterly periods ended June 30, September 30, and December 31, 2018, we declared cash dividends of $0.25 per share ($75 million in aggregate for the year). The declaration and payment of future dividends to holders of our common stock are at the discretion of our Board of Directors and depend upon many factors, including our financial condition, earnings, capital requirements of our business, covenants associated with certain debt obligations, legal requirements, regulatory constraints, industry practice and other factors that our Board of Directors deems relevant. There is no assurance that a payment of a dividend will occur in the future. Foreign Earnings Although the one-time mandatory deemed repatriation tax during 2017 and the territorial tax system created as a result of U.S. tax reform generally eliminate U.S. federal income taxes on dividends from foreign subsidiaries, we continue to assert that all of our undistributed foreign earnings of $39 million will be reinvested indefinitely as of December 31, 2018. In the event we determine not to continue to assert that all or part of our undistributed foreign earnings are permanently reinvested, such a determination in the future could result in the accrual and payment of additional foreign withholding taxes and U.S. taxes on currency transaction gains and losses, the determination of which is not practicable. LONG-TERM DEBT COVENANTS Our Credit Facilities contain customary covenants that, among other things, impose limitations on indebtedness; liens; mergers, consolidations, liquidations and dissolutions; dispositions, restricted debt payments, restricted payments and transactions with affiliates. Events of default in these Credit Facilities include, among others, failure to pay interest, principal and fees when due; breach of a covenant or warranty; acceleration of or failure to pay other debt in excess of a threshold amount; unpaid judgments in excess of a threshold amount, insolvency matters; and a change of control. The Credit Facilities require us to comply with a financial covenant to be tested quarterly, consisting of a maximum first-lien leverage ratio of 5.0 times. The ratio is calculated by dividing consolidated first lien indebtedness (as defined in the Credit Agreement) net of consolidated unrestricted cash as of the measurement date by consolidated EBITDA (as defined in the Credit Agreement), as measured on a trailing four-fiscal-quarter basis preceding the measurement date. As of December 31, 2018, our first-lien leverage ratio was 2.1 times. The Indenture under which the senior notes due 2026 were issued contains covenants that limit, among other things, Wyndham Hotels’ ability and that of certain of its subsidiaries to (i) create liens on certain assets; (ii) enter into sale and leaseback transactions; and (iii) merge, consolidate or sell all or substantially all of Wyndham Hotels’ assets. These covenants are subject to a number of important exceptions and qualifications. As of December 31, 2018, we were in compliance with the financial covenants described above. SEASONALITY While the hotel industry is seasonal in nature, periods of higher revenues vary property-by-property and performance is dependent on location and guest base. Based on historical performance, revenues from franchise and management contracts are generally higher in the second and third quarters than in the first or fourth quarters due to increased leisure travel during the spring and summer months. The seasonality of our business may cause fluctuations in our quarterly operating results, earnings and profit margins. As we expand into new markets and geographical locations, we may experience increased or different seasonality dynamics that create fluctuations in operating results different from the fluctuations we have experienced in the past. COMMITMENTS AND CONTINGENCIES We are involved in claims, legal and regulatory proceedings and governmental inquiries related to our business. Litigation is inherently unpredictable and, although we believe that our accruals are adequate and/or that we have valid defenses in these matters, unfavorable results could occur. As such, an adverse outcome from such proceedings for which claims are awarded in excess of the amounts accrued, if any, could be material to us with respect to earnings and/or cash flows in any given reporting period. As of December 31, 2018, the potential exposure resulting from adverse outcomes of such legal proceedings could, in the aggregate, range up to approximately $35 million in excess of recorded accruals, a significant portion of which is expected to be covered by insurance. However, we do not believe that the impact of such litigation should result in a material liability to us in relation to our financial position or liquidity. For a more detailed description of our commitments and contingencies see Note 13 - Commitments and Contingencies to the Consolidated and Combined Financial Statements contained in Part IV of this report. CONTRACTUAL OBLIGATIONS The following table summarizes our future contractual obligations for the years set forth below: ______________________ (a) Includes interest on long-term debt; estimated using the stated interest rates on our senior notes and the swapped interest rates on our term loan. (b) Includes $89 million for information technology activities and $17 million for marketing-related activities. (c) Relates to liability which is expected to be paid in early 2019 to tax authorities and/or CorePoint related to the La Quinta acquisition. (d) Excludes a $16 million liability for unrecognized tax benefits associated with the accounting guidance for uncertainty in income taxes since it is not reasonably estimable to determine the periods in which such liability would be settled with the respective tax authorities. (e) Excludes guarantees for which the periods in which such commitments would be settled are not reasonably estimable (See Note 13 - Commitments and Contingencies to the Consolidated and Combined Financial Statements for further details). CRITICAL ACCOUNTING ESTIMATES AND POLICIES In presenting our financial statements in conformity with U.S. GAAP, we are required to make estimates and assumptions that affect the amounts reported therein. Several of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. However, events that are outside of our control cannot be predicted and, as such, they cannot be contemplated in evaluating such estimates and assumptions. If there is a significant unfavorable change to current conditions, it could result in a material impact to our consolidated and combined results of operations, financial position and liquidity. We believe that the estimates and assumptions we used when preparing our financial statements were the most appropriate at that time. Presented below are those accounting policies that we believe require subjective and complex judgments that could potentially affect reported results. However, the majority of our business activities are in environments where we are paid a fee for a service performed, and therefore the results of the majority of our recurring operations are recorded in our financial statements using accounting policies that are not particularly subjective, nor complex. Impairment of Long-Lived Assets With regard to goodwill and other indefinite-lived intangible assets recorded in connection with business combinations, we annually (during the fourth quarter of each year subsequent to completing our annual forecasting process), or more frequently if circumstances indicate that the value of goodwill may be impaired, review the reporting units’ carrying values as required by the guidance for goodwill and other intangible assets. This is done either by performing a qualitative assessment or utilizing the two-step process, with an impairment being recognized only where the fair value is less than carrying value. In any given year, we can elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is in excess of its carrying value. If it is not more likely than not that the fair value is in excess of the carrying value, or we elect to bypass the qualitative assessment, we would use the two-step process. The qualitative factors evaluated include macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, our historical share price as well as other industry-specific considerations. We performed a quantitative assessment for impairment on each reporting unit’s goodwill for 2018. Based on the results of our quantitative assessments performed during the fourth quarter of 2018, we determined that no impairment existed, nor do we believe there is a material risk of it being impaired in the near term at our (i) hotel franchising, (ii) hotel management and (iii) owned hotel reporting units. To the extent estimated market-based valuation multiples and/or discounted cash flows are revised downward, we may be required to write-down all or a portion of goodwill, which would adversely impact earnings. We also determine whether the carrying values of other indefinite-lived intangible assets are impaired on an annual basis or more frequently if indicators of potential impairment exist. Application of the other indefinite-lived intangible assets impairment test requires judgment in the assumptions underlying the approach used to determine fair value. The fair value of each other indefinite-lived intangible asset is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including anticipated market conditions, operating expense trends, estimation of future cash flows, which are dependent on internal forecasts, and estimation of long-term rates of growth. The estimates used to calculate the fair value of other indefinite-lived intangible assets change from year to year based on operating results and market conditions. Changes in these estimates and assumptions could materially affect the determination of fair value and the other indefinite-lived intangible assets’ impairment. We also evaluate the recoverability of our other long-lived assets, including property and equipment and amortizable intangible assets, if circumstances indicate impairment may have occurred, pursuant to guidance for impairment or disposal of long-lived assets. This analysis is performed by comparing the respective carrying values of the assets to the current and expected future cash flows, on an undiscounted basis, to be generated from such assets. Property and equipment is evaluated separately within each segment. If such analysis indicates that the carrying value of these assets is not recoverable, the carrying value of such assets is reduced to fair value. Business Combinations A component of our growth strategy has been to acquire and integrate businesses that complement our existing operations. We account for business combinations in accordance with the guidance for business combinations and related literature. Accordingly, we allocate the purchase price of acquired companies to the tangible and intangible assets acquired and liabilities assumed based upon their estimated fair values at the date of purchase. The difference between the purchase price and the fair value of the net assets acquired is recorded as goodwill. In determining the fair values of assets acquired and liabilities assumed in a business combination, we use various recognized valuation methods including present value modeling and referenced market values, where available. Further, we make assumptions within certain valuation techniques including discount rates and timing of future cash flows. Valuations are performed by management or independent valuation specialists under management’s supervision, where appropriate. We believe that the estimated fair values assigned to the assets acquired and liabilities assumed are based on reasonable assumptions that marketplace participants would use. However, such assumptions are inherently uncertain and actual results could differ from those estimates. Loyalty Programs Wyndham Hotels operates the Wyndham Rewards loyalty program. Wyndham Rewards members accumulate points by staying in hotels operated under one of Wyndham Hotels’ brands. Wyndham Rewards members may also accumulate points by purchasing everyday services and products with their co-branded credit card. Wyndham Hotels earns revenue from these programs (i) when a member stays at a participating hotel, club resort or vacation rental from a fee charged by Wyndham Hotels to the franchisee, which is based upon a percentage of room revenues generated from such stay which we recognize, net of redemptions, over time based upon loyalty point redemption patterns, including an estimate of loyalty points that will expire or will never be redeemed, and (ii) based upon a percentage of the member’s spending on the co-branded credit cards for which revenues are paid to Wyndham Hotels by a third-party issuing bank which we recognize over time based upon the redemption patterns of the loyalty points earned under the program, including an estimate of loyalty points that will expire or will never be redeemed. As members earn points through the Wyndham Rewards loyalty program, Wyndham Hotels records a liability for the estimated future redemption costs, which is calculated based on (i) an estimated cost per point and (ii) an estimated redemption rate of the overall points earned, which is determined through historical experience, current trends and the use of an actuarial analysis. Hotel Management Guarantees We have entered into performance guarantees related to certain hotels that we manage. Upon the inception date of the guarantee, we record a performance liability that is measured at fair value. In order to estimate its fair value, we use a weighted probability approach to determine the probability of possible outcomes. The valuation methodology requires that we make certain assumptions and judgments regarding discount rates, volatility and hotel operating results. The fair value is established at inception and is not revalued due to future changes in assumptions. Certain of our performance guarantees have recapture provisions, which allow us to recover amounts funded under such guarantees. We record receivables for amounts expected to be recovered in the future. We make certain assumptions and judgments regarding the recoverability of these receivables, which includes reviewing hotel operating results and current hotel net operating income projections. Income Taxes Prior to our spin-off, current and deferred income taxes and related tax expense have been determined based on Wyndham Hotels’ stand-alone results by applying a separate return methodology, as if the Wyndham Hotels’ entities were separate taxpayers in the respective jurisdictions. We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities using currently enacted tax rates. We regularly review our deferred tax assets to assess their potential realization and establish a valuation allowance for portions of such assets that we believe will not be ultimately realized. In performing this review, we make estimates and assumptions regarding projected future taxable income, the expected timing of the reversals of existing temporary differences and the implementation of tax planning strategies. A change in these assumptions may increase or decrease our valuation allowance resulting in an increase or decrease in our effective tax rate, which could materially impact our results of operations. For tax positions we have taken or expect to take in our tax return, we apply a more likely than not threshold, under which we must conclude a tax position is more likely than not to be sustained, assuming that the position will be examined by the appropriate taxing authority that has full knowledge of all relevant information, in order to recognize or continue to recognize the benefit. In determining our provision for income taxes, we use judgment, reflecting our estimates and assumptions, in applying the more likely than not threshold. RECENTLY ADOPTED AND NEW ACCOUNTING PRONOUNCEMNTS For a detailed description of recently adopted and new accounting pronouncements see Note 2 - Summary of Significant Accounting Policies to the Consolidated and Combined Financial Statements contained in Part IV of this report. OFF-BALANCE SHEET ARRANGEMENTS There were no off-balance sheet transactions, arrangements or other relationships with unconsolidated entities or other persons in 2018, 2017 and 2016 that have, or are reasonably likely to have, a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

<s>[INST] References herein to “Wyndham Hotels,” the “Company,” “we,” “our” and “us” refer to both (i) Wyndham Hotels & Resorts, Inc. and its consolidated subsidiaries for time periods following the consummation of the spinoff and (ii) the Wyndham Hotels & Resorts businesses for time periods prior to the consummation of our spinoff from Wyndham Worldwide. Unless the context otherwise suggests, references herein to “Wyndham Worldwide,” “Wyndham Destinations” and “former Parent” refer to Wyndham Worldwide Corporation and its consolidated subsidiaries. BUSINESS AND OVERVIEW Wyndham Hotels & Resorts is a leading global hotel franchisor, licensing its renowned hotel brands to hotel owners in more than 80 countries around the world. Wyndham Hotels operates in the following segments: Hotel franchising licenses our lodging brands and provides related services to thirdparty hotel owners and others. Hotel management provides hotel management services for fullservice and limitedservice hotels as well as two hotels that are owned by Wyndham Hotels. The Consolidated and Combined Financial Statements presented herein have been prepared on a standalone basis and prior to May 31, 2018 are derived from the consolidated financial statements and accounting records of Wyndham Worldwide. The Consolidated and Combined Financial Statements include Wyndham Hotels’ assets, liabilities, revenues, expenses and cash flows and all entities in which Wyndham Hotels has a controlling financial interest. RESULTS OF OPERATIONS Discussed below are our key operating statistics, combined results of operations and the results of operations for each of our reportable segments. The reportable segments presented below represent our operating segments for which discrete financial information is available and used on a regular basis by our chief operating decision maker to assess performance and to allocate resources. In identifying our reportable segments, we also consider the nature of services provided by our operating segments. Management evaluates the operating results of each of our reportable segments based upon net revenues and Adjusted EBITDA. Beginning with the third quarter of 2018, our calculation of Adjusted EBITDA excludes the currency effects of highly inflationary countries. Adjusted EBITDA is defined as net income excluding interest expense, depreciation and amortization, impairment charges, restructuring and related charges, contract termination costs, transactionrelated expenses (acquisition, disposition or separationrelated), foreign currency impacts of highly inflationary countries, stockbased compensation expense, early extinguishment of debt costs and income taxes. We believe that Adjusted EBITDA is a useful measure of performance for our segments and, when considered with U.S. GAAP measures, gives a more complete understanding of our operating performance. Adjusted EBITDA is not a recognized term under U.S. GAAP and should not be considered as an alternative to net income or other measures of financial performance or liquidity derived in accordance with U.S. GAAP. Our presentation of Adjusted EBITDA may not be comparable to similarlytitled measures used by other companies. We generate royalties and franchise fees, management fees and other revenues from hotel franchising and hotel management activities, as well as fees from licensing our “Wyndham” trademark, certain other trademarks and intellectual property. In addition, pursuant to our franchise and management contracts with thirdparty hotel owners, we generate marketing, reservation and loyalty fee revenues and cost reimbursement revenues that over time are offset, respectively, by the marketing, reservation and loyalty costs and property operating costs that we incur. OPERATING STATISTICS 2018 VS. 2017 The table below presents our operating statistics for the years ended December 31, 2018 and 2017. “Rooms” represent the number of hotel rooms in our brand systems as of the last date of the period. “RevPAR” represents the room rental revenues generated by our franchisees divided by the number of available roomnights in the period. These operating statistics are drivers of our revenues and therefore provide an enhanced understanding of our business. Refer to the section below for a discussion [/INST] Positive. </s>

WYNDHAM HOTELS & RESORTS, INC.

2020-02-13

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. (Unless otherwise noted, all amounts are in millions, except share and per share amounts) References herein to “Wyndham Hotels,” the “Company,” “we,” “our” and “us” refer to both (i) Wyndham Hotels & Resorts, Inc. and its consolidated subsidiaries for time periods following the consummation of the spin-off and (ii) the Wyndham Hotels & Resorts businesses for time periods prior to the consummation of our spin-off from Wyndham Worldwide. Unless the context otherwise suggests, references herein to “Wyndham Worldwide,” “Wyndham Destinations” and “former Parent” refer to Wyndham Worldwide Corporation and its consolidated subsidiaries. BUSINESS AND OVERVIEW Wyndham Hotels & Resorts is a leading global hotel franchisor, licensing its renowned hotel brands to hotel owners in approximately 90 countries around the world. Wyndham Hotels operates in the following segments: • Hotel Franchising - licenses our lodging brands and provides related services to third-party hotel owners and others. • Hotel Management - provides hotel management services for full-service and limited-service hotels as well as two hotels that are owned by Wyndham Hotels. The Consolidated and Combined Financial Statements presented herein have been prepared on a stand-alone basis and prior to May 31, 2018 are derived from the consolidated financial statements and accounting records of Wyndham Worldwide. The Consolidated and Combined Financial Statements include Wyndham Hotels’ assets, liabilities, revenues, expenses and cash flows and all entities in which Wyndham Hotels has a controlling financial interest. RESULTS OF OPERATIONS Discussed below are our key operating statistics, combined results of operations and the results of operations for each of our reportable segments. The reportable segments presented below represent our operating segments for which discrete financial information is available and used on a regular basis by our chief operating decision maker to assess performance and to allocate resources. In identifying our reportable segments, we also consider the nature of services provided by our operating segments. Management evaluates the operating results of each of our reportable segments based upon net revenues and adjusted EBITDA. Beginning with the third quarter of 2018, our calculation of adjusted EBITDA excludes the currency effects of highly inflationary countries. Adjusted EBITDA is defined as net income excluding interest expense, depreciation and amortization, impairment charges, restructuring and related charges, contract termination costs, transaction-related items (acquisition-, disposition- or separation-related), foreign currency impacts of highly inflationary countries, stock-based compensation expense and income taxes. We believe that adjusted EBITDA is a useful measure of performance for our segments and, when considered with U.S. GAAP measures, gives a more complete understanding of our operating performance. We use these measures internally to assess operating performance, both absolutely and in comparison to other companies, and to make day to day operating decisions, including in the evaluation of selected compensation decisions. Adjusted EBITDA is not a recognized term under U.S. GAAP and should not be considered as an alternative to net income or other measures of financial performance or liquidity derived in accordance with U.S. GAAP. Our presentation of adjusted EBITDA may not be comparable to similarly-titled measures used by other companies. We generate royalties and franchise fees, management fees and other revenues from hotel franchising and hotel management activities, as well as fees from licensing our “Wyndham” trademark, certain other trademarks and intellectual property. In addition, pursuant to our franchise and management contracts with third-party hotel owners, we generate marketing, reservation and loyalty fee revenues and cost reimbursement revenues that over time are offset, respectively, by the marketing, reservation and loyalty costs and property operating costs that we incur. We completed our acquisition of La Quinta Holdings, Inc. in May 2018, and, as a result certain comparisons of operating and financial metrics for the years ended December 31, 2019 and 2018 to the respective prior periods include significant acquisition impacts. OPERATING STATISTICS - 2019 VS. 2018 The table below presents our operating statistics for the years ended December 31, 2019 and 2018. “Rooms” represent the number of hotel rooms at the end of the period which are either under franchise and/or management agreements, or are Company-owned, and properties under affiliation agreements for which we receive a fee for reservation and/or other services provided. “RevPAR” represents the room rental revenues generated by our franchisees divided by the number of available room-nights in the period. These operating statistics are drivers of our revenues and therefore provide an enhanced understanding of our business. Refer to the section below for a discussion as to how these operating statistics affected our business for the periods presented. ______________________ (a) Includes the impact of acquisition and disposition from their respective dates forward. (b) Excluding currency effects, international RevPAR increased 1% and total RevPAR increased 2%. YEAR ENDED DECEMBER 31, 2019 VS. YEAR ENDED DECEMBER 31, 2018 During 2019, net revenues increased 10% compared with the prior-year, which included $267 million of incremental revenues from La Quinta (acquired in May 2018) of which $152 million reflected cost reimbursement revenues. Excluding the incremental impact from the La Quinta acquisition and a $5 million unfavorable impact from currency translation, net revenues decreased 4% primarily reflecting: • lower cost-reimbursement revenues due to a change in our responsibility from being the principal for certain property-related activities to being an agent, and therefore, these costs are no longer reflected in our Consolidated and Combined Statements of Income and property terminations; and • a $20 million fee credit for past services with a customer, which is reflected as a reduction to hotel-management revenues. Such decreases were partially offset by higher license and other fees, an increase in marketing, reservation and loyalty fees and an increase in owned-hotel revenues. During 2019, total expenses increased 10%, which included an estimated $204 million of incremental expenses associated with the La Quinta acquisition and a $45 million non-cash impairment charge and $42 million of contract termination costs, both associated with the termination of unprofitable hotel-management guarantee arrangements. The increases were partially offset by $55 million of lower separation-related costs year-over-year. Excluding cost reimbursement revenues and the incremental impact from the La Quinta acquisition, during 2019: • Marketing, reservation and loyalty expenses increased to 39.6% of revenues from 37.9% during 2018, primarily due to higher marketing spend to support our “by Wyndham” campaign and the relaunch of the Wyndham Rewards program with La Quinta integrated, as well as a change in classification of certain costs from operating expenses, partially offset by higher net revenues; • Operating expenses decreased to 12.3% of revenues from 14.3% during 2018, primarily due to a change in classification of certain costs to our marketing, reservation and loyalty funds; and • General and administrative expenses were 9.2% of revenues during 2019 and 2018. During 2019, net interest expense increased $40 million primarily due to the borrowings made by us in the second quarter of 2018 to fund the La Quinta acquisition. Our effective tax rates were 24.2% and 27.4% for 2019 and 2018, respectively. The decrease was primarily due to one-time state tax benefits resulting from a settlement with state taxing authorities and from a change in our state income tax filing position due to our spin-off from Wyndham Worldwide. This was partially offset by higher foreign taxes on the Company’s international operations in 2019 and the absence of a net tax benefit in 2019 from the impact of U.S. tax reform. As a result of these items, net income decreased $5 million compared with 2018. A reconciliation of net income to adjusted EBITDA is represented below: Following is a discussion of the results of each of our segments and Corporate and Other for 2019 compared to 2018: Hotel Franchising ______________________ (a) Includes the impact of acquisition and disposition from their respective dates forward. (b) Excluding currency effects, international RevPAR increased 1% and total RevPAR increased 2%. Net revenues increased 13% during 2019, which included $97 million of incremental revenues from La Quinta (acquired in May 2018) and a $5 million unfavorable impact from foreign currency translation. Excluding such items, net revenues increased 5%, primarily due to higher license and other fee revenues and an increase in marketing, reservation and loyalty fees. Adjusted EBITDA increased 21% during 2019 which included an estimated incremental impact from the acquisition and integration of La Quinta of $50 million and a $4 million unfavorable impact from foreign currency. Excluding such items, adjusted EBITDA grew 13%, reflecting the growth in revenues and lower general and administrative spend, partially offset by higher net marketing, reservation and loyalty expenses, which reduced adjusted EBITDA by $19 million. Excluding the incremental impact from the acquisition of La Quinta, during 2019: • Marketing, reservation and loyalty expenses increased to 42.3% of revenues from 41.2% during the prior year primarily due to marketing spend to support our “by Wyndham” campaign and the relaunch of the Wyndham Rewards program with La Quinta integrated, as well as a change in classification of certain costs from operating expenses, partially offset by higher net revenues; • Operating expenses decreased to 6.7% of revenue compared to 9.6% during the prior year primarily due to a change in classification of certain costs to our marketing, reservation and loyalty funds; and • General and administrative expenses decreased to 2.3% of revenues from 3.6% during the prior year, primarily due to the impact of reorganizing certain functions into our Corporate and Other segment as a result of our spin-off to a stand-alone public company. Hotel Management ______________________ (a) Includes the impact of acquisition and disposition from their respective dates forward. (b) Excluding currency effects, international RevPAR decreased 1% and total RevPAR decreased 5%. Net revenues increased $42 million or 6% during 2019, reflecting $170 million of incremental revenues from the La Quinta acquisition which included $152 million of cost reimbursement revenues. Excluding the incremental impact from the acquisition of La Quinta, net revenues decreased $128 million primarily due to lower cost-reimbursement revenues as discussed above, which have no impact on adjusted EBITDA and a $20 million fee credit for past services with a customer, which is reflected as a reduction to hotel-management revenues. Such decreases were partially offset by higher termination fees and an increase in owned hotel revenues. Adjusted EBITDA increased $19 million or 40% in 2019, primarily reflecting an estimated $13 million of incremental adjusted EBITDA from La Quinta. Corporate and Other Corporate and Other revenues were $6 million and $7 million during 2019 and 2018, respectively, which represents fees earned under a transition services agreement with our former Parent. Adjusted EBITDA decreased $20 million during 2019 compared to the prior year, primarily due to a reorganization of certain functions into our Corporate and Other segment in connection with our spin-off to a stand-alone public company. OPERATING STATISTICS - 2018 VS. 2017 The table below presents our operating statistics for the years ended December 31, 2018 and 2017. “Rooms” represent the number of hotel rooms in our brand systems as of the last date of the period. “RevPAR” represents the room rental revenues generated by our franchisees divided by the number of available room-nights in the period. These operating statistics are drivers of our revenues and therefore provide an enhanced understanding of our business. Refer to the section below for a discussion as to how these operating statistics affected our business for the periods presented. ______________________ (a) Includes the impact of acquisitions and disposition from their respective dates forward. (b) Excluding currency effects, international RevPAR increased 4% and total RevPAR increased 9%. YEAR ENDED DECEMBER 31, 2018 VS. YEAR ENDED DECEMBER 31, 2017 During 2018, net revenues increased 46% compared with the prior-year, which was driven by $513 million of revenues from the La Quinta acquisition, which included $324 million of cost reimbursement revenues. Excluding the La Quinta acquisition, net revenues increased 6% primarily due to higher license and other fees and higher royalties. During 2018, total expenses increased 54%, which included $443 million of expenses associated with the La Quinta acquisition, $77 million of separation-related costs and $36 million of net transaction-related costs that were primarily associated with the La Quinta acquisition. Excluding cost reimbursement revenues and the acquisition of La Quinta, during 2018: • Marketing, reservation and loyalty expenses increased to 37.0% of revenues from 36.7% during 2017, primarily due to higher marketing, reservation and loyalty expenses resulting from the increase in marketing and reservation fee revenues from franchisees; • Operating expenses decreased to 16.2% of revenues from 17.9% during 2017, primarily as a result of reduced expenses at our owned hotel in Puerto Rico resulting from insurance recoveries received in 2018 related to hurricanes that occurred in 2017; and • General and administrative expenses increased to 9.6% of revenues from 8.7% during 2017, primarily due to higher employee-related and information technology costs, principally related to operating as a stand-alone public company. During 2018, net interest expense increased $54 million primarily due to the borrowings used to fund the La Quinta acquisition. Our effective tax rates were 27.4% and 5.3% for 2018 and 2017, respectively. The increase was principally due to the net tax benefit of $85 million recorded from the enactment of the U.S. Tax Cuts and Jobs Act in 2017. As a result of these items, principally driven by the net income tax benefit in 2017, separation-related and transaction-related expenses in 2018 and higher interest expense in 2018, net income decreased $68 million compared with 2017. A reconciliation of net income to adjusted EBITDA is represented below: Following is a discussion of the results of each of our segments and Corporate and Other for 2018 compared to 2017: Hotel Franchising ______________________ (a) Includes the impact of acquisitions and disposition from their respective dates forward. (b) Excluding currency effects, international RevPAR increased 4% and total RevPAR increased 8%. Net revenues increased 27% during 2018 primarily due to the acquisition of La Quinta, which contributed to 6% total hotel franchising system growth and 7% higher RevPAR. Excluding the La Quinta acquisition, net revenues increased 8% primarily due to higher license fees, an increase in marketing, reservation and loyalty fees and higher royalties and franchise fees. Adjusted EBITDA increased 28% during 2018 primarily due to higher revenues. Excluding the La Quinta acquisition, Adjusted EBITDA increased 9% primarily due to higher revenues. Excluding the La Quinta acquisition, during 2018: • Marketing, reservation and loyalty expenses were 40.5% of revenues during 2018 and 40.6% during 2017; • Operating expenses were 10.8% of revenues during 2018 and 10.4% during 2017; and • General and administrative expenses decreased to 3.4% of revenues from 4.2% during the prior year, primarily due to lower employee-related expenses coupled with higher net revenues. Hotel Management ______________________ (a) Includes the impact of acquisitions and disposition from their respective dates forward. (b) Excluding currency effects, international RevPAR increased 5% and total RevPAR decreased 11%. Net revenues increased 90% during 2018 primarily due to $351 million of revenues from the La Quinta acquisition (including $324 million of cost reimbursement revenues). Excluding La Quinta, net revenues decreased 2% due primarily to certain management contracts being transferred to our former Parent upon our spin-off. Adjusted EBITDA increased 124% in 2018 including approximately $14 million of adjusted EBITDA from La Quinta. Excluding La Quinta, adjusted EBITDA increased 57% due to reduced expenses at our owned hotel in Puerto Rico due to insurance recoveries in 2018 related to hurricanes that occurred in 2017. Corporate and Other Corporate and Other revenues increased $7 million during 2018, which represents fees earned under a transition services agreement with our former Parent. Adjusted EBITDA decreased $15 million during 2018 compared to the prior year, primarily due to an increase in general overhead expenses in connection with operating as a stand-alone public company, partially offset by higher revenues. FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES Financial condition Total assets decreased $443 million from December 31, 2018 to December 31, 2019 primarily due to a reduction in cash reflecting payments for taxes assumed with the La Quinta acquisition, as well as stock repurchases and dividends. Total liabilities decreased $237 million from December 31, 2018 to December 31, 2019 primarily due to the payment of the aforementioned tax liability assumed with the La Quinta acquisition. Total equity decreased $206 million from December 31, 2018 to December 31, 2019 primarily due to stock repurchases and dividends partially offset by our net income for the year. Liquidity and capital resources We intend to use the cash flow generated by our operations to create value for stockholders. Our asset-light business model, with low fixed costs and stable, recurring franchise fee revenue, generates attractive margins and cash flow. In addition to investments in the business, including acquisitions of brands and businesses that would expand our presence and capabilities in the lodging industry, we expect to return capital to our stockholders through dividends and share repurchases. In 2020, we expect to pay a regular dividend and, absent any accretive and strategically-enhancing acquisition, use our cash on hand and cash provided by operating activities to repurchase shares. As of December 31, 2019, we had a Term Loan with an aggregate principal amount of $1.6 billion maturing in 2025 and a five-year revolving credit facility maturing in 2023 with an aggregate principal amount of $750 million, all of which was undrawn. The interest rate per annum applicable to our Term Loan is equal to, at our option, either a base rate plus a margin of 0.75% or LIBOR plus a margin of 1.75%. The revolving credit facility is subject to an interest rate per annum equal to, at our option, either a base rate plus a margin ranging from 0.50% to 1.00% or LIBOR plus a margin ranging from 1.50% to 2.00%, in either case based upon the total leverage ratio of the Company and its restricted subsidiaries. As of December 31, 2019, we hedged a portion of our $1.6 billion term loan with pay-fixed/receive-variable interest rate swaps hedging $1.1 billion of our term loan interest rate exposure. The aggregate fair value of these interest rate swaps was a $34 million liability as of December 31, 2019. The Federal Reserve has established the Alternative Reference Rates Committee to identify alternative reference rates in the event that LIBOR ceases to exist after 2021. Our credit facility, which includes its revolving credit facility and term loan, gives the option to use LIBOR as a base rate and our interest rate swaps are based on the one-month U.S. dollar LIBOR rate. In the event that LIBOR is no longer published, the credit facility allows us and the administrative agent of the facility to replace LIBOR with an alternative benchmark rate, subject to the rejection of the majority of the lenders. The International Swaps and Derivatives Association is expected to issue protocols to allow swap parties to amend their existing contracts. Our liquidity and access to capital may be impacted by our credit ratings, financial performance and global credit market conditions. We believe that our existing cash, cash equivalents, cash generated through operations and our expected access to financing facilities, together with funding through our revolving credit facility, will be sufficient to fund our operating activities, anticipated capital expenditures and growth needs. CASH FLOW The following table summarizes the changes in cash, cash equivalents and restricted cash during the years ended December 31, 2019, 2018 and 2017: During 2019, net cash provided by operating activities decreased $131 million compared to the prior year primarily due to the incremental payment of tax liabilities assumed in the La Quinta acquisition in 2018, partially offset by a decrease in cash used for separation and transaction-related costs. 2019 net cash provided by operating activities included a $195 million payment of tax liabilities assumed in the La Quinta acquisition, $78 million of separation and transaction related costs and $35 million of contract termination costs. 2018 net cash provided by operating activities included a $35 million payment of tax liabilities assumed in the La Quinta acquisition and $98 million of separation and transaction related costs. Net cash used in investing activities decreased $1.7 billion compared to the prior year, primarily due to the purchase price for our acquisition of La Quinta in 2018. Net cash used in financing activities increased $2.1 billion compared to the prior year, primarily due to the absence of the proceeds from borrowings used to fund the La Quinta acquisition in 2018. During 2018, net cash provided by operating activities decreased $47 million compared to the prior year primarily due to lower net income resulting from separation-related and transaction-related costs and the tax payments assumed with the La Quinta acquisition as noted above. Net cash used in investing activities increased $1.5 billion compared to the prior year, primarily due to the purchase price for our acquisition of La Quinta. Net cash provided by financing activities increased $1.9 billion compared to the prior year, primarily reflecting the proceeds from the borrowings used to fund the La Quinta acquisition. Capital deployment We expect to maintain discipline in our capital allocation approach. We expect to maintain a regular dividend payment, invest in select technology improvements across our business that further our strategic objectives and deploy capital on a selective basis to obtain hotel franchise agreements and hotel-management contracts. The remaining capital we have available will be used for either acquisitions that are accretive and strategically enhancing to our business or stock repurchases, with the amount going to each depending largely on the opportunities that are available. During 2019, we spent $50 million on capital expenditures, primarily related to information technology and the integration of La Quinta. During 2020, we anticipate spending approximately $45 to $50 million on capital expenditures and approximately $25 to $30 million on development advances. In addition, during 2019, we spent $17 million, net of repayments, on development advance notes to acquire new hotel franchise agreements and hotel-management contracts. In an effort to support growth in our business, we intend to continue to provide development advance notes, which may include agreements with multi-unit owners, from time to time. We may also continue to provide other forms of financial support. We also expect to pay less than $50 million of previously incurred separation, transaction and contract termination costs in 2020. We expect all our cash needs to be funded from cash on hand, cash generated through operations, and/or availability under our revolving credit facility. Stock repurchase program In May 2018, our Board of Directors ("Board") approved a share repurchase plan pursuant to which we were authorized to purchase up to $300 million of our common stock. In August 2019, the Board increased the capacity of the program by another $300 million. Under the plan, we may, from time to time, purchase our common stock through various means, including, without limitation, open market transactions, privately negotiated transactions or tender offers, subject to the terms of the tax matters agreement entered into in connection with our spin-off. Under our current stock repurchase program, we repurchased approximately 4.5 million shares at an average price of $54.25 for a cost of $244 million during 2019. Since inception, we repurchased approximately 6.8 million shares at an average price of $53.67 per share for a cost of $364 million. As of December 31, 2019, we had $237 million of remaining availability under our program. Dividend policy During 2019, we declared quarterly cash dividends of $0.29 per share ($113 million in aggregate for the year). The declaration and payment of future dividends to holders of our common stock are at the discretion of our Board and depend upon many factors, including our financial condition, earnings, capital requirements of our business, covenants associated with certain debt obligations, legal requirements, regulatory constraints, industry practice and other factors that our Board deems relevant. Though we intend to continue paying a regular dividend, there is no assurance that a payment of a dividend will occur in the future. In February 2020, our Board authorized a 10% increase in the quarterly cash dividend to $0.32 per share, beginning with the dividend that is expected to be declared in the first quarter of 2020. Foreign earnings Although the one-time mandatory deemed repatriation tax during 2017 and the territorial tax system created as a result of U.S. tax reform generally eliminate U.S. federal income taxes on dividends from foreign subsidiaries, we continue to assert that all of our undistributed foreign earnings of $55 million will be reinvested indefinitely as of December 31, 2019. In the event we determine not to continue to assert that all or part of our undistributed foreign earnings are permanently reinvested, such a determination in the future could result in the accrual and payment of additional foreign withholding taxes and U.S. taxes on currency transaction gains and losses, the determination of which is not practicable. LONG-TERM DEBT COVENANTS Our credit facilities contain customary covenants that, among other things, impose limitations on indebtedness; liens; mergers, consolidations, liquidations and dissolutions; dispositions, restricted debt payments, restricted payments and transactions with affiliates. Events of default in these credit facilities include, among others, failure to pay interest, principal and fees when due; breach of a covenant or warranty; acceleration of or failure to pay other debt in excess of a threshold amount; unpaid judgments in excess of a threshold amount, insolvency matters; and a change of control. The credit facilities require us to comply with a financial covenant to be tested quarterly, consisting of a maximum first-lien leverage ratio of 5.0 times. The ratio is calculated by dividing consolidated first lien indebtedness (as defined in the credit agreement) net of consolidated unrestricted cash as of the measurement date by consolidated EBITDA (as defined in the credit agreement), as measured on a trailing four-fiscal-quarter basis preceding the measurement date. As of December 31, 2019, our first-lien leverage ratio was 2.4 times. The indenture under which the senior notes due 2026 were issued contains covenants that limit, among other things, Wyndham Hotels & Resorts, Inc.’s ability and that of certain of its subsidiaries to (i) create liens on certain assets; (ii) enter into sale and leaseback transactions; and (iii) merge, consolidate or sell all or substantially all of Wyndham Hotels & Resorts, Inc.’s assets. These covenants are subject to a number of important exceptions and qualifications. As of December 31, 2019, we were in compliance with the financial covenants described above. SEASONALITY While the hotel industry is seasonal in nature, periods of higher revenues vary property-by-property and performance is dependent on location and guest base. Based on historical performance, revenues from franchise and management contracts are generally higher in the second and third quarters than in the first or fourth quarters due to increased leisure travel during the spring and summer months. Our cash provided by operating activities tends to be lower in the first half of the year and substantially higher than in the second half of the year. The seasonality of our business may cause fluctuations in our quarterly operating results, earnings, profit margins and cash flows. As we expand into new markets and geographical locations, we may experience increased or different seasonality dynamics that create fluctuations in operating results different from the fluctuations we have experienced in the past. COMMITMENTS AND CONTINGENCIES We are involved in claims, legal and regulatory proceedings and governmental inquiries related to our business. Litigation is inherently unpredictable and, although we believe that our accruals are adequate and/or that we have valid defenses in these matters, unfavorable results could occur. As such, an adverse outcome from such proceedings for which claims are awarded in excess of the amounts accrued, if any, could be material to us with respect to earnings and/or cash flows in any given reporting period. As of December 31, 2019, the potential exposure resulting from adverse outcomes of such legal proceedings could, in the aggregate, range up to approximately $10 million in excess of recorded accruals. However, we do not believe that the impact of such litigation should result in a material liability to us in relation to our financial position or liquidity. For a more detailed description of our commitments and contingencies see Note 13 - Commitments and Contingencies to the Consolidated and Combined Financial Statements contained in Part IV of this report. CONTRACTUAL OBLIGATIONS The following table summarizes our future contractual obligations for the years set forth below: ______________________ (a) Includes interest on long-term debt; estimated using the stated interest rates on our senior notes and the swapped interest rates on our term loan. (b) Excludes a $13 million liability for unrecognized tax benefits associated with the accounting guidance for uncertainty in income taxes since it is not reasonably estimable to determine the periods in which such liability would be settled with the respective tax authorities. CRITICAL ACCOUNTING ESTIMATES AND POLICIES In presenting our financial statements in conformity with U.S. GAAP, we are required to make estimates and assumptions that affect the amounts reported therein. Several of the estimates and assumptions we are required to make relate to matters that are inherently uncertain as they pertain to future events. However, events that are outside of our control cannot be predicted and, as such, they cannot be contemplated in evaluating such estimates and assumptions. If there is a significant unfavorable change to current conditions, it could result in a material impact to our consolidated and combined results of operations, financial position and liquidity. We believe that the estimates and assumptions we used when preparing our financial statements were the most appropriate at that time. Presented below are those accounting policies that we believe require subjective and complex judgments that could potentially affect reported results. However, the majority of our business activities are in environments where we are paid a fee for a service performed, and therefore the results of the majority of our recurring operations are recorded in our financial statements using accounting policies that are not particularly subjective, nor complex. Impairment of long-lived assets Goodwill and other indefinite-lived intangible assets that were recorded in connection with business combinations, are reviewed annually (during the fourth quarter of each year subsequent to completing our annual forecasting process), or more frequently if circumstances indicate that the value of goodwill may be impaired, to the reporting units’ carrying values as required by the guidance. This is done either by performing a qualitative assessment or utilizing the two-step process, with an impairment being recognized only where the fair value is less than carrying value. In any given year, we can elect to perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is in excess of its carrying value. If it is not more likely than not that the fair value is in excess of the carrying value, or we elect to bypass the qualitative assessment, we would use the two-step process. The qualitative factors evaluated include macroeconomic conditions, industry and market considerations, cost factors, overall financial performance, our historical share price as well as other industry-specific considerations. We performed a quantitative assessment for impairment on each reporting unit’s goodwill for 2019. Based on the results of our quantitative assessments performed during the fourth quarter of 2019, we determined that no impairment existed, nor do we believe there is a material risk of it being impaired in the near term at our (i) hotel franchising, (ii) hotel management and (iii) owned hotel reporting units. To the extent estimated market-based valuation multiples and/or discounted cash flows are revised downward, we may be required to write-down all or a portion of goodwill, which would adversely impact earnings. We also determine whether the carrying values of other indefinite-lived intangible assets are impaired on an annual basis or more frequently if indicators of potential impairment exist. Application of the other indefinite-lived intangible assets impairment test requires judgment in the assumptions underlying the approach used to determine fair value. The fair value of each other indefinite-lived intangible asset is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including anticipated market conditions, operating expense trends, estimation of future cash flows, which are dependent on internal forecasts, discount rates and estimation of long-term rates of growth. The estimates used to calculate the fair value of other indefinite-lived intangible assets change from year to year based on operating results and market conditions. Changes in these estimates and assumptions could materially affect the determination of fair value and the other indefinite-lived intangible assets’ impairment. We also evaluate the recoverability of our other long-lived assets, including property and equipment and amortizable intangible assets, if circumstances indicate impairment may have occurred, pursuant to guidance for impairment or disposal of long-lived assets. This analysis is performed by comparing the respective carrying values of the assets to the current and expected future cash flows, on an undiscounted basis, to be generated from such assets. Property and equipment is evaluated separately within each segment. If such analysis indicates that the carrying value of these assets is not recoverable, the carrying value of such assets is reduced to fair value. Business combinations A component of our growth strategy has been to acquire and integrate businesses that complement our existing operations. We account for business combinations in accordance with the guidance for business combinations and related literature. Accordingly, we allocate the purchase price of acquired companies to the tangible and intangible assets acquired and liabilities assumed based upon their estimated fair values at the date of purchase. The difference between the purchase price and the fair value of the net assets acquired is recorded as goodwill. In determining the fair values of assets acquired and liabilities assumed in a business combination, we use various recognized valuation methods including present value modeling and referenced market values, where available. Further, we make assumptions within certain valuation techniques including discount rates and timing of future cash flows. Valuations are performed by management or external valuation specialists under management’s supervision, where appropriate. We believe that the estimated fair values assigned to the assets acquired and liabilities assumed are based on reasonable assumptions that marketplace participants would use. However, such assumptions are inherently uncertain and actual results could differ from those estimates. Loyalty program Wyndham Hotels operates the Wyndham Rewards loyalty program. Wyndham Rewards members primarily accumulate points by staying in hotels operated under one of our brands. Wyndham Rewards members may also accumulate points by purchasing everyday services and products with their co-branded credit card. Wyndham Hotels earns revenue from these programs (i) when a member stays at a participating hotel, club resort or vacation rental from a fee charged by us to the franchisee, which is based upon a percentage of room revenues generated from such stay which we recognize, net of redemptions, over time based upon loyalty point redemption patterns, including an estimate of loyalty points that will expire or will never be redeemed, and (ii) based upon a percentage of the member’s spending on the co-branded credit cards for which revenues are paid to us by third-party issuing banks which we primarily recognize over time based upon the redemption patterns of the loyalty points earned under the program, including an estimate of loyalty points that will expire or will never be redeemed. As members earn points through the Wyndham Rewards loyalty program, we record a liability for the estimated future redemption costs, which is calculated based on (i) an estimated cost per point and (ii) an estimated redemption rate of the overall points earned, which is determined with the assistance of a third-party actuarial firm through historical experience, current trends and the use of an actuarial analysis. Income taxes Prior to our spin-off, current and deferred income taxes and related tax expense have been determined based on Wyndham Hotels’ stand-alone results by applying a separate return methodology, as if the Wyndham Hotels’ entities were separate taxpayers in the respective jurisdictions. We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities using currently enacted tax rates. We regularly review our deferred tax assets to assess their potential realization and establish a valuation allowance for portions of such assets that we believe will not be ultimately realized. In performing this review, we make estimates and assumptions regarding projected future taxable income, the expected timing of the reversals of existing temporary differences and the implementation of tax planning strategies. A change in these assumptions may increase or decrease our valuation allowance resulting in an increase or decrease in our effective tax rate, which could materially impact our results of operations. For tax positions we have taken or expect to take in our tax return, we apply a more likely than not threshold, under which we must conclude a tax position is more likely than not to be sustained, assuming that the position will be examined by the appropriate taxing authority that has full knowledge of all relevant information, in order to recognize or continue to recognize the benefit. In determining our provision for income taxes, we use judgment, reflecting our estimates and assumptions, in applying the more likely than not threshold. RECENTLY ADOPTED AND NEW ACCOUNTING PRONOUNCEMENTS For a detailed description of recently adopted and new accounting pronouncements see Note 2 - Summary of Significant Accounting Policies to the Consolidated and Combined Financial Statements contained in Part IV of this report. OFF-BALANCE SHEET ARRANGEMENTS There were no off-balance sheet transactions, arrangements or other relationships with unconsolidated entities or other persons in 2019, 2018 and 2017 that have, or are reasonably likely to have, a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

<s>[INST] References herein to “Wyndham Hotels,” the “Company,” “we,” “our” and “us” refer to both (i) Wyndham Hotels & Resorts, Inc. and its consolidated subsidiaries for time periods following the consummation of the spinoff and (ii) the Wyndham Hotels & Resorts businesses for time periods prior to the consummation of our spinoff from Wyndham Worldwide. Unless the context otherwise suggests, references herein to “Wyndham Worldwide,” “Wyndham Destinations” and “former Parent” refer to Wyndham Worldwide Corporation and its consolidated subsidiaries. BUSINESS AND OVERVIEW Wyndham Hotels & Resorts is a leading global hotel franchisor, licensing its renowned hotel brands to hotel owners in approximately 90 countries around the world. Wyndham Hotels operates in the following segments: Hotel Franchising licenses our lodging brands and provides related services to thirdparty hotel owners and others. Hotel Management provides hotel management services for fullservice and limitedservice hotels as well as two hotels that are owned by Wyndham Hotels. The Consolidated and Combined Financial Statements presented herein have been prepared on a standalone basis and prior to May 31, 2018 are derived from the consolidated financial statements and accounting records of Wyndham Worldwide. The Consolidated and Combined Financial Statements include Wyndham Hotels’ assets, liabilities, revenues, expenses and cash flows and all entities in which Wyndham Hotels has a controlling financial interest. RESULTS OF OPERATIONS Discussed below are our key operating statistics, combined results of operations and the results of operations for each of our reportable segments. The reportable segments presented below represent our operating segments for which discrete financial information is available and used on a regular basis by our chief operating decision maker to assess performance and to allocate resources. In identifying our reportable segments, we also consider the nature of services provided by our operating segments. Management evaluates the operating results of each of our reportable segments based upon net revenues and adjusted EBITDA. Beginning with the third quarter of 2018, our calculation of adjusted EBITDA excludes the currency effects of highly inflationary countries. Adjusted EBITDA is defined as net income excluding interest expense, depreciation and amortization, impairment charges, restructuring and related charges, contract termination costs, transactionrelated items (acquisition, disposition or separationrelated), foreign currency impacts of highly inflationary countries, stockbased compensation expense and income taxes. We believe that adjusted EBITDA is a useful measure of performance for our segments and, when considered with U.S. GAAP measures, gives a more complete understanding of our operating performance. We use these measures internally to assess operating performance, both absolutely and in comparison to other companies, and to make day to day operating decisions, including in the evaluation of selected compensation decisions. Adjusted EBITDA is not a recognized term under U.S. GAAP and should not be considered as an alternative to net income or other measures of financial performance or liquidity derived in accordance with U.S. GAAP. Our presentation of adjusted EBITDA may not be comparable to similarlytitled measures used by other companies. We generate royalties and franchise fees, management fees and other revenues from hotel franchising and hotel management activities, as well as fees from licensing our “Wyndham” trademark, certain other trademarks and intellectual property. In addition, pursuant to our franchise and management contracts with thirdparty hotel owners, we generate marketing, reservation and loyalty fee revenues and cost reimbursement revenues that over time are offset, respectively, by the marketing, reservation and loyalty costs and property operating costs that we incur. We completed our acquisition of La Quinta Holdings, Inc. in May 2018, and, as a result certain comparisons of operating and financial metrics for the years ended December 31, 2019 and 2018 to the respective prior periods include significant acquisition impacts. OPERATING STATISTICS 2019 VS. 2018 The table below presents our operating statistics for the years ended December 31, 2 [/INST] Negative. </s>

GraniteShares Gold Trust

2018-08-31

2018-06-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This information should be read in conjunction with the financial statements and notes to the financial statements included with this report. The discussion and analysis that follows may contain statements that relate to future events or future performance. In some cases, such forward-looking statements can be identified by terminology such as “may,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or the negative of these terms or other comparable terminology. We remind readers that forward-looking statements are merely predictions and therefore inherently subject to uncertainties and other factors and involve known and unknown risks that could cause the actual results, performance, levels of activity, or our achievements, or industry results, to be materially different from any future results, performance, levels of activity, or our achievements expressed or implied by such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Trust undertakes no obligation to publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Introduction. The GraniteShares Gold Trust (the “Trust”) is a trust formed under the laws of the State of New York. The Trust does not have any officers, directors, or employees, and is administered by The Bank of New York Mellon (the “Trustee”) acting as trustee pursuant to the Depositary Trust Agreement (the “Trust Agreement”) between the Trustee and GraniteShares LLC, the sponsor of the Trust (the “Sponsor”). The Trust issues Shares representing fractional undivided beneficial interests in its net assets. The assets of the Trust consist of gold bullion held by a custodian as an agent of the Trust and responsible only to the Trustee. The Trust is a passive investment vehicle and the objective of the Trust is for the value of each Share to approximately reflect, at any given time, the price of the gold bullion owned by the Trust, less the Trust’s liabilities (anticipated to be principally for accrued operating expenses), divided by the number of outstanding Shares. The Trust does not engage in any activities designed to obtain a profit from, or ameliorate losses caused by, changes in the price of gold. The Trust issues and redeems Shares only in exchange for gold, only in aggregations of 10,000 or integral multiples thereof (each, a “Basket”), and only in transactions with registered broker-dealers or other securities market participants not required to register as broker-dealers, such as a bank or other financial institution, that (1) are participants in DTC and (2) have previously entered into an agreement with the Trust governing the terms and conditions of such issuance (such dealers, the “Authorized Participants”). As of the date of this annual report the Authorized Participants that have signed an Authorized Participant Agreement with the J.P. Morgan Securities Inc., Merrill Lynch Professional Clearing Corp., and Virtu Financial BD, LLC. Shares of the Trust trade on the NYSE Arca under the symbol “BAR”. Investing in the Shares does not insulate the investor from certain risks, including price volatility. The following graph illustrates the movement in the net asset value (“NAV”) of the Shares against the corresponding gold price (per 1/10 of an oz. of gold) since inception: NAV per Share vs. 1/10th gold price from the August 24, 2017 (the Date of Inception) to June 30, 2018 Source: Bloomberg The divergence of the NAV per Share from the gold price over time reflects the cumulative effect of the Trust expenses that arise if an investment had been held since inception. Critical Accounting Policy The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements relies on estimates and assumptions that impact the Trust’s financial position and results of operations. These estimates and assumptions affect the Trust’s application of accounting policies. Below we describe the valuation of gold bullion, a critical accounting policy that we believe is important to understanding our results of operations and financial position. In addition, please refer to Note 2 to the Financial Statements for further discussion of our accounting policies. Valuation of Gold Gold is held by the Custodian on behalf of the Trust. Gold is recorded at fair value. The cost of gold is determined according to the average cost method and the fair value is based on the LBMA PM Gold Price. Realized gains and losses on transfers of gold, or gold distributed for the redemption of Shares, are calculated on a trade date basis as the difference between the fair value and cost of gold transferred. Inspection of Gold Under the Custody Agreements, the Trustee, the Sponsor and the Sponsor’s auditors and inspectors may, only up to twice a year, visit the premises of the Custodian for the purpose of examining the Trust’s gold and certain related records maintained by the Custodian. The Sponsor has exercised its right to visit the Custodian in order to examine the gold and the records maintained by them. The most recent inspection by Inspectorate International Limited, a leading commodity inspection and testing company retained by the Sponsor, of the Custodian was conducted as of June 29, 2018. Liquidity The Trust is not aware of any trends, demands, conditions or events that are reasonably likely to result in material changes to its liquidity needs. In exchange for a fee (the “Sponsor’s Fee”), the Sponsor has agreed to assume most of the expenses incurred by the Trust. As a result, the only expense of the Trust during the period covered by this report was the Sponsor’s Fee. The Trust’s only source of liquidity is its transfers and sales of gold. The Trustee will, at the direction of the Sponsor or in its own discretion, sell the Trust’s gold as necessary to pay the Trust’s expenses not otherwise assumed by the Sponsor. The Trustee will not sell gold to pay the Sponsor’s Fee but will pay the Sponsor’s Fee through in-kind transfers of gold to the Sponsor. At June 30, 2018 the Trust did not have any cash balances. Review of Financial Results Financial Highlights The fiscal year ended June 30, 2018 The net asset value (“NAV”) of the Trust is obtained by subtracting the Trust’s expenses and liabilities on any day from the value of the gold owned by the Trust on that day; the NAV per Share is obtained by dividing the NAV of the Trust on a given day by the number of Shares outstanding on that day. The Trust’s NAV increased from $2,578,000 on August 24, 2017 to $250,925,048 on June 30, 2018, a 9,633.32% increase for the year. The increase in the Trust’s NAV resulted primarily from an increase in outstanding Shares, which rose from 20,000 Shares on August 24, 2017 to 2,010,000 Shares on June 30, 2018, a result of 1,990,000 Shares (199 Baskets) being created and 0 Shares being redeemed during that period. The NAV per Share decreased 3.15% from $128.90 on August 24, 2017 to $124.84 on June 30, 2018. During that period the gold price decreased 2.99% from $1,289.00 on August 24, 2017 to $1,250.45 on June 30, 2018. The Trust’s NAV per Share decreased slightly more than the price per ounce of gold on a percentage basis due to the Sponsor’s Fee, which was $44,776 for the fiscal year, or 0.20% of the Trust’s assets on an annualized basis. Off-Balance Sheet Arrangements The Trust is not a party to any off-balance sheet arrangements.

<s>[INST] Introduction. The GraniteShares Gold Trust (the “Trust”) is a trust formed under the laws of the State of New York. The Trust does not have any officers, directors, or employees, and is administered by The Bank of New York Mellon (the “Trustee”) acting as trustee pursuant to the Depositary Trust Agreement (the “Trust Agreement”) between the Trustee and GraniteShares LLC, the sponsor of the Trust (the “Sponsor”). The Trust issues Shares representing fractional undivided beneficial interests in its net assets. The assets of the Trust consist of gold bullion held by a custodian as an agent of the Trust and responsible only to the Trustee. The Trust is a passive investment vehicle and the objective of the Trust is for the value of each Share to approximately reflect, at any given time, the price of the gold bullion owned by the Trust, less the Trust’s liabilities (anticipated to be principally for accrued operating expenses), divided by the number of outstanding Shares. The Trust does not engage in any activities designed to obtain a profit from, or ameliorate losses caused by, changes in the price of gold. The Trust issues and redeems Shares only in exchange for gold, only in aggregations of 10,000 or integral multiples thereof (each, a “Basket”), and only in transactions with registered brokerdealers or other securities market participants not required to register as brokerdealers, such as a bank or other financial institution, that (1) are participants in DTC and (2) have previously entered into an agreement with the Trust governing the terms and conditions of such issuance (such dealers, the “Authorized Participants”). As of the date of this annual report the Authorized Participants that have signed an Authorized Participant Agreement with the J.P. Morgan Securities Inc., Merrill Lynch Professional Clearing Corp., and Virtu Financial BD, LLC. Shares of the Trust trade on the NYSE Arca under the symbol “BAR”. Investing in the Shares does not insulate the investor from certain risks, including price volatility. The following graph illustrates the movement in the net asset value (“NAV”) of the Shares against the corresponding gold price (per 1/10 of an oz. of gold) since inception: NAV per Share vs. 1/10th gold price from the August 24, 2017 (the Date of Inception) to June 30, 2018 Source: Bloomberg The divergence of the NAV per Share from the gold price over time reflects the cumulative effect of the Trust expenses that arise if an investment had been held since inception. Critical Accounting Policy The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements relies on estimates and assumptions that impact the Trust’s financial position and results of operations. These estimates and assumptions affect the Trust’s application of accounting policies. Below we describe the valuation of gold bullion, a critical accounting policy that we believe is important to understanding our results of operations and financial position. In addition, please refer to Note 2 to the Financial Statements for further discussion of our accounting policies. Valuation of Gold Gold is held by the Custodian on behalf of the Trust. Gold is recorded at fair value. The cost of gold is determined according to the average cost method and the fair value is based on the LBMA PM Gold Price. Realized gains and losses on transfers of gold, or gold distributed for the redemption of Shares, are calculated on a trade date basis as the difference between the fair value and cost of gold transferred. Inspection of Gold Under the Custody Agreements, the Trustee, the Sponsor and the Sponsor’s auditors and inspectors may, only up to twice a year, visit the premises of the Custodian for the purpose of examining the Trust’s gold and certain related records maintained by the Custodian. The Sponsor has exercised its right to visit the Custodian in order to examine the gold and the records maintained by them. The most recent inspection by Inspectorate International Limited, a leading [/INST] Negative. </s>

GraniteShares Gold Trust

2019-08-20

2019-06-30

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This information should be read in conjunction with the financial statements and notes to the financial statements included with this report. The discussion and analysis that follows may contain statements that relate to future events or future performance. In some cases, such forward-looking statements can be identified by terminology such as “may,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or the negative of these terms or other comparable terminology. We remind readers that forward-looking statements are merely predictions and therefore inherently subject to uncertainties and other factors and involve known and unknown risks that could cause the actual results, performance, levels of activity, or our achievements, or industry results, to be materially different from any future results, performance, levels of activity, or our achievements expressed or implied by such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Trust undertakes no obligation to publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. Introduction. The GraniteShares Gold Trust (the “Trust”) is a trust formed under the laws of the State of New York. The Trust does not have any officers, directors, or employees, and is administered by The Bank of New York Mellon (the “Trustee”) acting as trustee pursuant to the Depositary Trust Agreement (the “Trust Agreement”) between the Trustee and GraniteShares LLC, the sponsor of the Trust (the “Sponsor”). The Trust issues Shares representing fractional undivided beneficial interests in its net assets. The assets of the Trust consist of gold bullion held by a custodian as an agent of the Trust and responsible only to the Trustee. The Trust is a passive investment vehicle and the objective of the Trust is for the value of each Share to approximately reflect, at any given time, the price of the gold bullion owned by the Trust, less the Trust’s liabilities (anticipated to be principally for accrued operating expenses), divided by the number of outstanding Shares. The Trust does not engage in any activities designed to obtain a profit from, or ameliorate losses caused by, changes in the price of gold. The Trust issues and redeems Shares only in exchange for gold, only in aggregations of 50,000 or integral multiples thereof (each, a “Basket”), and only in transactions with registered broker-dealers or other securities market participants not required to register as broker-dealers, such as a bank or other financial institution, that (1) are participants in DTC and (2) have previously entered into an agreement with the Trust governing the terms and conditions of such issuance (such dealers, the “Authorized Participants”). As of the date of this annual report the Authorized Participants that have signed an Authorized Participant Agreement with the J.P. Morgan Securities Inc., Merrill Lynch Professional Clearing Corp., and Virtu Financial BD, LLC. Shares of the Trust trade on the NYSE Arca under the symbol “BAR”. Investing in the Shares does not insulate the investor from certain risks, including price volatility. The following graph illustrates the movement in the net asset value (“NAV”) of the Shares against the corresponding gold price (per 1/100 of an oz. of gold) since inception: NAV per Share(1) vs. 1/100th gold price from August 30, 2017 to June 30, 2019 (1) Adjusted for effect of stock split. The stock split was effective on March 7, 2019. See Note 1 to the Financial Statements. Source: Bloomberg The divergence of the NAV per Share from the gold price over time reflects the cumulative effect of the Trust expenses that arise if an investment had been held since inception. Critical Accounting Policy The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements relies on estimates and assumptions that impact the Trust’s financial position and results of operations. These estimates and assumptions affect the Trust’s application of accounting policies. Below we describe the valuation of gold bullion, a critical accounting policy that we believe is important to understanding our results of operations and financial position. In addition, please refer to Note 2 to the Financial Statements for further discussion of our accounting policies. Valuation of Gold Gold is held by the Custodian on behalf of the Trust. Gold is recorded at fair value. The cost of gold is determined according to the average cost method and the fair value is based on the LBMA PM Gold Price. Realized gains and losses on transfers of gold, or gold distributed for the redemption of Shares, are calculated on a trade date basis as the difference between the fair value and cost of gold transferred. Inspection of Gold Under the Custody Agreements, the Trustee, the Sponsor and the Sponsor’s auditors and inspectors may, only up to twice a year, visit the premises of the Custodian for the purpose of examining the Trust’s gold and certain related records maintained by the Custodian. The Sponsor has exercised its right to visit the Custodian in order to examine the gold and the records maintained by them. The most recent inspection by Inspectorate International Limited, a leading commodity inspection and testing company retained by the Sponsor, of the Custodian was conducted as of June 28, 2019. Liquidity The Trust is not aware of any trends, demands, conditions or events that are reasonably likely to result in material changes to its liquidity needs. In exchange for a fee (the “Sponsor’s Fee”), the Sponsor has agreed to assume most of the expenses incurred by the Trust. As a result, the only expense of the Trust during the period covered by this report was the Sponsor’s Fee. The Trust’s only source of liquidity is its transfers and sales of gold. The Trustee will, at the direction of the Sponsor or in its own discretion, sell the Trust’s gold as necessary to pay the Trust’s expenses not otherwise assumed by the Sponsor. The Trustee will not sell gold to pay the Sponsor’s Fee but will pay the Sponsor’s Fee through in-kind transfers of gold to the Sponsor. At June 30, 2019 the Trust did not have any cash balances. Review of Financial Results Financial Highlights (1) Adjusted for effect of stock split. The stock split was effective on March 7, 2019. See Note 1 to the Financial Statements. For the fiscal year ended June 30, 2019 The net asset value (“NAV”) of the Trust is obtained by subtracting the Trust’s expenses and liabilities on any day from the value of the gold owned by the Trust on that day; the NAV per Share is obtained by dividing the NAV of the Trust on a given day by the number of Shares outstanding on that day. The Trust’s NAV increased from $250,925,048 on June 30, 2018 to $545,511,107 on June 30, 2019, a 117% increase for the year. The increase in the Trust’s NAV resulted primarily from an increase in outstanding Shares, which rose, on a post stock split basis (see Note 1 to the Financial Statements), from 20,100,000 Shares on June 30, 2018 to 38,850,000 Shares on June 30, 2019, a result of 22,100,000 Shares (442 Baskets) being created and 3,350,000 Shares (67 Baskets) being redeemed during that period. On a post stock split basis (see Note 1 to the Financial Statements), the NAV per Share increased 12.50% from $12.48 on June 30, 2018 to $14.04 on June 30, 2019. During that period the gold price increased 12.68% from $1,250.45 on June 30, 2018 to $1,409.00 on June 28, 2019. The Trust’s NAV per Share increased slightly less than the price per ounce of gold on a percentage basis due to the Sponsor’s Fee, which was $666,919 for the fiscal year, or 0.18% of the Trust’s assets on an annualized basis. The Sponsor’s Fee was reduced from 0.20% to 0.1749% on October 5, 2018 (see Note 2.2 in the Financial Statements) Off-Balance Sheet Arrangements The Trust is not a party to any off-balance sheet arrangements.

<s>[INST] Introduction. The GraniteShares Gold Trust (the “Trust”) is a trust formed under the laws of the State of New York. The Trust does not have any officers, directors, or employees, and is administered by The Bank of New York Mellon (the “Trustee”) acting as trustee pursuant to the Depositary Trust Agreement (the “Trust Agreement”) between the Trustee and GraniteShares LLC, the sponsor of the Trust (the “Sponsor”). The Trust issues Shares representing fractional undivided beneficial interests in its net assets. The assets of the Trust consist of gold bullion held by a custodian as an agent of the Trust and responsible only to the Trustee. The Trust is a passive investment vehicle and the objective of the Trust is for the value of each Share to approximately reflect, at any given time, the price of the gold bullion owned by the Trust, less the Trust’s liabilities (anticipated to be principally for accrued operating expenses), divided by the number of outstanding Shares. The Trust does not engage in any activities designed to obtain a profit from, or ameliorate losses caused by, changes in the price of gold. The Trust issues and redeems Shares only in exchange for gold, only in aggregations of 50,000 or integral multiples thereof (each, a “Basket”), and only in transactions with registered brokerdealers or other securities market participants not required to register as brokerdealers, such as a bank or other financial institution, that (1) are participants in DTC and (2) have previously entered into an agreement with the Trust governing the terms and conditions of such issuance (such dealers, the “Authorized Participants”). As of the date of this annual report the Authorized Participants that have signed an Authorized Participant Agreement with the J.P. Morgan Securities Inc., Merrill Lynch Professional Clearing Corp., and Virtu Financial BD, LLC. Shares of the Trust trade on the NYSE Arca under the symbol “BAR”. Investing in the Shares does not insulate the investor from certain risks, including price volatility. The following graph illustrates the movement in the net asset value (“NAV”) of the Shares against the corresponding gold price (per 1/100 of an oz. of gold) since inception: NAV per Share(1) vs. 1/100th gold price from August 30, 2017 to June 30, 2019 (1) Adjusted for effect of stock split. The stock split was effective on March 7, 2019. See Note 1 to the Financial Statements. Source: Bloomberg The divergence of the NAV per Share from the gold price over time reflects the cumulative effect of the Trust expenses that arise if an investment had been held since inception. Critical Accounting Policy The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements relies on estimates and assumptions that impact the Trust’s financial position and results of operations. These estimates and assumptions affect the Trust’s application of accounting policies. Below we describe the valuation of gold bullion, a critical accounting policy that we believe is important to understanding our results of operations and financial position. In addition, please refer to Note 2 to the Financial Statements for further discussion of our accounting policies. Valuation of Gold Gold is held by the Custodian on behalf of the Trust. Gold is recorded at fair value. The cost of gold is determined according to the average cost method and the fair value is based on the LBMA PM Gold Price. Realized gains and losses on transfers of gold, or gold distributed for the redemption of Shares, are calculated on a trade date basis as the difference between the fair value and cost of gold transferred. Inspection of Gold Under the Custody Agreements, the Trustee, the Sponsor and the Sponsor’s auditors and inspectors may, only up to twice a year, visit the premises of the Custodian for the purpose of examining the Trust’s gold and certain related records maintained by the Custodian. The Sponsor has exerc [/INST] Positive. </s>

Megalith Financial Acquisition Corp

2019-04-01

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations References in this report (the “Annual Report”) to “we,” “us” or the “Company” refer to Megalith Financial Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “sponsor” refer to MFA Investor Holdings LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Annual Report. Certain information contained in the discussion and analysis set forthbelow includes forward-looking statements that involve risks and uncertainties. Special Note Regarding Forward-Looking Statements This Annual Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Annual Report including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s final prospectus for the Initial Public Offering filed with the SEC. The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. Overview We are a blank check company in November 2017 and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our Initial Public Offering and the Private Placement, our securities, debt issued to bank or other lenders or the owners of the target, or a combination of the foregoing. The issuance of additional shares of common stock or preferred stock: ● may significantly dilute the equity interest of our investors, which dilution would increase if the anti-dilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than one to one basis upon conversion of the Class B common stock; ● may subordinate the rights of holders of common stock if we issue preferred shares with rights senior to those afforded to our common stock; ● could cause a change in control if a substantial number of our shares of common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; ● may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: ● default and foreclosure on our assets if our operating revenues after our business combination are insufficient to pay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; ● our inability to obtain additional financing if the debt security contains covenants restricting our ability to obtain additional financing while such security is outstanding; ● our inability to pay dividends on our common stock; ● using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, expenses, capital expenditures, acquisitions and other general corporate purposes; ● limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; ● increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; and ● limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, execution of our strategy and other purposes and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our initial business combination plans. We cannot assure you that our plans to raise capital or to complete our initial business combination will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from November 13, 2017 (date of inception) through December 31, 2018 were organizational activities, efforts relating to the Initial Public Offering, and identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination. We expect to generate non-operating income in the form of interest income on cash marketable securities held in the Trust Account. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as expenses as we conduct due diligence on prospective business combination candidates. For the year ended December 31, 2018 and for the period from November 13, 2017 (inception) through December 31, 2017, we had net income of $294,957 and net loss of $1,767, respectively, which consists of operating costs of $720,212 and $1,767, respectively, offset by interest income on marketable securities held in the Trust Account of $1,232,015 and $0, respectively. Liquidity and Capital Resources The completion of the Initial Public Offering and simultaneous Private Placement, inclusive of the underwriters’ exercise of their over-allotment option, generated gross proceeds to the Company of $170,981,779. Related transaction costs amounted to $10,521,211, consisting of $3,192,889 of underwriting fees, $6,771,556 of deferred underwriting commissions payable (which are held in the Trust Account) and $556,766 of other costs. As of December 31, 2018, $1,192,945 of cash was held outside of the Trust Account and was available for working capital purposes, including paying business, legal and accounting due diligence costs on prospective acquisitions and continuing general and administrative expenses. Following the Initial Public Offering and the exercise of the over-allotment option, a total of $170,981,778 was placed in the Trust Account and we had $1,785,062 of cash held outside of the Trust Account, after payment of all costs related to the Initial Public Offering and the exercise of the over-allotment option. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (which shall be net of taxes payable and excluding deferred underwriting commissions) to complete our initial business combination. We may withdraw interest to pay franchise and income taxes. We expect the interest earned on the amount in the trust account will be sufficient to pay our income taxes. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete an initial business combination. In order to fund working capital deficiencies or finance transaction costs in connection with an intended initial business combination, our sponsor or an affiliate of our sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant at the option of the lender. The warrants would be identical to the private placement warrants, including as to exercise price, exercisability and exercise period. The terms of such loans by our officers and directors, if any, have not been determined and no written agreements exist with respect to such loans. We do not expect to seek loans from parties other than our sponsor or an affiliate of our sponsor as we do not believe third parties will be willing to loan such funds and provide a waiver against any and all rights to seek access to funds in our trust account. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial business combination. Moreover, we may need to obtain additional financing either to complete our initial business combination or because we become obligated to redeem a significant number of our public shares upon completion of our initial business combination, in which case we may issue additional securities or incur debt in connection with such business combination. In addition, we intend to acquire a company with an enterprise value significantly above the net proceeds of this offering and the sale of the private placement warrants. Depending on the size of the transaction we may potentially utilize several additional financing sources, including but not limited to the issuance of additional securities to the sellers of a target business, debt issued to bank or other lenders or the owners of the target, a private placement to raise additional funds, or a combination of the foregoing. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. In addition, following our initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations and working capital needs. Off-balance sheet financing arrangements As of December 31, 2018 and 2017, we did not have obligations, assets or liabilities which would be considered off-balance sheet arrangements as defined in Item 303(a)(4)(ii). We are not a party to any transaction that creates relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Related Party The Company will pay an entity affiliated with the President a fee of approximately $16,667 per month until the earlier of the consummation of the Business Combination or liquidation. A bonus of $78,000 was paid out after the successful completion of the Initial Public Offering. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. Contractual obligations As of December 31, 2018, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than the deferred underwriter commission discussed above, payment to an entity affiliated with the President a fee of approximately $16,667 per month until the earlier of the consummation of the Business Combination or liquidation, as well as a bonus of $78,000 which was paid out after the successful completion of the Initial Public Offering, and an agreement to pay the sponsor a monthly fee of $2,000 for office space, utilities and administrative support provided to the Company. We began incurring these fees on August 24, 2018 and will continue to incur these fees monthly until the earlier of the completion of the Business Combination or the Company’s liquidation. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. Class A Common Stock Subject to Possible Redemption The Company accounts for its Class A common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Shares of Class A common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable Class A common stock (including Class A common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company's control) is classified as temporary equity. At all other times, Class A common stock is classified as stockholders' equity. The Company's Class A common stock features certain redemption rights that are considered to be outside of the Company's control and subject to occurrence of uncertain future events. Accordingly, at December 31, 2018 and 2017, 15,943,727 and 0 shares of Class A common stock subject to possible redemption is presented as temporary equity, outside of the stockholders' equity section of the Company's balance sheets.

<s>[INST] Special Note Regarding ForwardLooking Statements This Annual Report includes “forwardlooking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Annual Report including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forwardlooking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forwardlooking statements. Such forwardlooking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forwardlooking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forwardlooking statements, please refer to the Risk Factors section of the Company’s final prospectus for the Initial Public Offering filed with the SEC. The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forwardlooking statements whether as a result of new information, future events or otherwise. Overview We are a blank check company in November 2017 and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our Initial Public Offering and the Private Placement, our securities, debt issued to bank or other lenders or the owners of the target, or a combination of the foregoing. The issuance of additional shares of common stock or preferred stock: may significantly dilute the equity interest of our investors, which dilution would increase if the antidilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than one to one basis upon conversion of the Class B common stock; may subordinate the rights of holders of common stock if we issue preferred shares with rights senior to those afforded to our common stock; could cause a change in control if a substantial number of our shares of common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: default and foreclosure on our assets if our operating revenues after our business combination are insufficient to pay our debt obligations; acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; our inability to obtain additional financing if the debt security contains covenants restricting our ability to obtain additional financing while such security is outstanding; our inability to pay dividends on our common stock; using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, expenses, capital expenditures, acquisitions and other general corporate purposes; limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; increased vulnerability to adverse changes in general economic, [/INST] Negative. </s>

Megalith Financial Acquisition Corp

2020-03-16

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations References in this report (the “Annual Report”) to “we,” “us” or the “Company” refer to Megalith Financial Acquisition Corp. References to our “management” or our “management team” refer to our officers and directors, and references to the “sponsor” refer to MFA Investor Holdings LLC. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this Annual Report. Certain information contained in the discussion and analysis set forthbelow includes forward-looking statements that involve risks and uncertainties. Special Note Regarding Forward-Looking Statements This Annual Report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Annual Report including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forward-looking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forward-looking statements. Such forward-looking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forward-looking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forward-looking statements, please refer to the Risk Factors section of the Company’s final prospectus for the Initial Public Offering filed with the SEC. The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise. Overview We are a blank check company in November 2017 and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our Initial Public Offering and the Private Placement, our securities, debt issued to bank or other lenders or the owners of the target, or a combination of the foregoing. The issuance of additional shares of common stock or preferred stock: ● may significantly dilute the equity interest of our investors, which dilution would increase if the anti-dilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than one to one basis upon conversion of the Class B common stock; ● may subordinate the rights of holders of common stock if we issue preferred shares with rights senior to those afforded to our common stock; ● could cause a change in control if a substantial number of our shares of common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; ● may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and ● may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: ● default and foreclosure on our assets if our operating revenues after our business combination are insufficient to pay our debt obligations; ● acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; ● our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; ● our inability to obtain additional financing if the debt security contains covenants restricting our ability to obtain additional financing while such security is outstanding; ● our inability to pay dividends on our common stock; ● using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, expenses, capital expenditures, acquisitions and other general corporate purposes; ● limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; ● increased vulnerability to adverse changes in general economic, industry and competitive conditions and adverse changes in government regulation; and ● limitations on our ability to borrow additional amounts for expenses, capital expenditures, acquisitions, debt service requirements, execution of our strategy and other purposes and other disadvantages compared to our competitors who have less debt. We expect to continue to incur significant costs in the pursuit of our initial business combination plans. We cannot assure you that our plans to raise capital or to complete our initial business combination will be successful. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception through December 31, 2019 were organizational activities, efforts relating to the Initial Public Offering, and identifying a target company for a Business Combination. We do not expect to generate any operating revenues until after the completion of our Business Combination. We expect to generate non-operating income in the form of interest income on cash marketable securities held in the Trust Account. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as expenses as we conduct due diligence on prospective business combination candidates. For the year ended December 31, 2019, we had net income of $2,363,522 which consists of operating costs of $799,387 and a provision for income taxes of $788,018, offset by interest income on marketable securities held in the Trust Account of $3,950,927. For the year ended December 31, 2018, we had net income of $294,957, which consists of operating costs of $720,212, offset by interest income on marketable securities held in the Trust Account of $1,232,015. Liquidity and Capital Resources The completion of the Initial Public Offering and simultaneous Private Placement, inclusive of the underwriters’ exercise of their over-allotment option, generated gross proceeds to the Company of $170,981,779. Related transaction costs amounted to $10,521,211, consisting of $3,192,889 of underwriting fees, $6,771,556 of deferred underwriting commissions payable (which are held in the Trust Account) and $556,766 of other costs. As of December 31, 2019, $482,665 of cash was held outside of the Trust Account and was available for working capital purposes, including paying business, legal and accounting due diligence costs on prospective acquisitions and continuing general and administrative expenses. Following the Initial Public Offering and the exercise of the over-allotment option, a total of $170,981,778 was placed in the Trust Account and we had $1,785,062 of cash held outside of the Trust Account, after payment of all costs related to the Initial Public Offering and the exercise of the over-allotment option. We intend to use substantially all of the funds held in the Trust Account, including any amounts representing interest earned on the Trust Account (which shall be net of taxes payable and excluding deferred underwriting commissions) to complete our initial business combination. We may withdraw interest to pay franchise and income taxes. We expect the interest earned on the amount in the trust account will be sufficient to pay our income taxes. To the extent that our capital stock or debt is used, in whole or in part, as consideration to complete our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business or businesses, make other acquisitions and pursue our growth strategies. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete an initial business combination. In order to fund working capital deficiencies or finance transaction costs in connection with an intended initial business combination, our sponsor or an affiliate of our sponsor or certain of our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Up to $1,500,000 of such loans may be convertible into warrants, at a price of $1.00 per warrant at the option of the lender. The warrants would be identical to the private placement warrants, including as to exercise price, exercisability and exercise period. The terms of such loans by our officers and directors, if any, have not been determined and no written agreements exist with respect to such loans. We do not expect to seek loans from parties other than our sponsor or an affiliate of our sponsor as we do not believe third parties will be willing to loan such funds and provide a waiver against any and all rights to seek access to funds in our trust account. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our initial business combination. Moreover, we may need to obtain additional financing either to complete our initial business combination or because we become obligated to redeem a significant number of our public shares upon completion of our initial business combination, in which case we may issue additional securities or incur debt in connection with such business combination. In addition, we intend to acquire a company with an enterprise value significantly above the net proceeds of this offering and the sale of the private placement warrants. Depending on the size of the transaction we may potentially utilize several additional financing sources, including but not limited to the issuance of additional securities to the sellers of a target business, debt issued to bank or other lenders or the owners of the target, a private placement to raise additional funds, or a combination of the foregoing. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. In addition, following our initial business combination, if cash on hand is insufficient, we may need to obtain additional financing in order to meet our obligations and working capital needs. Off-balance sheet financing arrangements As of December 31, 2019 and 2018, we did not have obligations, assets or liabilities which would be considered off-balance sheet arrangements as defined in Item 303(a)(4)(ii). We are not a party to any transaction that creates relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Related Party The Company will pay an entity affiliated with the President a fee of approximately $16,667 per month until the earlier of the consummation of the Business Combination or liquidation. A bonus of $78,000 was paid out after the successful completion of the Initial Public Offering. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We qualify as an “emerging growth company” and under the JOBS Act are allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result, our financial statements may not be comparable to companies that comply with new or revised accounting pronouncements as of public company effective dates. Contractual obligations As of December 31, 2019, we did not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities, other than the deferred underwriter commission discussed above, payment to an entity affiliated with the President a fee of approximately $16,667 per month until the earlier of the consummation of the Business Combination or liquidation, as well as a bonus of $78,000 which was paid out after the successful completion of the Initial Public Offering, and an agreement to pay the sponsor a monthly fee of $2,000 for office space, utilities and administrative support provided to the Company. We began incurring these fees on August 24, 2018 and will continue to incur these fees monthly until the earlier of the completion of the Business Combination or the Company’s liquidation. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. Class A Common Stock Subject to Possible Redemption The Company accounts for its Class A common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Shares of Class A common stock subject to mandatory redemption (if any) is classified as a liability instrument and is measured at fair value. Conditionally redeemable Class A common stock (including Class A common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, Class A common stock is classified as stockholders’ equity. The Company’s Class A common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, at December 31, 2019 and 2018, 16,177,739 and 15,943,727 shares of Class A common stock subject to possible redemption is presented as temporary equity, outside of the stockholders’ equity section of the Company’s balance sheets.

<s>[INST] Special Note Regarding ForwardLooking Statements This Annual Report includes “forwardlooking statements” within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act that are not historical facts, and involve risks and uncertainties that could cause actual results to differ materially from those expected and projected. All statements, other than statements of historical fact included in this Annual Report including, without limitation, statements in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding the Company’s financial position, business strategy and the plans and objectives of management for future operations, are forwardlooking statements. Words such as “expect,” “believe,” “anticipate,” “intend,” “estimate,” “seek” and variations and similar words and expressions are intended to identify such forwardlooking statements. Such forwardlooking statements relate to future events or future performance, but reflect management’s current beliefs, based on information currently available. A number of factors could cause actual events, performance or results to differ materially from the events, performance and results discussed in the forwardlooking statements. For information identifying important factors that could cause actual results to differ materially from those anticipated in the forwardlooking statements, please refer to the Risk Factors section of the Company’s final prospectus for the Initial Public Offering filed with the SEC. The Company’s securities filings can be accessed on the EDGAR section of the SEC’s website at www.sec.gov. Except as expressly required by applicable securities law, the Company disclaims any intention or obligation to update or revise any forwardlooking statements whether as a result of new information, future events or otherwise. Overview We are a blank check company in November 2017 and formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization or similar business combination with one or more businesses. We intend to effectuate our business combination using cash from the proceeds of our Initial Public Offering and the Private Placement, our securities, debt issued to bank or other lenders or the owners of the target, or a combination of the foregoing. The issuance of additional shares of common stock or preferred stock: may significantly dilute the equity interest of our investors, which dilution would increase if the antidilution provisions in the Class B common stock resulted in the issuance of Class A shares on a greater than one to one basis upon conversion of the Class B common stock; may subordinate the rights of holders of common stock if we issue preferred shares with rights senior to those afforded to our common stock; could cause a change in control if a substantial number of our shares of common stock are issued, which may affect, among other things, our ability to use our net operating loss carry forwards, if any, and could result in the resignation or removal of our present officers and directors; may have the effect of delaying or preventing a change of control of us by diluting the stock ownership or voting rights of a person seeking to obtain control of us; and may adversely affect prevailing market prices for our securities. Similarly, if we issue debt securities or otherwise incur significant debt to bank or other lenders or the owners of a target, it could result in: default and foreclosure on our assets if our operating revenues after our business combination are insufficient to pay our debt obligations; acceleration of our obligations to repay the indebtedness even if we have made all principal and interest payments when due if we breach certain covenants that require the maintenance of certain financial ratios or reserves without a waiver or renegotiation of that covenant; our immediate payment of all principal and accrued interest, if any, if the debt security is payable on demand; our inability to obtain additional financing if the debt security contains covenants restricting our ability to obtain additional financing while such security is outstanding; our inability to pay dividends on our common stock; using a substantial portion of our cash flow to pay principal and interest on our debt, which will reduce the funds available for dividends on our common stock if declared, expenses, capital expenditures, acquisitions and other general corporate purposes; limitations on our flexibility in planning for and reacting to changes in our business and in the industry in which we operate; increased vulnerability to adverse changes in general economic, [/INST] Positive. </s>

Covia Holdings Corp

2019-03-22

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following management’s discussion and analysis of financial condition and results of operations should be read together with the section entitled “Business” and our consolidated financial statements and related notes thereto and other financial information appearing elsewhere in this Report. The following discussion contains forward-looking statements that involve risks, uncertainties and assumptions. See the section entitled “Cautionary Statement Regarding Forward-Looking Statements” beginning on page 3 of this Annual Report. Our actual results could differ materially from those contained in forward-looking statements as a result of many factors, including those discussed in “Item 1A - Risk Factors” in Part I of this Report. The following discussion contains certain non-GAAP (defined herein) financial measures, including EBITDA and Adjusted EBITDA (defined herein). See “-Key Metrics Used to Evaluate Covia’s Business” for a reconciliation of net income (loss) to EBITDA and Adjusted EBITDA. Overview We are an application-focused minerals company providing materials solutions to customers drawing from a diversified product portfolio. We produce a wide range of specialized silica sand, feldspar, nepheline syenite, calcium carbonate, clay, kaolin, lime, and lime products for use in the energy and Industrial markets in North America and around the world. We have 44 sand mining facilities with over 50 million tons of annual sand processing capacity and significant proven and probable mineral reserves that serve both the Industrial and Energy markets and six active coating facilities with more than two million tons of annual coating capacity. Our mining and coating facilities span North America and also include operations in China and Denmark. We believe our U.S., Mexico, and Canada operations are among the largest, most flexible, and cost-efficient facilities in the industry with close proximity to our customer base. Our operations are organized into two segments based on the primary end markets we serve - Energy and Industrial. Our Energy segment offers the oil and gas industry a comprehensive portfolio of raw frac sand, value-added proppants, well-cementing additives, gravel-packing media and drilling mud additives that meet or exceed the API standards. Our products serve hydraulic fracturing operations in the U.S., Canada, Argentina, Mexico, China, and northern Europe. Our Industrial segment provides raw, value-added, and custom-blended products to the glass, construction, ceramics, foundry, coatings, polymers, sports and recreation, filtration and various other industries primarily in North America. We believe our segments are complementary. Our ability to sell to a wide range of customers across multiple end markets allows us to maximize the recovery of our reserve base within our mining operations and to mitigate the cyclicality of our earnings. Recent Trends and Outlook Energy segment market trends: • Volatility of drilling activity. Demand for proppant is primarily determined by the level of drilling and well completions by E&P companies, which depends largely on the current and anticipated profitability of developing oil and natural gas reserves. Drilling and completions activity increased in the first half of 2018 as a result of rising oil prices, but softened in the second half of 2018 relative to the first half of the year, largely as a result of E&P budget constraints and lower oil prices in the fourth quarter of 2018. WTI benchmark prices averaged nearly $65 per barrel in 2018 versus $51 per barrel in 2017. However, the WTI benchmark was approximately $45 per barrel at the end of 2018. In response to the improved returns generated by higher average oil prices, E&P companies increased their capital spending on drilling and completion in 2018 relative to 2017. In 2019, E&P capital spending on drilling and completions activity is expected to decline in response to lower hydrocarbon prices and a desire from E&P companies to generate additional cash flow. Current WTI pricing, as of March 15, 2019 was approximately $58 per barrel. • Shifts in drilling activity affect the mix of proppants customers require. Well design and completion trends in oil and gas impact the demand for and the mix of proppants we sell. In 2013 and 2014, well designs centered around guar and crosslinked gel utilizing coarse grade proppants with high conductivity. E&P companies also used ceramics and/or resin-coated proppants for added strength and flowback control. In 2015 and 2016, lower crude oil prices caused E&P companies to seek to reduce short-term operating costs, including experimenting with slickwater designs utilizing longer laterals and high loading of lower priced, finer grades of proppant. Beginning in 2018, and continuing into 2019, E&P companies began widespread usage of sand that is mined within the same basin as their well locations due to the lower transportation costs associated with this sand, which is almost entirely fine mesh. In 2018, and several preceding years, the amount of proppant used per well increased annually, aiding overall proppant demand. In 2019, the proppant usage per well is expected to remain relatively consistent with 2018. • Volatility in selling prices for proppants. The rapid decline in oil and gas prices that occurred later in 2014 and into 2016 reduced drilling activity and demand for proppants. As a result, the proppant market became oversupplied, which caused selling prices for all proppants to decline throughout the majority of 2016. In 2017 and the first half of 2018, the market experienced a turnaround and proppant pricing increased across all basins as growth outpaced the ability to add idled and new capacity back to the market. In the second half of 2018, decreased completions activity, combined with the opening of several new mines in basins with oil activity, namely the Permian, Eagle Ford and Mid-Con, resulted in a significant deterioration of proppant pricing in the second half of 2018. Some additional mines are expected to be commissioned in 2019, which may result in additional pricing pressure for certain products that are oversupplied. • Demand for in-basin delivery of proppant. A proppant vendor’s logistics capabilities have become an important differentiating factor when competing for business, on both a spot and contract basis. In recent years, many customers have sought to outsource proppant logistics and purchase proppant from a supplier’s own terminal (e.g., in-basin) or local mines, allowing them to focus on their core competencies, minimize inventory costs and maximize flexibility. Our terminal network in all major oil and gas basins and mines located within the Permian and Mid-Con basins are key differentiators for customers and enable us to provide proppants closer to the well site. • Emerging in-basin supply. In 2018 and continuing in 2019, multiple sand suppliers, including Covia, commissioned new sand mines in the Permian basin and, to a lesser extent, the Eagle Ford, and Mid-Con basins. Locating a plant in-basin significantly reduces the logistics costs, and therefore the overall delivered product cost. In the second half of 2018, we commissioned two plants in the Permian basin and one in the Mid-Con basin with a total added nameplate capacity of 8 million tons annually. These facilities allow us to offer a low cost local solution. At the same time in 2018, the total supply of in-basin sands has exceeded the demand in the Permian, putting pressure on market pricing for both local and Northern White proppants across North America. • Proppant intensity is expected to stablize. From 2015 through 2018 the amount of proppant used per well has increased as well laterals have become longer, frac stages have tightened and proppant per lateral foot has increased. In 2019, the amount of proppant used per well is expected to be relatively similar to 2018. • Shift toward finer proppant grades. Slickwater frac designs, which are generally less expensive, have become the dominant method for fracturing wells beginning in 2016 and continuing into recent periods. These designs rely on a higher percentage of fine grade sands compared to coarse grades. Currently, we estimate the market is over 80% fine grade (40/70 and 100 mesh) compared to roughly 55% fine grade in 2014. The strong demand for finer proppants negatively impacts production costs for facilities that have relatively coarse reserves. • E&P direct sales. Throughout 2018, E&P companies sourced an increasing percentage of their proppant directly from proppant suppliers to control cost and have better visibility across the entire supply chain. This trend presents an opportunity to work directly with the end user and provides improved communication between supplier and consumer with respect to job or grade changes and our percentage of sales directly to E&P companies increased in 2018. Concurrently with these direct sales, many E&P companies are looking to the supplier to coordinate the “last mile” of the supply chain, or the moving of product from the in-basin terminal to the well site. In response to this trend, we have entered into agreements with last mile solutions providers that allow us to provide this service to customers who desire it. • Reacting to changing conditions. In response to reduced customer demand, we idled mining operations at Shakopee, Minnesota, Brewer, Missouri, and Wexford, Michigan, and our Cutler, Missouri resin coating facility in the third quarter of 2018, adding to the previously idled mining operation at Hager Bay, Wisconsin. While we have also idled or reduced capacity at certain of our Northern White facilities and all of our Voca, Texas facilities, we have also commissioned two new facilities in the Permian basin in the third quarter 2018 and a facility in Oklahoma in the fourth quarter 2018. Through March 2019, we have reduced our Energy segment nameplate annual capacity by 6.9 million tons through these capacity reduction measures allowing us to lower fixed plant costs and consolidate volumes into lower cost operations. Industrial segment market trends: • Continued stable demand in Industrial end markets. The primary end markets served by production in our Industrial segment are glass, construction, ceramics, foundry, coatings, polymers and various other industries. Demand in our Industrial segment’s end markets is relatively stable and is primarily influenced by key macroeconomic drivers such as housing starts, light vehicle sales, repair and remodel activity, Industrial production as well as consumer trends. To the extent these demand drivers continue on their current trends, we expect that demand for products will remain relatively stable. • Favorable housing, commercial constructions and consumer trends. Certain submarkets and geographies within our Industrial segment continue to grow at attractive growth rates driven by attractive housing, commercial construction and various consumer trends which favor products that utilize our products. • Inflationary pressures and severe weather events in Mexico impacted Industrial segment results. Throughout 2017 and into 2018, Mexico experienced above-average inflation in energy costs with electricity and diesel costs. In addition, Mexico faced a number of severe weather-related events during 2017 that resulted in higher operating costs. How We Generate Our Sales We derive our sales from mining and processing silica sand products and other minerals that customers purchase for use in a wide variety of applications. Covia’s sales are primarily a function of the price per ton paid by the customer and the number of tons sold to the customer. The price invoiced reflects the cost of production, the cost of transportation to our distribution terminals or customer site and the cost of transloading the product from railcars to trucks, as applicable. Generally, logistics costs can comprise up to 70-80% of the delivered cost of products sold by the Energy segment, depending on the basin into which the product is delivered. We primarily sell products under supply agreements with terms that vary by contract. Generally, the supply agreements include both fixed prices and variable prices. Fixed price agreements have prices set for one or more years while variable price agreements are subject to regular price adjustments generally tied to market pricing or other market-related indices. Our supply agreements have a variety of volume provisions. While certain of our contracts have no minimum volume requirements, certain of our supply agreements require the customer to purchase a specified percentage of its product requirements or a minimum volume of product. Certain of these minimum volume contracts include a provision which may trigger penalties if the purchased volume does not meet the required minimums. Our Energy segment represented 60% of our revenues for the year ended December 31, 2018. A large portion of our sales are generated by our top customers, and the loss of, or significant reduction in, purchases by our largest customers could adversely affect our operations. During the years ended December 31, 2018 and 2017, our top ten customers were Energy customers and collectively represented 44% and 48% of our revenues, respectively. In the years ended December 31, 2018 and 2017, one customer exceeded 10% of revenues. This customer accounted for 13% of our revenues in each of 2018 and 2017. Our Industrial segment represented 40% of our revenues for the year ended December 31, 2018. The Costs of Conducting Our Business The principal costs involved in operating our business are logistics costs associated with transporting products from our production facilities to our terminals; production costs; labor costs; maintenance and repair costs at our production facilities; raw material costs; energy costs; stripping costs; and corporate costs. We own or lease most of our sand and other mineral reserves. We believe that the combination of owned and leased reserves helps us maintain a competitive cost position. Logistics Costs Logistics costs, including freight, railcar leases, demurrage and handling, represented approximately 36% and 34% of our revenues during the years ended December 31, 2018 and 2017, respectively. Freight costs primarily represent charges to transport our product by rail, but we also ship product by truck and barge. In order to move product by rail, we lease a substantial number of railcars under operating leases with durations ranging from three to 15 years. We currently have approximately 20,200 railcars (which includes approximately 4,000 customer railcars). Demurrage costs are charged by the railroads based on the time a railcar spends on the railroad property in excess of an allotted time which can vary significantly from period to period depending on railcar cycle times and delivery schedules. Handling costs are incurred at our distribution and terminal facilities to move product from one mode of transportation to another (e.g., railcar to truck) and to move product into storage facilities. Railcar storage costs are incurred when railcars are temporarily stored at a rail yard or storage facility. Labor Costs Labor costs associated with employees at our processing facilities represent the most significant cost of converting raw frac sand to finished product. Labor costs, including wages and benefits, represented approximately 11% and 12% of our revenues during the years ended December 31, 2018 and 2017, respectively. Approximately 34% of our workforce was party to collective bargaining contracts as of December 31, 2018. Raw Material Additives Costs We use a significant amount of raw material additives in the production of our products in both our Energy and Industrial segments. We purchase these products under supply agreements that contain annual pricing adjustments based on market dynamics. We also supply a portion of our resin requirements from our resin manufacturing facility located in Michigan. Raw material additives costs represented approximately 5% and 4% of revenues during the years ended December 31, 2018 and 2017, respectively. Maintenance and Repair Costs We capitalize the costs of our mining and processing equipment and depreciate them over their expected useful life. Depreciation, depletion, and amortization costs represented approximately 11% and 8% of revenues during the years ended December 31, 2018 and 2017, respectively. Repair and maintenance costs that do not involve the replacement of major components of our equipment and facilities are expensed through cost of goods sold as incurred. These repair and maintenance costs can be significant due to the abrasive nature of our products and represented approximately 4% of revenues during the each of the years ended December 31, 2018 and 2017. Energy Costs We consume energy, including natural gas, diesel and electricity, for mine and plant production. Natural gas is the primary fuel source used for drying sand in the commercial silica production process. Energy costs are typically negotiated on an annual or multi-year basis and certain input costs are subject to prevailing market prices for the underlying commodity (e.g., natural gas, diesel), which can vary during the year. Corporate Costs Our selling, general and administrative costs, which include the wages and benefits costs noted above, represented approximately 8% of revenues during each of the years ended December 31, 2018 and 2017. These costs are related to our corporate functions, including costs for the sales and marketing; research and development; finance; legal; and environmental, health and safety functions of our organization, as well as non-cash stock-based compensation expense. Merger with Fairmount Santrol On June 1, 2018 (“Merger Date”), Unimin completed a business combination (“Merger”) whereby Fairmount Santrol merged into a wholly-owned subsidiary of Unimin and ceased to exist as a separate corporate entity. Immediately following the consummation of the Merger, Unimin changed its name and began operating as Covia. The common stock of Fairmount Santrol was delisted from the NYSE prior to the market opening on June 1, 2018, and Covia commenced trading under the ticker symbol “CVIA” on that date. Upon the consummation of the Merger, the former stockholders of Fairmount Santrol (including holders of certain Fairmount Santrol equity awards) received, in the aggregate, $170 million in cash consideration and approximately 35% of the common stock of Covia. Approximately 65% of Covia common stock is owned by SCR-Sibelco NV (“Sibelco”), previously the parent company of Unimin. In connection with the Merger, we redeemed approximately 18.5 million shares of Unimin common stock from Sibelco in exchange for an amount in cash equal to (i) $660 million plus interest accruing at 5.0% per annum for the period from September 30, 2017 through June 1, 2018 less (ii) $170 million in cash paid to Fairmount Santrol stockholders. In the years ended December 31, 2018 and 2017, we incurred $53.0 million and $19.3 million of Merger-related expenses, respectively. Discontinued Operations On May 31, 2018, prior to, and as a condition to the closing of the Merger, Unimin contributed certain assets, comprising its global high purity quartz business in exchange for all of the stock of HPQ Co. and the assumption by HPQ Co. of certain liabilities. Unimin distributed 100% of the stock of HPQ Co. to Sibelco in exchange for certain shares of Unimin common stock held by Sibelco. HPQ Co. is presented as discontinued operations in our consolidated financial statements included in this Report. As part of the disposition of HPQ Co., Covia and HPQ Co. entered into the Tax Matters Agreement. Under the Tax Matters Agreement, Covia and HPQ Co. (and their affiliates) are responsible for income taxes required to be reported on their respective separate and group tax returns; however, HPQ Co. is responsible for any unpaid income taxes attributable to the HPQ Co. business prior to May 31, 2018, as well as any unpaid non-income taxes as of May 31, 2018 attributable to the HPQ Co. business (whether arising prior to May 31, 2018 or not). Covia is responsible for all other non-income taxes. We and HPQ Co. will equally bear any transfer taxes imposed as a result of the disposition of HPQ Co. Rights to refunds in respect of taxes will be allocated in the same manner as the responsibility for tax liabilities. How We Evaluate Our Business Our management uses a variety of financial and operational metrics to analyze our performance across our Energy and Industrial segments. The determination of segments is based on the primary industries we serve, our management structure and the financial information that is reviewed by our chief operating decision maker in deciding how to allocate resources and assess performance. We evaluate our performance of these segments based on their volumes sold, average selling price, and segment gross profit and associated per ton metrics. We evaluate the performance of our business based on company-wide operating cash flows, earnings before interest, taxes, depreciation and amortization (“EBITDA”) and Adjusted EBITDA, as defined in the Non-GAAP Financial Measures section below. We view these metrics as important factors in evaluating profitability and review these measurements frequently to analyze trends and make decisions. Segment Gross Profit Segment gross profit is a key metric we use to evaluate our operating performance and to determine resource allocation between segments. Segment gross profit is defined as segment revenue less segment cost of sales, excluding depreciation, depletion and amortization expenses, selling, general, and administrative costs and corporate costs. As a result of the Merger, inventories were written up to fair value under GAAP with certain amounts expensed through cost of sales thereby reducing segment gross profit. Additionally, for the year ended December 31, 2018, we booked charges to our Energy segment gross profit for the impairment of inventories located at recently idled facilities. Non-GAAP Financial Measures We define EBITDA as net income before interest expense, income tax expense (benefit), depreciation, depletion and amortization. Adjusted EBITDA is defined as EBITDA before non-cash stock-based compensation and certain other income or expenses, including restructuring charges, impairments, and Merger-related expenses. We believe EBITDA and Adjusted EBITDA are useful because they allow management to more effectively evaluate our normalized operations from period to period as well as provide an indication of cash flow generation from operations before investing or financing activities. Accordingly, EBITDA and Adjusted EBITDA do not take into consideration our financing methods, capital structure or capital expenditure needs. As previously noted, Adjusted EBITDA excludes certain non-operational income and/or costs, the removal of which improves comparability of operating results across reporting periods. However, EBITDA and Adjusted EBITDA have limitations as analytical tools and should not be considered as alternatives to, or more meaningful than, net income as determined in accordance with GAAP as indicators of our operating performance. Certain items excluded from EBITDA and Adjusted EBITDA are significant components in understanding and assessing a company’s financial performance, such as a company’s cost of capital and tax structure, as well as the historic costs of depreciable assets, none of which are components of EBITDA or Adjusted EBITDA. Additionally, Adjusted EBITDA is not intended to be a measure of free cash flow for management’s discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and debt service requirements. Adjusted EBITDA contains certain other limitations, including the failure to reflect our cash expenditures, cash requirements for working capital needs and cash costs to replace assets being depreciated and amortized, and excludes certain non-operational charges. We compensate for these limitations by relying primarily on our GAAP results and by using Adjusted EBITDA only as a supplement. Non-GAAP financial information should not be considered in isolation or viewed as a substitute for measures of performance as defined by GAAP. Although we attempt to determine EBITDA and Adjusted EBITDA in a manner that is consistent with other companies in our industry, our computation of EBITDA and Adjusted EBITDA may not be comparable to other similarly titled measures of other companies due to potential inconsistencies in the methods of calculation. We believe that EBITDA and Adjusted EBITDA are widely followed measures of operating performance. The following table sets forth a reconciliation of net income, the most directly comparable GAAP financial measure, to EBITDA and Adjusted EBITDA: Results of Operations The following table presents an overview of certain operating data by segment for the years ended December 31, 2018, 2017 and 2016, which are discussed in further detail following the consolidated overview. Financial results for the year ended December 31, 2018 include our results subsequent to the Merger on June 1, 2018. Our year ended December 31, 2018 reported financial results include legacy Unimin and legacy Fairmount Santrol for the twelve months and seven months ended December 31, 2018, respectively. Our reported financial results for the year ended December 31, 2017 and December 31, 2016 only include legacy Unimin. Our financial results, and the table above, exclude HPQ Co. (legacy Unimin’s Electronics segment), which was distributed to Sibelco at the close of the Merger and is reported as discontinued operations in our consolidated financial statements for 2018, 2017, and 2016. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 Revenues Revenues increased $547.8 million, or 42%, to $1.8 billion for the year ended December 31, 2018 compared to $1.3 billion for the year ended December 31, 2017. With the inclusion of legacy Fairmount Santrol revenues of $477.3 million for the five-month period ended May 31, 2018 and $959.8 million for the year ended December 31, 2017, our total revenues increased $65.3 million, or 3%. Our revenues increased due to improved pricing over the prior year period. Revenues in the Energy segment increased $458.5 million, or 70%, to $1.1 billion for the year ended December 31, 2018 compared to $655.9 million for the year ended December 31, 2017. With the inclusion of legacy Fairmount Santrol Energy revenues of $421.5 million for the five-month period ended May 31, 2018 and $834.7 million for the year ended December 31, 2017, Energy segment revenues increased $45.3 million, or 3%. Energy segment revenues increased primarily due to demand-driven price increases in the first half of 2018 as compared to a lower pricing environment throughout 2017. Volumes sold into the Energy segment were 16.1 million tons in the year ended December 31, 2018 compared to 11.2 million tons in the year ended December 31, 2017, an increase of 4.9 million tons, or 44%. Legacy Fairmount Santrol Energy volumes were 4.6 million tons for the five month period ended May 31, 2018 and 10.3 million tons for the year ended December 31, 2017. With the inclusion of legacy Fairmount Santrol Energy volumes in each respective period, Energy volumes decreased 0.8 million tons or 4% due to lower market demand in the second half of 2018. Revenues in the Industrial segment increased $89.3 million to $728.5 million for the year ended December 31, 2018 compared to $639.2 million for the year ended December 31, 2017. With the inclusion of legacy Fairmount Santrol Industrial revenues of $55.8 million for the five month period ended May 31, 2018 and $125.1 million for the year ended December 31, 2017, Industrial segment revenues increased $20.0 million, or 3%. Industrial revenues increased due to the annual price increase implemented at the beginning of 2018. Volumes sold into the Industrial segment increased 1.4 million tons, or 12%, to 13.5 million tons in the year ended December 31, 2018 compared to 12.1 million tons in the year ended December 31, 2017. Legacy Fairmount Santrol Industrial volumes were 1.0 million tons for the five month period ended May 31, 2018 and 2.5 million tons for the year ended December 31, 2017. With the inclusion of legacy Fairmount Santrol Industrial volumes in each respective period, Industrial volumes were relatively flat over the prior year. Segment Gross Profit Total segment gross profit was $462.2 million for the year ended December 31, 2018 compared to $366.4 million for the year ended December 31, 2017, an increase of $95.8 million, or 26%. With the inclusion of legacy Fairmount Santrol segment gross profit of $158.1 million for the five months ended May 31, 2018 and $288.6 million for the year ended December 31, 2017, segment gross profit decreased $34.7 million, or 5%. Total segment gross profit for the year ended December 31, 2018 includes $28.3 million of expense related to the $30.2 million write-up of legacy Fairmount Santrol’s inventories to fair value as a result of the Merger under GAAP, $6.7 million in inventory write-offs at facilities idled in 2018 and $21.4 million for the combined loss from our local facilities due to start-up activities and higher costs associated with scaling production. Energy segment gross profit was $259.0 million for the year ended December 31, 2018 compared to $181.7 million for the year ended December 31, 2017, an increase of $77.3 million. With the inclusion of legacy Fairmount Santrol Energy segment gross profit of $136.7 million for the five months ended May 31, 2018 and $234.6 million for the year ended December 31, 2017, Energy segment gross profit decreased $20.6 million, or 5%. Energy segment gross profit for the year ended December 31, 2018 includes $24.6 million of expense related to the write-up of legacy Fairmount Santrol’s inventories to fair value as a result of the Merger under GAAP, $6.7 million in inventory write-offs at recently idled facilities and $21.4 million in losses from the start up and scaling of local sand facilities. The remaining Energy segment gross profit decrease year-over-year was primarily due to the decline in volumes sold. Industrial segment gross profit was $203.2 million for the year ended December 31, 2018 compared to $184.7 million for the year ended December 31, 2017, an increase of $18.5 million, or 10%. With the inclusion of legacy Fairmount Santrol Industrial segment gross profit of $21.4 million for the five months ended May 31, 2018 and $54.0 million for the year ended December 31, 2017, Industrial segment gross profit decreased $14.1 million, or 6%. Industrial segment gross profit includes $3.7 million of expense related to the write-up of legacy Fairmount Santrol’s inventories to fair value under GAAP. The remaining Industrial segment gross profit decrease year-over-year was primarily due to higher production and energy costs in the U.S. and Mexico coupled with greater foreign exchange impact on the Mexican-Peso denominated revenues. Selling, General and Administrative Expenses Selling, general and administrative expenses (“SG&A”) increased $46.5 million, or 47%, to $145.6 million for the year ended December 31, 2018 compared to $99.1 million for the year ended December 31, 2017. SG&A includes non-cash stock compensation expense of $5.8 million for the year ended December 31, 2018. Legacy Fairmount Santrol SG&A for the five months ended May 31, 2018 was $44.2 million and included $8.5 million in non-cash stock compensation expenses. Legacy Fairmount Santrol SG&A for the year ended December 31, 2017 was $104.9 million excluding Merger-related expenses and including $10.1 million in non-cash stock compensation expense. With the inclusion of legacy Fairmount Santrol SG&A, SG&A decreased $14.3 million, or 7%, primarily due to lower variable compensation in 2017 which was offset by higher stock compensation expenses in 2018. Depreciation, Depletion and Amortization Depreciation, depletion and amortization increased $94.9 million, or 93%, to $196.5 million for the year ended December 31, 2018 compared to $101.6 million for the year ended December 31, 2017. The higher expense was due to the write-up to fair value of the legacy Fairmount Santrol property, plant, and equipment and intangibles under GAAP, as well as the effect of assets placed in service largely due to the commissioning of the West Texas and Oklahoma mining facilities in the fourth quarter of 2018. Other Operating Expense (Income), net Other operating expense (income), net decreased $8.1 million to income of $5.0 million for the year ended December 31, 2018 compared to $3.1 million of expense in the year ended December 31, 2017. The decrease in other operating expense for the year ended December 31, 2018 was largely due to a reduction of a contingent consideration liability resulting in income to Covia. The remaining change in other operating expense was related to foreign currency fluctuations. Goodwill and Other Asset Impairments We incurred goodwill and other asset impairments of $267.0 million in the year ended December 31, 2018. Goodwill and other asset impairments included non-cash charges for the impairment of assets from recently idled facilities and the impairment of goodwill in the Energy segment due to the current business conditions and the decline in our stock price over the last half 2018. There were no impairments in the year ended December 31, 2017. Restructuring Charges We incurred restructuring charges of $22.0 million in the year ended December 31, 2018. Restructuring charges included expenses associated with restructuring activities as a result of the Merger and idled plant facilities, including, severance, relocation and contract terminations. There were no restructuring charges in the year ended December 31, 2017. Operating Income (Loss) from Continuing Operations Operating income (loss) from continuing operations decreased $326.5 million to a loss of $163.8 million for the year ended December 31, 2018 compared to income of $162.7 million for the year ended December 31, 2017. The change in operating income from continuing operations for the year ended December 31, 2018 was largely due to Energy segment goodwill and asset impairments of $267.0 million and restructuring charges of $22.0 million. Interest Expense, net Interest expense increased $45.6 million, or 310%, to $60.3 million for the year ended December 31, 2018 compared to $14.7 million for the year ended December 31, 2017. The increase in expense for the year ended December 31, 2018 is primarily due to the increased debt that we placed to finance the Merger. Other Non-Operating Expense, net Other non-operating expense, net increased $28.8 million to $54.8 million in the year ended December 31, 2018 compared to $26.0 million in the year ended December 31, 2017. The increase is due to legal, accounting, and other expenses incurred in connection with the Merger and pension charges related to settlements. Provision (Benefit) for Income Taxes The provision for income taxes increased $12.8 million to $4.0 million for the year ended December 31, 2018 compared to a benefit of $8.8 million for the year ended December 31, 2017. Income before income taxes decreased $401.1 million to a loss of $279.0 million for the year ended December 31, 2018 compared to income of $122.1 million for the year ended December 31, 2017. The increase in tax expense recorded during the year ending December 31, 2018 was related to the non-deductibility of expense related to impairment of goodwill and a valuation allowance set up for interest expense disallowed under IRC Section 163(j), which management believes, more likely than not, will not be realized. The Tax Cuts and Jobs Act of 2017 (the “Tax Act”), effective December 22, 2017, established a corporate income tax rate of 21%, replacing the 35% rate, created a territorial tax system rather than a worldwide system, which generally eliminates the U.S. federal income tax on dividends from foreign subsidiaries, and included provisions limiting deductibility of interest expense. The transition to a territorial system included a one-time transition tax on certain unremitted foreign earnings. For 2017, we recognized a net provisional tax benefit of $39.3 million consisting of a tax benefit of $42.2 million for remeasurement of deferred taxes and tax expense of $2.9 million for the transition tax. We applied the guidance in Staff Accounting Bulletin 118 when accounting for the enactment-date effects of the Tax Act in 2017 and throughout 2018. At December 31, 2017, we had substantially completed our provisional analysis of the income tax effects of the Tax Act and recorded a reasonable estimate in 2017 of such effects. During 2018, we refined our calculations, evaluated changes in interpretations and assumptions that we had made, applied additional guidance issued by the U.S. Government, and evaluated actions and related accounting policy decisions we have made. We have completed our accounting for all of the enactment-date income tax effects of the Tax Act and did not identify any material changes to the provisional, net, one-time charge for the transition tax on certain unremitted foreign earnings or for the re-measurement of deferred taxes for the year ended December 31, 2017, related to the Tax Act. Net Income (Loss) Attributable to Covia Net income attributable to Covia decreased $424.7 million to a loss of $270.5 million for the year ended December 31, 2018 compared to $154.2 million for the year ended December 31, 2017. The change in net income attributable to Covia is due to the factors previously noted. Adjusted EBITDA Adjusted EBITDA increased $73.6 million to $331.2 million for the year ended December 31, 2018 compared to $257.6 million for the year ended December 31, 2017. Adjusted EBITDA for 2018 excludes the impact of $5.8 million of non-cash stock compensation expense, $267.0 million of goodwill and other asset impairments, $27.7 million in restructuring charges, and $53.0 million in Merger-related expenses. Adjusted EBITDA for 2018 includes $28.3 million of additional expense included in cost of goods sold related to the write-up of legacy Fairmount Santrol’s inventories to fair value in connection with the Merger, and $24.1 million for the combined loss from our local facilities due to start-up costs and higher costs associated with scaling production, which was partially offset by the positive impact of $5.0 million revaluation of a contingent consideration liability. The change in Adjusted EBITDA is largely due to the incremental EBITDA from the legacy Fairmount Santrol business which was offset by lower volumes and lower gross profit for the reasons previously noted above. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 Revenues Revenues were $1,295.1 million for the year ended December 31, 2017 compared to $982.7 million for the year ended December 31, 2016, an increase of $312.4 million, or 32%. This increase was primarily due to an increase in volumes and average selling price in our Energy segment. Revenues in the Energy segment were $655.9 million for the year ended December 31, 2017 compared to $349.0 million for the year ended December 31, 2016, an increase of $306.9 million, or 88%. The increase in Energy segment revenues was primarily due to growth in demand for frac sand as well as increased prices. Total volumes sold in the Energy segment were 11.2 million tons in the year ended December 31, 2017 compared to 6.8 million tons in the year ended December 31, 2016, an increase of 4.4 million tons, or 65%. In addition, the average selling prices for all proppants during 2017 increased as compared to the prior year by approximately 14% due to improving supply and demand dynamics driven by higher oil prices and corresponding increases in frac sand demand. Revenues in the Industrial segment were $639.2 million for the year ended December 31, 2017 compared to $625.7 million for the year ended December 31, 2016, an increase of $13.5 million, or 2%. Volumes sold in the Industrial segment remained consistent at 12.1 million tons for both the years ended December 31, 2017 and 2016. The revenues increase in the Industrial segment was driven by an increase in average selling price during 2017, which was due to changes in product mix as well as price increases for certain products. There was no revenue generated in the Corporate & Other segment for the year ended December 31, 2017 compared to $8.0 million in the year ended December 31, 2016, a decrease of $8.0 million. Revenue in this segment declined because Unimin transferred Unimin Brazil to Sibelco in March 2016 and sold Unimin Venezuela to an unrelated third party in April 2016. There was no revenue generated by the Corporate & Other segment subsequent to April 2016. Segment Gross Profit Segment gross profit was $366.4 million for the year ended December 31, 2017 compared to $230.0 million for the year ended December 31, 2016, an increase of $136.4 million. The increase in segment gross profit was primarily due to the increase in volumes sold and average selling prices in our Energy segment. Energy segment gross profit was $181.7 million for the year ended December 31, 2017 compared to $38.0 million for the year ended December 31, 2016, an increase of $143.7 million. The increase was due primarily to the increased volumes and increased selling prices. Industrial segment gross profit was $184.7 million for the year ended December 31, 2017 compared to $188.9 million for the year ended December 31, 2016, a decrease of $4.2 million. Industrial segment gross profit during the year was primarily impacted by higher energy costs and weather-related events in Mexico, increased lease costs for mobile equipment and temporary disruptions at certain customer facilities which impacted volumes during the year. There was no gross profit generated in the Corporate & Other segment for the year ended December 31, 2017 compared to $3.1 million for the year ended December 31, 2016. The decrease in gross profit in the Corporate & Other segment was driven by the transfer of Unimin Brazil and sale of Unimin Venezuela in early 2016. Accordingly, this segment has generated no gross profit subsequent to April 2016. Selling, General, and Administrative Expenses SG&A was $99.1 million for the year ended December 31, 2017 compared to $83.8 million for the year ended December 31, 2016, an increase of $18.0 million, or 22%. The increase in SG&A during the year ended December 31, 2017 compared to the year ended December 31, 2016 was primarily the result of higher compensation related expense of $9.3 million, higher infrastructure and communications technologies related costs of $3.2 million and increased bad debt expense of $3.0 million as 2016 benefitted from the reversal of a provision for bad debt. Depreciation, Depletion, and Amortization Depreciation, depletion and amortization remained relatively consistent for the year ended December 31, 2017 compared to the year ended December 31, 2016. Depreciation, depletion and amortization was $101.6 million for the year ended December 31, 2017 and was $105.0 million for the year ended December 31, 2016. Goodwill and Other Asset Impairments There were no goodwill and other asset impairments during the year ended December 31, 2017. Goodwill and other asset impairments were $9.6 million for the year ended December 31, 2016. The goodwill and other asset impairments of $9.6 million for the year ended December 31, 2016 represent long-lived asset impairment charges for a terminal that was closed and the write down of undeveloped greenfield land. Restructuring charges For the year ended December 31, 2016, there was a $2.7 million restructuring provision recorded for the closure of several sales offices. Other Operating Expense (Income), net Other operating expense (income), net was $3.1 million for the year ended December 31, 2017 and $4.3 million for the year ended December 31, 2016. Other operating expense (income), net of $3.1 million for the year ended December 31, 2017 principally consisted of the unfavorable impact of foreign exchange. Other operating expense (income), net of $4.3 million for the year ended December 31, 2016 primarily consisted of a $3.0 million penalty to defer the delivery of railcars that were due to be delivered in 2016; and the unfavorable impact of foreign exchange. Operating Income (Loss) from Continuing Operations Operating income (loss) from continuing operations was $162.7 million for the year ended December 31, 2017, an increase of $138.2 million compared to $24.5 million for the year ended December 31, 2016 due to the factors noted above. Interest Expense, net Interest expense, net was $14.7 million for the year ended December 31, 2017 compared to $24.0 million for the year ended December 31, 2016, a decrease of $9.3 million, or 39%. The change in interest expense, net was due to having a lower amount of debt outstanding during 2017 compared to 2016. Other Non-Operating Expense, net Other non-operating expense, net was $26.0 million for the year ended December 31, 2017 compared to $31.6 million for the year ended December 31, 2016. Other non-operating expense, net for the year ended December 31, 2017, primarily consisted of Merger-related costs. Other non-operating expense, net for the year ended December 31, 2016 included the loss on the sale of Unimin Venezuela of $12.9 million and a settlement charge of $13.3 million for our U.S. pension plan. The settlement charge resulted from a restructuring program where a significant number of employees opted to take a lump sum distribution which exceeded the sum of our service and interest costs for the year ended December 31, 2016. Provision (Benefit) for Income Taxes As a result of the enactment of the Tax Act, we were required to adjust deferred tax assets and liabilities as of December 22, 2017 to comply with ASC 740-10-25-47, which requires the effect of a change in tax laws or rates to be recognized as of the date of enactment. Accordingly, we recorded a deferred income tax benefit of $39.3 million for the year ended December 31, 2017. The income tax benefit was $8.8 million for the year ended December 31, 2017 compared to an income tax benefit of $25.3 million for the year ended December 31, 2016. The decrease was due to increased profit before income taxes, offset primarily by the deferred income tax benefit of the Tax Act for the year ended December 31, 2017. The tax rate for the year ended December 31, 2017 is not predictive of future tax rates due to the deferred income tax benefit of the Tax Act. The tax rate would have been 24.9% without the tax effects of the deferred income tax benefit of the Tax Act. Net Income (Loss) Attributable to Covia Net income attributable to Covia increased $150.5 million to net income of $154.2 million for the year ended December 31, 2017 compared to $3.7 million for the year ended December 31, 2016 due to the factors noted above. Adjusted EBITDA Adjusted EBITDA increased $120.3 million to $257.6 million for the year ended December 31, 2017 compared to $139.5 million for the year ended December 31, 2016 primarily due to increases in volumes and average selling prices within our energy segment. Liquidity and Capital Resources Overview Our liquidity is principally used to service our debt, meet our working capital needs, and invest in both maintenance and organic growth capital expenditures. Historically, we have met our liquidity and capital investment needs with funds generated from operations and the issuance of debt, if necessary. On the Merger Date, we entered into a credit and guarantee agreement with a group of banks, financial institutions, and other entities with Barclays Bank PLC, serving as administrative agent, and Barclays Bank PLC and BNP Paribas Securities Corp., serving as joint lead arrangers and joint bookrunners, for the $1.65 billion Term Loan and the $200 million Revolver. The Term Loan matures seven years after the Merger Date and amortizes in equal quarterly installments in an amount equal to 1% per year beginning with the first full fiscal quarter after the Merger Date, with the balance due at maturity. Loans under the Term Loan would be prepaid with, subject to various exceptions, (a) 100% of the net cash proceeds of all non-ordinary course asset sales or dispositions and insurance proceeds, (b) 100% of the net cash proceeds of issuances of indebtedness and (c) 50% of annual excess cash flow (with stepdowns to 25% and 0% based on total net leverage ratio levels). Voluntary prepayments of the Term Loan will be permitted at any time without premium or penalty other than customary “breakage” costs with respect to LIBOR borrowings. The Revolver matures five years after the Merger Date. Voluntary reductions of the unused portion of the Revolver will be allowed at any time. The Revolver includes a total net leverage ratio covenant, tested on a quarterly basis, of no more than 4.00:1.00. Interest on the Term Loan and Revolver accrues at a per annum rate of either (at our option) (a) LIBOR plus a spread or (b) the alternate base rate plus a spread. The spread will vary depending on our total net leverage ratio [(defined as the ratio of debt (less up to $150 million of cash) to EBITDA for the most recent four fiscal quarter period)], as follows: The credit agreement provides that the interest rate spreads set forth in the table above will each be reduced by 0.25% if our corporate credit ratings issued in connection with the initial syndication of the Term Loan and Revolver are BB- (with a stable or better outlook) or higher and Ba3 (with a stable or better outlook) or higher from S&P and Moody’s, respectively. As of the date hereof, S&P and Moody’s have announced that our ratings are at or above such levels. The Term Loan and Revolver are guaranteed by all of our wholly-owned material restricted subsidiaries (including Bison Merger Sub, LLC, as successor to Fairmount Santrol, and all of the wholly-owned material restricted subsidiaries of Fairmount Santrol), subject to certain exceptions. In addition, subject to various exceptions, the Term Loan and Revolver are secured by substantially all of our assets and those of each guarantor, including, but not limited to (a) a perfected first-priority pledge of all of the capital stock held by us or any guarantor of each existing or subsequently acquired or organized wholly-owned restricted subsidiary (no more than 65% of the voting stock of any foreign subsidiary) and (b) perfected first-priority security interests in substantially all of our tangible and intangible assets and those of each guarantor. The Term Loan and Revolver contain customary representations and warranties, affirmative covenants, negative covenants and events of default. Negative covenants include, among others, limitations on debt, liens, asset sales, mergers, consolidations and fundamental changes, dividends and repurchases of equity securities, repayments or redemptions of subordinated debt, investments, transactions with affiliates, restrictions on granting liens to secure obligations, restrictions on subsidiary distributions, changes in the conduct of the business, amendments and waivers in organizational documents and junior debt instruments and changes in the fiscal year. In addition, the credit agreement permits us to add one or more incremental term loan facilities and/or increase the commitments under the Revolver in an aggregate principal amount up to the sum of (i) $250 million, plus (ii) an amount of incremental facilities so that, after giving effect to any such incremental facility, on a pro forma basis, our total net leverage ratio would not exceed 2.75:1.00, plus (iii) an amount equal to all voluntary prepayments of the Term Loan. In addition to incremental term loan facilities and Revolver increases, this incremental credit capacity can be allowed to be utilized in the form of (a) senior unsecured notes or loans, subject to a pro forma total net leverage ratio of up to 3.75:1.00, (b) senior secured notes or loans that are secured by the collateral on a junior basis, subject to a pro forma total net leverage ratio of up to 3.25:1.00, or (c) senior secured notes that are secured by the collateral on a pari passu basis, subject to a pro forma total net leverage ratio of up to 2.75:1.00. The proceeds of the Term Loan were used to primarily repay certain debt of legacy Fairmount Santrol and legacy Unimin, which included additional debt incurred to fund the Cash Redemption and to pay $170 million to Fairmount Santrol stockholders as part of the Merger. See Note 11 in the consolidated financial statements included in this Report for further detail regarding the credit agreement. As of December 31, 2018, we had outstanding Term Loan borrowings of $1.64 billion and cash on-hand of $134.1 million. In addition, our Revolver can provide additional liquidity, if needed. As of December 31, 2018, we had $200.0 million of availability under our Revolver with $11.7 million committed to letters of credit, leaving net availability at $188.3 million. Our operations are capital intensive and short-term capital expenditures related to certain strategic projects are expected to be substantial. As of the date of this Report, we believe that our liquidity will be sufficient to meet cash obligations, including working capital requirements, anticipated capital expenditures, and scheduled debt service over the next 12 months. Working Capital Working capital is the amount by which current assets exceed current liabilities, excluding cash and debt, and represents a measure of liquidity. Our working capital was $216.3 million at December 31, 2018 and $210.7 million at December 31, 2017. The increase in working capital is primarily due to the Merger with Fairmount Santrol, whose working capital is included in December 31, 2018. This increase was partially offset by lower working capital requirements of our Energy segment due to the downturn in the proppant industry. Cash Flow Analysis Net Cash Provided by (Used in) Operating Activities Operating activities consist primarily of net income adjusted for non-cash items, including depreciation, depletion, and amortization, and the effect of changes in working capital. Net cash provided by operating activities was $247.4 million for the year ended December 31, 2018 compared with $232.2 million provided in the year ended December 31, 2017. This $15.2 million variance was primarily the result of a $424.7 million decrease in net income, partially offset by a $91.3 million increase in depreciation, depletion, and amortization expense (largely due to purchase accounting adjustments), a $267.4 million non-cash impairment of goodwill and other assets, non-cash restructuring charges of $21.2 million, and $51.6 million in other net decreases to reconcile net income to net cash provided by operating activities, primarily related to the change in our deferred tax provision. Additionally, changes in working capital resulted in a source of cash of $22.6 million. Net cash provided by operating activities was $232.2 million for the year ended December 31, 2017 compared with $93.2 million provided in the year ended December 31, 2016. This $139.0 million increase was the result of the improved operating results in 2017 and decrease in working capital during 2017. Net Cash Used in Investing Activities Investing activities consist primarily of capital expenditures for growth and maintenance. Capital expenditures generally are for expansions of production or terminal facilities, land and reserve acquisition or maintenance related expenditures which are generally for asset replacement and health, safety, and quality improvements. Net cash used in investing activities was $356.6 million for the year ended December 31, 2018 compared to $107.4 million used for the year ended December 31, 2017. The $249.2 million variance was primarily related to the increase in capital expenditures of $154.8 million as well as Merger-related cash flows, including the $31.0 million transferred to HPQ Co., and $64.7 million in net payments to Fairmount Santrol stockholders. Capital expenditures of $264.1 million, including stripping costs, in the year ended December 31, 2018 were primarily focused on construction of new facilities in West Texas and Seiling, Oklahoma, completion of the expansion of the Utica, Illinois, and Oregon facilities, and expanding capacity at the Canoitas facility in Mexico, as well as our nepheline syenite operations in Canada. Net cash used in investing activities was $107.4 million for the year ended December 31, 2017 compared to $71.3 million of net cash used in investing activities for the year ended December 31, 2016. The $36.1 million increase was primarily the result of higher capital expenditures. Capital expenditures were $108.9 million in the year ended December 31, 2017 were primarily focused on a new facility in West Texas; completion of several expansion projects at our Utica, Illinois and Oregon, Illinois facilities to support growth in the energy business; and to expand capacity at our Canoitas facility in Mexico. For 2019, we expect capital expenditures to be in a range of $80 million to $100 million. This primarily includes maintenance capital expenditures and carryover spend on our greenfield mine projects in West Texas and Oklahoma and growth spend in Canada and Mexico. Net Cash Provided by (Used in) Financing Activities Financing activities consist primarily of borrowings under our Term Loan and repayments of debt of Unimin and Fairmount Santrol, in addition to the Cash Redemption payment, as a result of the Merger. Net cash used in financing activities was $66.8 million in the year ended December 31, 2018 compared to $0.5 million used in the year ended December 31, 2017. The $66.3 million variance is due to borrowing the $1.65 billion Term Loan, partially offset by $1.11 billion in payments on Unimin and Fairmount Santrol debts, a $520.4 million Cash Redemption payment, and $41.2 million in Merger related debt refinancing fees. Net cash used by financing activities was $0.5 million in the year ended December 31, 2017 compared to $197.6 million used in the year ended December 31, 2016. In 2016, we repaid $210 million of borrowings compared to $0.1 million in 2017. Inflation We conduct the majority of our business operations in the U.S., Canada, and Mexico. During the year ended December 31, 2018, certain inflationary pressures in Mexico impacted costs during the period relative to year ended December 31, 2017. Off-Balance Sheet Arrangements We have no undisclosed off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations As of December 31, 2018, we have contractual obligations for long-term debt, capital leases, operating leases, terminal operating costs, capital commitments, purchase obligations, and other long-term liabilities. Substantially all of the operating lease obligations are for railcars. Additionally, we are obligated through 2048 for contingent consideration on Propel SSP® and the balance of this contingent consideration at December 31, 2018 is $4.5 million. See Note 19 in the Notes to our Consolidated Financial Statements for further detail regarding our commitments and contingencies. Environmental Matters We are subject to various federal, state and local laws and regulations governing, among other things, hazardous materials, air and water emissions, environmental contamination and reclamation and the protection of the environment and natural resources. We have made, and expect to make in the future, expenditures to comply with such laws and regulations, but cannot predict the full amount of such future expenditures. We may also incur fines and penalties from time to time associated with noncompliance with such laws and regulations. As of December 31, 2018 and 2017, we had $31.2 million and $12.5 million, respectively, accrued for Asset Retirement Obligations, which include future reclamation costs. The increase is primarily related to purchase accounting adjustments recorded in the third and fourth quarter of 2018 to increase the Asset Retirement Obligations for Fairmount Santrol mines acquired in the Merger. There were no other significant changes with respect to environmental liabilities or future reclamation costs. We discuss certain environmental matters relating to our various production and other facilities, certain regulatory requirements relating to human exposure to crystalline silica and our mining activity and how such matters may affect our business in the future under the “Regulation and Legislation” section in “Item 1 - Business” and “Item 1A - Risk Factors” in Part I of this Report. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported revenues and expenses during the reporting periods. We evaluate these estimates and assumptions on an ongoing basis and base our estimates on historical experience, current conditions and various other assumptions that are believed to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities as well as identifying and assessing the accounting treatment with respect to commitments and contingencies. Our actual results may materially differ from these estimates. These critical accounting policies and estimates should be read in conjunction with our consolidated financial statements as filed in this Report. Listed below are the accounting policies we believe are critical to our financial statements due to the degree of uncertainty regarding the estimates or assumptions involved, and that we believe are critical to the understanding of our operations. Impairment of Long-Lived Assets, Definite-Lived Intangible Assets and Goodwill We periodically evaluate whether current events or circumstances indicate that the carrying value of our long-lived assets, including property, plant and equipment, mineral reserves or mineral rights and definite-lived intangible assets may not be recoverable. If such circumstances are determined to exist, an estimate of future cash flows produced by the asset group or individual assets within the asset group is compared to the carrying value to determine whether an impairment exists. If an asset is determined to be impaired, the loss is measured based on quoted market prices in active markets, if available. If quoted market prices are not available, the estimate of fair value is based on various valuation techniques, including a discounted value of estimated future cash flows. A detailed determination of the fair value may be carried forward from one year to the next if certain criteria have been met. We report an asset to be disposed of at the lower of its carrying value or its estimated fair value. Factors we generally consider important in our evaluation and that could trigger an impairment review of the carrying value of the asset group or individual assets within the asset group include expected operating trends, significant changes in the way assets are used, underutilization of our tangible assets, discontinuance of certain products by us or by our customers, and significant negative industry or economic trends. The recoverability of the carrying value of our development stage mineral properties is dependent upon the successful development, start-up and commercial production of our mineral deposits and related processing facilities. Our evaluation of mineral properties for potential impairment primarily includes assessing the existence or availability of required permits and evaluating changes in our mineral reserves, or the underlying estimates and assumptions, including estimated production costs. Assessing the economic feasibility requires certain estimates, including the prices of products to be produced and processing recovery rates, as well as operating and capital costs. The evaluation of goodwill for possible impairment includes a qualitative assessment of macroeconomic conditions, industry and market environments, overall performance of the reporting unit and specific events. Goodwill is evaluated annually as of October 31 or more frequently if we believe indicators of impairment exist. If the qualitative assessment indicates it is more likely than not that the fair value of a reporting unit is less than its carrying amount, including goodwill, then a quantitative assessment is performed which requires estimating fair value using one or a combination of valuation techniques, such as discounted cash flows or based on comparable companies or transactions. These valuations require us to make estimates and assumptions regarding future operating results, cash flows, changes in working capital and capital expenditures, selling prices, profitability, and the cost of capital. Deviations from these assumptions and estimates could produce a materially different result. As a result of declining market conditions in the Energy segment and a decline in our share price, our evaluation of goodwill provided impairment charges of $217.1 million. See Note 10 in the consolidated financial statements for further detail. Asset Retirement Obligations Initially, we recognize a liability for asset retirement obligations, including reclamation costs at fair value, upon acquisition, construction or development and/or through the normal operation of the asset, if sufficient information exists to reasonably estimate the fair value of the liability. These obligations generally include the estimated net future costs of dismantling, restoring and reclaiming operating mines and related mine sites, in accordance with federal, state, local regulatory and land lease agreement requirements. We also factor in other assumptions, such as inflation, market risk premium, and discount rate, in estimating the fair value of the liability. The liability is accreted over time through periodic charges to earnings. In addition, the asset retirement cost is capitalized as part of the asset’s carrying value and amortized over the life of the related asset. Reclamation costs are periodically adjusted to reflect changes in the estimated present value resulting from the passage of time and revisions to the estimates of either the timing or amount of the reclamation and abandonment costs. The reclamation obligation is based on when spending for an existing environmental disturbance will occur. If the asset retirement obligation is settled for an amount other than the carrying amount of the liability, a gain or loss is recognized on settlement. We review, on an annual basis, unless otherwise deemed necessary, the reclamation obligation at each mine site. Future remediation costs for inactive mines are accrued based on management’s best estimate at the end of each period of the costs expected to be incurred at a site. Such cost estimates include, where applicable, ongoing care, maintenance and monitoring costs. Changes in estimates at inactive mines are reflected in earnings in the period an estimate is revised. Accounts Receivable and Allowance for Doubtful Accounts Trade accounts receivable are recognized at their invoiced amounts and do not bear interest. Credit is extended based on evaluation of a customer’s financial condition and, generally, collateral is not required. Accounts receivable are generally due between 30 and 60 days, and are stated at amounts due from customers net of an allowance for doubtful accounts. Accounts outstanding longer than the payment terms are considered past due. We determine our allowance by considering a number of factors, including the length of time trade accounts receivable are past due, our previous loss history, the customer’s current ability to pay its obligation to us, and the condition of the general economy and the industry as a whole. Ongoing credit evaluations are performed. We write-off accounts receivable when they are deemed uncollectible, and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. Employee Benefit Plans We provide a range of benefits to our employees and retired employees, including pensions and post-retirement healthcare and life insurance benefits. We record annual amounts relating to these plans based on calculations specified by GAAP, which include various actuarial assumptions, including discount rates, assumed rates of returns, compensation increases, turnover rates, mortality rates and healthcare cost trend rates. We review the actuarial assumptions on an annual basis and makes modifications to the assumptions based on current rates and trends when it is deemed appropriate to do so. As required by GAAP, the effect of changes in assumptions are generally recorded or amortized over future periods. We believe that the assumptions utilized in recording our obligations under the plans are reasonable based on advice from actuaries. In 2018, the assumptions included discount rates from 3.90% to 8.75% and rates of return from 4.29% to 7.70%. Equity Awards We estimate future compensation expense related to equity-based awards through a fair value method and record the expense for awards over the vesting period. Fair value methods use a valuation model to theoretically value stock option grants even though they are not available for trading and are of longer duration. The Black-Scholes-Merton option-pricing model that we use includes the input of certain variables that are dependent on future expectations, including the expected lives of our options from grant date to exercise date, the volatility of our common stock, and our expected dividend rate of zero. Our estimates of these variables are made for the purpose of using the valuation model to determine an expense for each reporting period and are not subsequently adjusted. We recognize forfeitures when they occur. We value our restricted stock units at the closing price of our stock as of the date of grant. Fair Value of Derivatives We record derivative instruments used to hedge interest rate exposure on the variable-rate debt obligations at their fair values. Changes in the fair value of derivatives are recorded each period in other accumulated comprehensive income. For derivatives not designated as hedges, the gain or loss is recognized in current earnings. No components of our hedging instruments were excluded from the assessment of hedge effectiveness. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for making fixed-rate payments over the life of the agreements without exchange of the underlying notional value. The gain or loss on the interest rate swap is recorded in accumulated other comprehensive loss and subsequently reclassified into interest expense in the same period during which the hedged transaction affects earnings. The fair values and effectiveness testing of our derivatives are based on prevailing market data and derived from proprietary models based on well recognized financial principles and reasonable estimates about relevant future market conditions including interest rates, counterparty risk, and credit risk. These assumptions could cause material changes in the fair value or effectiveness of our derivative instruments. Taxes Deferred taxes are provided on the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. This approach requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based upon the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the expenses are expected to reverse. Valuation allowances are provided if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. We recognize a tax benefit associated with an uncertain tax position when, in our judgment, it is more likely than not that the position will be sustained upon examination by a taxing authority. For a tax position that meets the more-likely-than-not recognition threshold, we initially and subsequently measure the tax benefit as the largest amount that we judge to have a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority. The liability associated with unrecognized tax benefits is adjusted periodically due to changing circumstances, such as the progress of tax audits, case law developments and new or emerging legislation. Such adjustments are recognized entirely in the period in which they are identified. The effective tax rate includes the net impact of changes in the liability for unrecognized tax benefits and subsequent adjustments as considered appropriate by management. We evaluate quarterly the realizability of our deferred tax assets by assessing the need for a valuation allowance and by adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization are our forecast of future taxable income in the appropriate jurisdiction to utilize the asset, and available tax planning strategies that could be implemented to realize the net deferred tax assets. Failure to achieve forecasted taxable income might affect the ultimate realization of the net deferred tax assets. Factors that may affect our ability to achieve sufficient forecasted taxable income include, but are not limited to, the following: a decline in sales or margins, increased competition or loss of market share. In addition, we operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended time to resolve. We believe that adequate provisions for income taxes have been made for all years. Typically, the largest permanent item in computing both our effective rate and taxable income is the deduction for statutory depletion. The depletion deduction is dependent upon a mine-by-mine computation of both gross income from mining and taxable income. The Tax Act subjects us to current tax on our global intangible low-taxed income (“GILTI”). To the extent that tax expense is incurred under the GILTI provisions, it will be treated as a component of income tax expense in the period incurred.

<s>[INST] Overview We are an applicationfocused minerals company providing materials solutions to customers drawing from a diversified product portfolio. We produce a wide range of specialized silica sand, feldspar, nepheline syenite, calcium carbonate, clay, kaolin, lime, and lime products for use in the energy and Industrial markets in North America and around the world. We have 44 sand mining facilities with over 50 million tons of annual sand processing capacity and significant proven and probable mineral reserves that serve both the Industrial and Energy markets and six active coating facilities with more than two million tons of annual coating capacity. Our mining and coating facilities span North America and also include operations in China and Denmark. We believe our U.S., Mexico, and Canada operations are among the largest, most flexible, and costefficient facilities in the industry with close proximity to our customer base. Our operations are organized into two segments based on the primary end markets we serve Energy and Industrial. Our Energy segment offers the oil and gas industry a comprehensive portfolio of raw frac sand, valueadded proppants, wellcementing additives, gravelpacking media and drilling mud additives that meet or exceed the API standards. Our products serve hydraulic fracturing operations in the U.S., Canada, Argentina, Mexico, China, and northern Europe. Our Industrial segment provides raw, valueadded, and customblended products to the glass, construction, ceramics, foundry, coatings, polymers, sports and recreation, filtration and various other industries primarily in North America. We believe our segments are complementary. Our ability to sell to a wide range of customers across multiple end markets allows us to maximize the recovery of our reserve base within our mining operations and to mitigate the cyclicality of our earnings. Recent Trends and Outlook Energy segment market trends: Volatility of drilling activity. Demand for proppant is primarily determined by the level of drilling and well completions by E&P companies, which depends largely on the current and anticipated profitability of developing oil and natural gas reserves. Drilling and completions activity increased in the first half of 2018 as a result of rising oil prices, but softened in the second half of 2018 relative to the first half of the year, largely as a result of E&P budget constraints and lower oil prices in the fourth quarter of 2018. WTI benchmark prices averaged nearly $65 per barrel in 2018 versus $51 per barrel in 2017. However, the WTI benchmark was approximately $45 per barrel at the end of 2018. In response to the improved returns generated by higher average oil prices, E&P companies increased their capital spending on drilling and completion in 2018 relative to 2017. In 2019, E&P capital spending on drilling and completions activity is expected to decline in response to lower hydrocarbon prices and a desire from E&P companies to generate additional cash flow. Current WTI pricing, as of March 15, 2019 was approximately $58 per barrel. Shifts in drilling activity affect the mix of proppants customers require. Well design and completion trends in oil and gas impact the demand for and the mix of proppants we sell. In 2013 and 2014, well designs centered around guar and crosslinked gel utilizing coarse grade proppants with high conductivity. E&P companies also used ceramics and/or resincoated proppants for added strength and flowback control. In 2015 and 2016, lower crude oil prices caused E&P companies to seek to reduce shortterm operating costs, including experimenting with slickwater designs utilizing longer laterals and high loading of lower priced, finer grades of proppant. Beginning in 2018, and continuing into 2019, E&P companies began widespread usage of sand that is mined within the same basin as their well locations due to the lower transportation costs associated with this sand, which is almost entirely fine mesh. In 2018, and several preceding years, the amount of proppant used per well increased annually, aiding overall proppant demand. In 2019, the proppant usage per well [/INST] Negative. </s>

Covia Holdings Corp

2020-03-16

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following management’s discussion and analysis of financial condition and results of operations (“MD&A”) should be read together with the section entitled “Business” and our consolidated financial statements and related notes thereto and other financial information appearing elsewhere in this Report. The following discussion contains forward-looking statements that involve risks, uncertainties and assumptions. See the section entitled “Cautionary Statement Regarding Forward-Looking Statements” beginning on page 3 of this Report. Our actual results could differ materially from those contained in forward-looking statements as a result of many factors, including those discussed in “Item 1A - Risk Factors” in Part I of this Report. The following discussion contains certain non-GAAP (defined herein) financial measures, including EBITDA and Adjusted EBITDA (defined herein). See “-Key Metrics Used to Evaluate Covia’s Business” for a reconciliation of net income (loss) to EBITDA and Adjusted EBITDA. Overview We are an application-focused minerals company providing materials solutions to customers drawing from a diversified product portfolio. We produce a wide range of specialized silica sand, feldspar, nepheline syenite, calcium carbonate, clay, and kaolin products for use in the Industrial and Energy markets in North America and around the world. We have 36 active mining facilities with over 40 million tons of annual processing capacity and significant proven and probable mineral reserves that serve both the Industrial and Energy markets and six active coating facilities with more than two million tons of annual coating capacity. Our mining and coating facilities span North America and also include operations in China and Denmark. We believe our U.S., Mexico, and Canada operations are among the largest, most flexible, and cost-efficient facilities in the industry with close proximity to our customer base. Our operations are organized into two segments based on the primary end markets we serve - Industrial and Energy. Our Energy segment offers the oil and gas industry a comprehensive portfolio of raw frac sand, value-added proppants, well-cementing additives, gravel-packing media and drilling mud additives that meet or exceed the API standards. Our products serve hydraulic fracturing operations in the U.S., Canada, Argentina, Mexico, China, and northern Europe. Our Industrial segment provides raw, value-added, and custom-blended products to the glass, construction, ceramics, foundry, coatings, polymers, sports and recreation, filtration and various other industries primarily in North America. We believe our segments are complementary. Our ability to sell to a wide range of customers across multiple end markets allows us to maximize the recovery of our reserve base within our mining operations and to mitigate the cyclicality of our earnings. Our Strategy Our strategy is centered on three objectives - repositioning our Energy segment, growing our Industrial segment’s profitability and strengthening our balance sheet. During 2019, we made significant progress executing on these three areas. • Repositioning our Energy Segment. In response to a customer shift in demand toward in-basin sand, from late 2018 through 2019, we idled approximately 15 million tons of our Northern White or regional sand production capacity. The remaining production capacity of Northern White sand is located at our lower-cost plants. We also commissioned three in-basin sand production plants to meet growing customer demand for this product. The market shift in demand toward in-basin sand also resulted in a reduction in demand for the railcars and terminals that are used to transport Northern White sand to an oil and gas basin. This resulted in an industry oversupply of railcars, including within our own fleet. In response, we negotiated with railcar builders to terminate approximately $195 million in future railcar purchase commitments in exchange for immaterial consideration, which included cash and lease modifications to a small portion of the fleet. Additionally, we exited leases from terminals which were no longer necessary to serve customers. • Growing our Industrial Segment’s Profitability. During 2019, we successfully lowered unit production costs in our Industrial segment, which served as a tailwind to Industrial segment profitability. We also made capital investments within our Industrial segment to target specific growth opportunities. These investments included expanding our Canoitas, Mexico silica plant and expanding and modernizing our nepheline syenite plant in Nephton, Ontario. The Canoitas expansion was completed in 2019 and is expected to add additional capacity to meet growing customer demand in Mexico. The Nephton expansion and modernization is expected to be completed in 2021 and reduce costs and maintenance capital, as well as add production capacity to meet forecasted growth in demand for nepheline syenite. • Strengthening our Balance Sheet. To improve our liquidity and strengthen our balance sheet, in 2019 we successfully divested several non-core assets, including our Calera, Alabama lime processing facility and Winchester & Western Railroad, which collectively generated over $240 million in proceeds. Additionally, we took advantage of favorable trading conditions to repurchase $63 million of face value of our Term Loan for $48 million. Other actions we took to improve our balance sheet in 2019 included improving working capital by more than $100 million and securing a commitment for a $75 million standby liquidity facility. Recent Trends and Outlook Energy segment market trends: • Volatility of drilling activity. Demand for proppant is primarily determined by the level of drilling and well completions by E&P companies, which depends largely on the current and anticipated profitability of developing oil and natural gas reserves. In 2019, E&P capital spending on drilling and completions activity accelerated in the first half of the year, due in part to higher hydrocarbon prices. Activity declined in the second half of 2019 as many of our customers exhausted their annual budgets and did not want to outspend the cash flow they were generating. In March 2020, OPEC and non-OPEC producers failed to secure an agreement on plans for oil production cuts. This is anticipated to result in increased competition amongst oil producers for gaining market share, increasing the supply of oil. Combined with a decrease in consumer demand for oil due to the coronavirus, the supply of oil could far exceed demand and further reduce the need for drilling activity and E&P capital spending in 2020 and, relatedly, a reduction in demand for proppant. WTI pricing, as of March 11, 2020 was approximately $33 per barrel. The full impact of these dynamics are not yet known. • Shifts in drilling activity affect the mix of proppants customers require. Well design and completion trends in oil and gas impact the demand for and the mix of proppants we sell. In 2013 and 2014, well designs centered on guar and crosslinked gel utilizing coarse grade proppants with high conductivity. E&P companies also used ceramics and/or resin-coated proppants for added strength and flowback control. In 2015 and 2016, lower crude oil prices caused E&P companies to seek to reduce short-term operating costs, including experimenting with slickwater designs utilizing longer laterals and high loading of lower priced, finer grades of proppant. Beginning in 2018, E&P companies began increasing their usage of sand that is mined within the same basin as their well locations (in-basin sand) due to the lower transportation costs associated with this sand, which is almost entirely fine mesh and significant reduce the use of many more expensive value added proppants. This trend accelerated in 2019 as E&P companies increased adoption of in-basin sand and new in-basin mines opened in multiple oil and gas plays. We believe that in-basin sand adoption will continue in 2020, but at a slower pace than 2019. • Reacting to changing conditions. In response to reduced customer demand, between the third quarter of 2018 and the end of 2019, we idled mining operations at Shakopee, Minnesota; Brewer, Missouri; Wexford, Michigan; Kasota, Minnesota; Maiden Rock, Wisconsin; and resin-coating faciliities atRoff, Oklahoma; Guion, Arkansas; and Cutler, Missouri, adding to the previously idled mining operation at Hager Bay, Wisconsin. While we also idled or reduced capacity at certain of our Northern White facilities and all of our Voca, Texas facilities, we also commissioned two new facilities in the Permian basin in the third quarter 2018 and a facility in Oklahoma in the fourth quarter 2018. Through March 2020, we reduced our Energy segment nameplate annual capacity by 15 million tons through these capacity reduction measures, allowing us to lower fixed plant costs and consolidate volumes into lower cost and logistically-advantaged operations. With the reduced expectation for the future demand of Northern White sand and associated logistical assets, as well as reduced expectations for Mid-Continental in-basin sand, we incurred non-cash impairment charges of $1.4 billion in 2019 and $267.0 million in 2018. • Volatility in selling prices for proppants. The rapid decline in oil and gas prices that occurred in late 2014 into 2016, and again in 2020, reduced drilling activity and demand for proppants. As a result, the proppant market became oversupplied, which caused selling prices for all proppants to decline throughout the majority of 2016. In 2017 and the first half of 2018, the market experienced a turnaround and proppant pricing increased across all basins as growth outpaced the ability to add idled and new capacity back into the market. In the second half of 2018, decreased completions activity, combined with the opening of several new mines in basins with oil activity, namely the Permian, Eagle Ford and Mid-Continental, resulted in a significant deterioration of proppant pricing in the second half of 2018. In 2019, several new in-basin sand mines opened, while demand plateaued, resulting in a large oversupply of sand. This had a significantly negative impact on proppant pricing. Coupled with the low cost to reactivate idled capacity, we expect this supply imbalance to continue and do not expect significant price improvement for the foreseeable future. • Demand for in-basin delivery of proppant. A proppant vendor’s logistics capabilities have become an important differentiating factor when competing for business, on both a spot and contract basis. In recent years, many customers have sought to outsource proppant logistics and purchase proppant from a supplier’s own terminal (e.g., in-basin) or local mines, allowing them to focus on their core competencies, minimize inventory costs and maximize flexibility. Our terminal network in all major oil and gas basins differentiates us from competitors but was utilized less in 2019 than in prior years as more customers choose to use in-basin sand, which does not need to be delivered to a terminal. • In-basin supply. In 2018 and 2019, multiple sand suppliers, including Covia, commissioned new sand mines in the Permian basin and, to a lesser extent, the Eagle Ford, and Mid-Continental basins. In 2020, new in-basin mines are being developed in the Bakken and Rocky Mountain basins. Locating a plant in-basin significantly reduces the logistics costs, and therefore the overall delivered product cost. However, the quality of in-basin proppant differs from Northern White sand in that in-basin proppant generally possesses lower crush strength and less sphericity, which we believe may impact well performance under higher pressure wells. Local proppant products appear, however, to be fit for purpose in certain well applications, and given their lower costs, demand for local proppant products has strengthened considerably. Most local plants were developed to supply local basins in which they are located and lack the logistical infrastructure to economically ship product to other basins. The proliferation of in-basin mines has resulted in significant oversupply across North American and put pressure on pricing of all proppants. In the second half of 2018, we commissioned two plants in the Permian basin and one in the Mid-Continental basin with a total added nameplate capacity of 8 million tons annually. These facilities allow us to offer a low-cost local solution. In the Mid-Continental basin, demand for proppant declined precipitously late in 2019 and into 2020 causing a severe oversupply of in-basin sand. • Shift toward finer proppant grades. Slickwater frac designs, which are generally less expensive, became the dominant method for fracturing wells beginning in 2016 and continuing into recent periods. These designs rely on a higher percentage of fine grade sands compared to coarse grades. Currently, we estimate the market is over 85% fine grade (40/70 and 100 mesh) compared to roughly 55% fine grade in 2014. The strong demand for finer proppants negatively impacts production costs for facilities that have relatively coarse reserves. • Reduced consumption of value-added proppants. As E&P companies’ budgets have contracted over the last year, the demand for proppant and the average selling price of proppant both decreased. In efforts to keep well completion costs low, E&P companies significantly reduced their consumption of certain value-added proppants, leading to a decline in the sales of such value-added proppants. In response to this trend, we discontinued sales and marketing efforts related to our Propel SSP® self-suspending proppant due to lack of demand for high-price point value-added proppant. Accordingly, in the third quarter of 2019, we recorded an impairment charge of $7.8 million related to property, plant, and equipment used in the production of our Propel SSP® self-suspending proppant, as well as the associated intangible asset and earn-out contingent consideration liability. The discontinued sale of our Propel SSP® self-suspending proppant is not expected to have a material impact on our financial results in the future. • E&P direct sales. Throughout 2019, E&P companies sourced an increasing percentage of their proppant directly from proppant suppliers to control cost and have better visibility across the entire supply chain. This trend presents an opportunity to work directly with the end user and provides improved communication between supplier and consumer with respect to job or grade changes and our percentage of sales directly to E&P companies increased in 2019. Concurrently with these direct sales, many E&P companies are looking to the supplier to coordinate the “last mile” of the supply chain, or the moving of product from the in-basin terminal to the well site. In response to this trend, we have entered into agreements with last mile solutions providers that allow us to provide this service to customers who desire it. • Proppant intensity is expected to stabilize. From 2015 through 2018 the amount of proppant used per well increased as well laterals became longer, frac stages tightened and proppant per lateral foot increased. In 2019, the amount of proppant used per well was similar to 2018 and this trend is expected to continue in 2020. Industrial segment market trends: • Historically stable demand in Industrial end markets. The primary end markets served by production in our Industrial segment are glass, building products, ceramics, foundry, coatings, polymers and various other industries. The sales in our Industrial segment historically correlate strongly with overall economic activity levels in the U.S. and Mexico as reflected in the gross domestic product, unemployment levels, vehicle production and growth in the housing market. Demand in our Industrial segment’s end markets is historically relatively stable and is primarily influenced by key macroeconomic drivers such as housing starts, light vehicle sales, repair and remodel activity, industrial production as well as consumer trends. To the extent these demand drivers continue on their current trends, we expect that demand for the products of our Industrial segment will remain relatively stable. The effects of the coronavirus on our Industrial segment are not yet known. Overall, we expect Industrial markets to grow at rates similar to GDP growth. To the extent trends deviate from those of 2019 due to the economic uncertainty introduced by the coronavirus pandemic or other U.S. and global market developments, we may see similar deviations in our Industrial segment trends. • Historically favorable housing, commercial constructions and consumer trends. Certain submarkets and geographies within our Industrial segment historically grow at attractive rates driven by solid housing, commercial construction and various consumer trends that utilize our products. These trends are expected to benefit our products serving the building products and coating and polymers end markets. • Certain U.S. end markets facing pressure. Due to reduced manufacturing activity in the U.S., foundry markets felt pressure in the second half of 2019 and are expected to face continued pressure in 2020. Consumer trends of consuming less U.S.-produced beer caused demand from containerized glass customers in the U.S. to decline in 2019. This trend is expected to continue throughout 2020. How We Generate Our Sales We derive our sales from mining and processing silica sand products and other minerals that customers purchase for use in a wide variety of applications. Covia’s sales are primarily a function of the price per ton paid by the customer and the number of tons sold to the customer. The price invoiced reflects the cost of production, the cost of transportation to our distribution terminals or customer site and the cost of transloading the product from railcars to trucks, as applicable. Generally, logistics costs can comprise up to 70-80% of the delivered cost of products sold by the Energy segment, depending on the basin into which the product is delivered. We primarily sell products under supply agreements with terms that vary by contract. Generally, the supply agreements include both fixed prices and variable prices. Fixed price agreements have prices set for one or more years while variable price agreements are subject to regular price adjustments generally tied to market pricing or other market-related indices. Our supply agreements have a variety of volume provisions. While certain of our contracts have no minimum volume requirements, certain of our supply agreements require the customer to purchase a specified percentage of its product requirements or a minimum volume of product. Certain of these minimum volume contracts include a provision which may trigger penalties if the purchased volume does not meet the required minimums. Our Energy segment represented 54% of our revenues for the year ended December 31, 2019. A large portion of our sales are generated by our top customers, and the loss of, or significant reduction in, purchases by our largest customers could adversely affect our operations. During the years ended December 31, 2019 and 2018, our top ten customers were Energy customers and collectively represented 36% and 44% of our revenues, respectively. In 2019, no customers exceeded 10% of revenues. In 2018, one customer exceeded 10% of revenues. This customer accounted for 13% of our revenues in 2018. Our Industrial segment represented 46% of our revenues for the year ended December 31, 2019. The Costs of Conducting Our Business The principal costs involved in operating our business are: logistics costs associated with transporting products from our production facilities to our terminals; production costs; labor costs; maintenance and repair costs at our production facilities; raw material costs; energy costs; stripping costs; and corporate costs. We own or lease most of our sand and other mineral reserves. Logistics Costs Logistics costs, including freight, railcar leases, demurrage and handling, represented approximately 34% and 36% of our revenues during the years ended December 31, 2019 and 2018, respectively. Freight costs primarily represent charges to transport our product by rail, but we also ship product by truck and barge. In order to move product by rail, we lease a substantial number of railcars under operating leases with durations ranging from three to 15 years. Demurrage costs are charged by the railroads based on the time a railcar spends on the railroad property in excess of an allotted time which can vary significantly from period to period depending on railcar cycle times and delivery schedules. Handling costs are incurred at our distribution and terminal facilities to move product from one mode of transportation to another (e.g., railcar to truck) and to move product into storage facilities. Railcar storage costs are incurred when railcars are temporarily stored at a rail yard or storage facility. Labor Costs Labor costs associated with employees at our processing and production facilities represent the most significant cost of converting raw frac sand to finished product. Labor costs, including wages and benefits, represented approximately 13% and 11% of our revenues during the years ended December 31, 2019 and 2018, respectively. Approximately 35% of our workforce was party to collective bargaining contracts as of December 31, 2019. Maintenance and Repair Costs We capitalize the costs of our mining and processing equipment and depreciate such equipment over their expected useful life. Depreciation, depletion, and amortization costs represented approximately 14% and 11% of revenues during the years ended December 31, 2019 and 2018, respectively. Repair and maintenance costs that do not involve the replacement of major components of our equipment and facilities are expensed through cost of goods sold as incurred. These repair and maintenance costs can be significant due to the abrasive nature of our products and represented approximately 4% of revenues during each of the years ended December 31, 2019 and 2018. Energy Costs We consume energy, including natural gas, diesel and electricity, for mine and plant production. Natural gas is the primary fuel source used for drying sand in the commercial silica production process. Energy costs are typically negotiated on an annual or multi-year basis and certain input costs are subject to prevailing market prices for the underlying commodity (e.g., natural gas, diesel), which can vary during the year. Corporate Costs Our selling, general and administrative costs, which include the wages and benefits costs noted above, represented approximately 10% and 8% of revenues during the years ended December 31, 2019 and 2018, respectively. These costs are related to our corporate functions, including costs for the sales and marketing; research and development; finance; legal; and environmental, health and safety functions of our organization, as well as non-cash stock-based compensation expense. Combination with Fairmount Santrol On June 1, 2018 (“Merger Date”), Unimin completed a business combination (“Merger”) whereby Fairmount Santrol merged into a wholly-owned subsidiary of Unimin and ceased to exist as a separate corporate entity. Immediately following the consummation of the Merger, Unimin changed its name and began operating as Covia. The common stock of Fairmount Santrol was delisted from the NYSE prior to the market opening on June 1, 2018, and Covia commenced trading under the ticker symbol “CVIA” on that date. Upon the consummation of the Merger, the former stockholders of Fairmount Santrol (including holders of certain Fairmount Santrol equity awards) received, in the aggregate, $170 million in cash consideration and approximately 35% of the common stock of Covia. Approximately 65% of Covia common stock is owned by SCR-Sibelco NV (“Sibelco”), previously the parent company of Unimin. In connection with the Merger, we redeemed approximately 18.5 million shares of Unimin common stock from Sibelco in exchange for an amount in cash equal to (i) $660 million plus interest accruing at 5.0% per annum for the period from September 30, 2017 through June 1, 2018 less (ii) $170 million in cash paid to Fairmount Santrol stockholders. In the years ended December 31, 2019, 2018, and 2017, we incurred $0.9 million, $53.0 million and $19.3 million, respectively, of costs and expenses related to the Merger, which are recorded in Other non-operating expense, net in the accompanying Consolidated Statements of Income and include legal, accounting, valuation and financial advisory services, integration and other costs. Discontinued Operations On May 31, 2018, prior to, and as a condition to the closing of the Merger, Unimin contributed certain assets, comprising its global high purity quartz business to HPQ Co. in exchange for all of the stock of HPQ Co. and the assumption by HPQ Co. of certain liabilities. Unimin distributed all of the stock of HPQ Co. to Sibelco in exchange for certain shares of Unimin common stock held by Sibelco. HPQ Co. is presented as discontinued operations in our Consolidated Financial Statements included in this Report. As part of the disposition of HPQ Co., Covia and HPQ Co. entered into the Tax Matters Agreement. Under the Tax Matters Agreement, Covia and HPQ Co. (and their affiliates) are responsible for income taxes required to be reported on their respective separate and group tax returns; however, HPQ Co. is responsible for any unpaid income taxes attributable to the HPQ Co. business prior to May 31, 2018, as well as any unpaid non-income taxes as of May 31, 2018 attributable to the HPQ Co. business (whether arising prior to May 31, 2018 or not). Covia is responsible for all other non-income taxes. We and HPQ Co. will equally bear any transfer taxes imposed as a result of the disposition of HPQ Co. Rights to refunds in respect of taxes will be allocated in the same manner as the responsibility for tax liabilities. Dispositions On August 1, 2019, we completed the sale of the Calera, Alabama lime processing facility (“Calera”), to Mississippi Lime Company for approximately $135 million in cash, subject to certain adjustments. Calera was a non-core asset included within our Industrial segment. On September 10, 2019, we completed the sale of the Winchester & Western Railroad (“W&W Railroad”) to an affiliate of OmniTRAX, Inc. for approximately $105 million in cash, subject to certain adjustments. The W&W Railroad was a non-core asset that was included in both our Energy and Industrial segments. How We Evaluate Our Business Our management uses a variety of financial and operational metrics to analyze our performance across our Industrial and Energy segments. We determine our reportable segments based on the primary industries we serve, our management structure and the financial information reviewed by our chief operating decision maker in deciding how to allocate resources and assess performance. We evaluate the performance of our segments based on their volumes sold, average selling price, and segment contribution margin and associated per ton metrics. We evaluate the performance of our business based on company-wide operating cash flows, earnings before interest, taxes, depreciation and amortization (“EBITDA”), costs incurred that are considered non-operating, and Adjusted EBITDA. Segment contribution margin, EBITDA, and Adjusted EBITDA are defined in the Non-GAAP Financial Measures section below. We view these metrics as important factors in evaluating profitability and review these measurements frequently to analyze trends and make decisions, and believe these metrics provide beneficial information for investors for similar reasons. Segment Gross Profit Segment gross profit is defined as segment revenue less segment cost of sales, excluding depreciation, depletion and amortization expenses, selling, general, and administrative costs, and corporate costs. Non-GAAP Financial Measures Segment contribution margin, EBITDA, and Adjusted EBITDA are supplemental non-GAAP financial measures used by management in evaluating our operating performance. Segment contribution margin is a key metric we use to evaluate our operating performance and to determine resource allocation between segments, as it excludes non-operating site costs and excess railcar costs. This metric allows for evaluation of business results without unnecessary overlap of costs that are inconsistent with current market conditions. We define segment contribution margin as segment revenue less segment cost of sales, excluding any depreciation, depletion and amortization expenses, selling, general, and administrative costs, and operating costs of idled facilities and excess railcar capacity. Segment contribution margin per ton is defined as segment contribution margin divided by tons sold. Segment contribution margin is not a measure of our financial performance under GAAP and should not be considered as an alternative or superior to measures derived in accordance with GAAP. Refer to Note 26 to our Consolidated Financial Statements for further detail regarding the use of segment contribution margin to evaluate our operating segments, including a reconciliation of operating income (loss) from continuing operations, the most directly comparable GAAP financial measure, to segment contribution margin. We define EBITDA as net income before interest expense, income tax expense (benefit), depreciation, depletion and amortization. Adjusted EBITDA is defined as EBITDA before non-cash stock-based compensation and certain other income or expenses, including restructuring and other charges, impairments, and Merger-related expenses. Beginning in the first quarter of 2019, we also include non-cash lease expense of intangible assets in our calculation of Adjusted EBITDA as a result of the adoption of ASC 842. We believe EBITDA and Adjusted EBITDA are useful because they allow management to more effectively evaluate our normalized operations from period to period as well as provide an indication of cash flow generation from operations before investing or financing activities. Accordingly, EBITDA and Adjusted EBITDA do not take into consideration our financing methods, capital structure or capital expenditure needs. As previously noted, Adjusted EBITDA excludes certain non-operational income and/or costs, the removal of which improves comparability of operating results across reporting periods. However, EBITDA and Adjusted EBITDA have limitations as analytical tools and should not be considered as alternatives to, or more meaningful than, net income as determined in accordance with GAAP as indicators of our operating performance. Certain items excluded from EBITDA and Adjusted EBITDA are significant components in understanding and assessing our financial performance, such as our cost of capital and tax structure, as well as the historic costs of depreciable assets, none of which are components of EBITDA or Adjusted EBITDA. Additionally, Adjusted EBITDA is not intended to be a measure of free cash flow for management’s discretionary use, as it does not consider certain cash requirements such as interest payments, tax payments and debt service requirements. Adjusted EBITDA contains certain other limitations, including the failure to reflect our cash expenditures, cash requirements for working capital needs and cash costs to replace assets being depreciated and amortized, and excludes certain non-operational charges. We compensate for these limitations by relying primarily on our GAAP results and by using Adjusted EBITDA only as a supplement. Non-GAAP financial information should not be considered in isolation or viewed as a substitute for measures of performance as defined by GAAP. Although we attempt to determine EBITDA and Adjusted EBITDA in a manner that is consistent with other companies in our industry, our computation of EBITDA and Adjusted EBITDA may not be comparable to other similarly titled measures of other companies due to potential inconsistencies in the methods of calculation. We believe that EBITDA and Adjusted EBITDA are widely followed measures of operating performance. The following table sets forth a reconciliation of net income, the most directly comparable GAAP financial measure, to EBITDA and Adjusted EBITDA. Refer to Note 26 in the Notes to our Consolidated Financial Statements for a reconciliation of segment contribution margin to operating income (loss) from continuing operations, the most directly comparable GAAP financial measure: Results of Operations The following table presents an overview of certain operating data by segment for the years ended December 31, 2019, 2018, and 2017, which are discussed in further detail following the consolidated overview. Financial results for 2018 include our results subsequent to the Merger on June 1, 2018, and legacy Unimin and legacy Fairmount Santrol for the twelve months and seven months ended December 31, 2018, respectively. Our reported financial results for 2017 include legacy Unimin. Our financial results, and the table above, exclude HPQ Co. (legacy Unimin’s Electronics segment), which is reported as discontinued operations in our consolidated financial statements for 2018 and 2017. 2019 Compared to 2018 Revenues and Volumes Revenues were $1.6 billion for 2019 compared to $1.8 billion for 2018, a decrease of $0.2 billion, or 11%. With the inclusion of legacy Fairmount Santrol revenues of $477.3 million for the five months ended May 31, 2018, total revenues for 2018 were $2.3 billion. Total revenues for 2019 decreased $724.7 million, or 31%, from 2018, including legacy Fairmount Santrol revenues for the five months ended May 31, 2018. Volumes were 30.5 million tons for 2019 compared to 29.6 million tons for 2018, an increase of 0.9 million tons, or 3%. With the inclusion of legacy Fairmount Santrol volumes of 5.6 million tons for the five months ended May 31, 2018, total volumes for 2018 were 35.2 million tons. Total volumes for 2019 decreased 4.7 million tons, or 13%, from 2018, including legacy Fairmount Santrol volumes for the five months ended May 31, 2018. Our revenues decreased largely due to pricing and volumes declines in Energy business, as well as a shift in mix from Northern White sand toward local sands, which carry lower average selling prices. Revenues in the Energy segment were $862.9 million for 2019, compared to $1.1 billion for 2018, a decrease of $251.5 million, or 23%. With the inclusion of legacy Fairmount Santrol Energy revenues of $421.5 million for five months ended May 31, 2018, total Energy revenues were $1.5 billion for 2018. Total Energy revenues for 2019 decreased $673.0 million, or 44%, from 2018, including legacy Fairmount Santrol revenues for the five months ended May 31, 2018. Volumes in the Energy segment were 16.5 million tons for 2019 compared to 16.1 million tons for 2018, an increase of 0.4 million tons, or 2%. With the inclusion of legacy Fairmount Santrol Energy volumes of 4.6 million tons for the five months ended May 31, 2018, total Energy volumes for 2018 were 20.7 million tons. Total volumes for 2019 decreased 4.2 million tons, or 20%, from 2018, including legacy Fairmount Santrol volumes for the five months ended May 31, 2018. Energy revenues decreased primarily due to pricing and volume declines coupled with product mix shifts toward local sand sales and sales at the mine, each of which carry lower average selling prices. Additionally, E&P companies reached budget exhaustion for year and began to reduce operations starting in third quarter of 2019, further impacting the proppant market and reducing demand. Revenues in the Industrial segment were $732.6 million for 2019, compared to $728.5 million for 2018, an increase of $4.1 million, or 1%. With the inclusion of legacy Fairmount Santrol Industrial revenues of $55.8 million for the five months ended May 31, 2018, total Industrial revenues for 2018 were $784.3 million. Total Industrial revenues for 2019 decreased $51.7 million, or 7%, from 2018, including legacy Fairmount Santrol revenues for the five months ended May 31, 2018. Volumes in the Industrial segment were 14.0 million tons for 2019, compared to 13.5 million tons for 2018, an increase of 0.5 million tons, or 4%. With the inclusion of legacy Fairmount Santrol Industrial volumes of 1.0 million tons for the five months ended May 31, 2018, total Industrial volumes for 2018 were 14.5 million tons. Total Industrial volumes decreased 0.5 million tons, or 3%, from 2018, including legacy Fairmount Santrol volumes for the five months ended May 31, 2018. Industrial revenues decreased primarily due to lower transportation-related revenues (for which we do not earn a margin), the sale of our Calera, Alabama lime facility and the W&W Railroad, and lower volumes in ceramics markets, offset somewhat by increased volumes in coatings and polymers markets. Segment Gross Profit and Segment Contribution Margin Segment gross profit was $276.3 million for 2019 compared to segment gross profit of $462.2 million for 2018, a decrease of $185.9 million, or 40%. With the inclusion of legacy Fairmount Santrol segment gross profit of $158.1 million for the five months ended May 31, 2018, total segment gross profit for 2018 was $620.3 million. Total segment gross profit for 2019 decreased $344.0 million, or 55%, from the 2018, including legacy Fairmount Santrol gross profit for the five months ended May 31, 2018. The segment gross profit decrease was primarily due to lower volumes as a result of the proppant market downturn and reductions in E&P operations. Segment gross profit was also negatively affected by downward pricing pressure and higher railcar maintenance and storage costs. Additionally, for 2019, gross profit was negatively impacted by $7.9 million in costs associated with operating lease expense related to the adoption of ASC 842. Segment contribution margin was $311.4 million for 2019 and further excludes $5.4 million of operating costs of idled facilities and $29.7 million of excess railcar capacity costs. Segment contribution margin was $479.1 million for 2018 and further excludes $3.0 million of operating costs of idled facilities and $14.0 million of excess railcar capacity costs. These excluded costs are entirely attributable to the Energy segment Energy segment gross profit was $54.1 million for 2019 compared to $259.0 million for 2018, a decrease of $204.9 million, or 79%. With the inclusion of legacy Fairmount Santrol Energy segment gross profit of $136.7 million for the five months ended May 31, 2018, total Energy segment gross profit was $395.7 million. Total Energy segment gross profit for 2019 decreased $341.6 million, or 86%, from 2018, including legacy Fairmount Santrol gross profit for the five months ended May 31, 2018. For 2019, the Energy segment gross profit included $7.9 million of operating lease expense related to the adoption of ASC 842, and $0.4 million of expense related to the write-up of legacy Fairmount Santrol’s inventories to fair value as a result of the Merger under GAAP. The remaining Energy segment gross profit decrease was primarily due to lower volumes, downward pricing pressure, reductions in E&P operations and higher railcar maintenance and storage costs. Industrial segment gross profit was $222.2 million for 2019 compared to $203.2 million for 2018, an increase of $19.0 million, or 9%. With the inclusion of legacy Fairmount Santrol Industrial segment gross profit of $21.4 million for the five months ended May 31, 2018, total Industrial segment gross profit was $224.6 million, a decrease of $2.4 million, or 1% from 2018. Excluding divested Calera and W&W Railroad businesses, Industrial segment gross profit would have increased 9% in 2019 from 2018. For 2019, the Industrial segment gross profit included $0.7 million of expense related to the write-up of legacy Fairmount Santrol’s inventories to fair value as a result of the Merger under GAAP. Selling, General and Administrative Expenses (“SG&A”) SG&A increased $8.0 million, or 5%, to $153.6 million for 2019 compared to $145.6 million for 2018. SG&A for 2019 included stock compensation expense of $10.0 million compared to $5.8 million of stock compensation expense for 2018. With the inclusion of legacy Fairmount Santrol SG&A of $44.2 million for 2018, total SG&A was $189.8 million. Total SG&A decreased $36.2 million, or 19%, from 2018, including legacy Fairmount Santrol SG&A for the five months ended May 31, 2018. The decrease is primarily due to expense reduction initiatives, facility and headcount rationalization, and synergy realization. Depreciation, Depletion and Amortization Depreciation, depletion and amortization increased $25.5 million to $222.0 million for 2019, compared to $196.5 million for 2018. The increase compared to the prior year was due to the inclusion of mineral reserves depletion for production facilities acquired in connection with the Merger, partially offset by the full amortization, disposal, or impairment of certain intangible assets. Goodwill and Other Asset Impairments For 2019, goodwill and other asset impairments was $1.4 billion, an increase of $1.2 billion, compared to goodwill and other asset impairments of $267.0 million for 2018. In 2019, due to a sharp decline in customer demand for Northern White sand caused by shifts toward local in-basin frac sands with lower logistics costs, we impaired Propel SSP® technology for $7.8 million, long-lived assets and right-of-use assets for $1.4 billion, idled facilities and railcars for $11.0 million, and spare parts inventory for $3.9 million. In 2018, we impaired goodwill for $217.1 million, idled facilities for $37.7 million, and assets under construction for $12.3 million. Throughout 2019, our Energy segment was impacted by new sources of supply and sequentially slower proppant demand, resulting in a surplus of proppant and significantly lower proppant pricing. In response to changing market demands, we idled operations at certain mines, terminals, and resin-coating facilities, rationalized our railcar fleet and reduced production capacity and total production at certain of our Northern White sand plants. In total, we have reduced our Energy segment annual production capacity by over 15 million tons since September 2018. Restructuring and Other Charges We incurred restructuring and other charges of $30.6 million in 2019 compared to $22.0 million in 2018, an increase of $8.6 million, or 39%. Restructuring charges are primarily related to separation costs associated with plant closures and other headcount initiatives. Restructuring charges in 2019 also include minimum quantity penalties incurred in connection with reduced production at idled facilities, $5.5 million of other charges related to executive severance and benefits, and $9.0 million of strategic-related charges. Gain on Sale of Subsidiaries In 2019, we recorded a gain of $125.4 million on the sale of Calera and the W&W Railroad. There were no such sales in 2018. Other Operating Income, net Other operating income, net increased $1.0 million to $6.0 million for 2019, compared to $5.0 million for 2018. Other operating income, net for 2019 included the income related to realization of liquidated damages from certain customers who failed to meet minimum purchase obligations and income related to easements granted for consideration on certain of our properties in Mexico and Virginia. Operating Income (Loss) from Continuing Operations Operating loss from continuing operations increased $1.2 billion to a loss of $1.4 billion for 2019, compared to a loss of $163.8 million for 2018. The change in operating income from continuing operations for 2019 was primarily due to Energy asset impairments and lower profitability the in Energy segment, partially offset by the gain on the sales of Calera and the W&W Railroad. Interest Expense, net Interest expense increased $47.6 million, or 79%, to $107.9 million for 2019, compared to $60.3 million for 2018. The increase in expense was primarily due to a full year of interest on our Term Loan, compared to only seven months of 2018. The Term Loan was used to finance the Merger. Other Non-Operating Expense, net Other non-operating expense, net decreased $47.8 million to $7.0 million in 2019, compared to $54.8 million in 2018. The decrease was primarily due to a $49.0 million reduction in legal, accounting, and other expenses incurred in connection with the Merger, partially offset by $1.2 million in acceleration of previously deferred pension-related expenses due to settlement accounting application in 2019 as distributions exceed the current period service and interest cost recognized. Provision (Benefit) for Income Taxes The provision for income taxes decreased $248.1 million to a benefit of $244.1 million for 2019 compared to a provision of $4.0 million for 2018. Loss before income taxes increased $1.2 billion to a loss of $1.5 billion for 2019 compared to a loss of $279.0 million for 2018. The increase in tax benefit was primarily related to the asset impairment, which resulted in a large reversal of our deferred tax liability, offset by adjustments to our valuation allowance on deferred taxes. The Tax Cuts and Jobs Act of 2017 (the “Tax Act”), effective December 22, 2017, established a corporate income tax rate of 21% replacing the 35% rate and created a territorial tax system rather than a worldwide system. The transition to a territorial system included a one-time transition tax on certain unremitted foreign earnings. The Tax Act generally eliminated the U.S. federal income tax on dividends from foreign subsidiaries but included new provisions for the taxation of global intangible low-taxed income (GILTI). The Tax Act also included new provisions limiting the deductibility of interest expense. We applied the guidance in Staff Accounting Bulletin 118 when accounting for the enactment-date effects of the Tax Act in 2017 and throughout 2018. We completed our accounting of the Tax Act during 2018. The effective rate for the period differs from the U.S. federal statutory rate primarily due to depletion, the impact of foreign taxes, tax provisions requiring U.S. income inclusion of foreign income, and changes to a valuation allowance set up on deferred taxes. Net Income (Loss) Attributable to Covia Net loss attributable to Covia increased $1.0 billion to a loss of $1.3 billion for 2019 compared to a loss of $270.5 million for 2018, which includes income of $12.6 million from discontinued operations. The remaining change in net loss attributable to Covia is primarily due to the increases in goodwill and other asset impairments and lower profitability in Energy segment, partially offset by the gain on the sales of Calera and the W&W Railroad. Adjusted EBITDA Adjusted EBITDA decreased $188.2 million to $143.0 million for 2019 compared to $331.2 million for 2018. Adjusted EBITDA for 2019 excludes the impact of $10.0 million of non-cash stock compensation expense, $1.4 billion of impairment charges, $33.2 million in restructuring and other charges, $125.4 million in gain on the sale of subsidiaries, $13.4 million in gain on extinguishment of debt, $0.9 million in Merger-related and integration expenses and $7.9 million in costs associated with operating lease expense related to the adoption of ASC 842. The change in Adjusted EBITDA is largely due to lower profitability. 2018 Compared to 2017 Discussions of 2017 items and full year comparisons between 2018 and 2017 that are not included in this Report can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our Annual Report on Form 10-K for 2018. Liquidity and Capital Resources Overview Our liquidity is principally used to service our debt, meet our working capital needs, and invest in both maintenance and organic growth capital expenditures. Historically, we have met our liquidity and capital investment needs with funds generated from operations and the issuance of debt, if necessary. On the Merger Date, we entered into the $1.65 billion Term Loan to repay the outstanding debt of each of Fairmount Santrol and Unimin and to pay the cash portion of the Merger consideration and transaction costs related to the Merger. The Term Loan was issued at par with a maturity date of June 1, 2025. The Term Loan requires quarterly principal payments of $4.1 million, reduced to $4.0 million after the December 2019 repurchases, and quarterly interest payments from September 30, 2018 through March 31, 2025 with the balance payable at the maturity date. Interest accrues at the rate of the three-month LIBOR plus 325 to 400 basis points depending on Total Net Leverage (as hereinafter defined) with a LIBOR floor of 1.0% or the Base Rate (as hereinafter defined). Total Net Leverage is defined as total debt net of up to $150.0 million of non-restricted cash, divided by EBITDA. The Term Loan is guaranteed by all of our wholly-owned, material, domestic, restricted subsidiaries (including Bison Merger Sub, LLC, as successor to Fairmount Santrol, and all of the wholly-owned material restricted subsidiaries of Fairmount Santrol), subject to certain exceptions. In addition, subject to various exceptions, the Term Loan is secured by substantially all of our assets and those of each guarantor, including, but not limited to (a) a perfected first-priority pledge of all of the capital stock held by us or any guarantor of each existing or subsequently acquired or organized wholly-owned restricted subsidiary (no more than 65% of the voting stock of any foreign subsidiary) and (b) perfected first priority security interests in substantially all of our tangible and intangible assets and those of each guarantor. The Term Loan is not guaranteed by certain foreign subsidiaries, including our Mexican and Canadian subsidiaries. We have the option to prepay the Term Loan without premium or penalty other than customary breakage costs with respect to LIBOR borrowings. There are no financial covenants governing the Term Loan. The Term Loan places certain restrictions on our ability to pay dividends on our common stock. Due to the continued challenging market conditions impacting our Energy segment, deteriorating financial performance, and the risk of exceeding the financial ratio covenant contained in the Revolver, we voluntarily cancelled the Revolver effective December 31, 2019. The Revolver, as amended by the First Amendment on March 19, 2019, included a total net leverage ratio covenant, tested on a quarterly basis, of no more than 6.60:1.00 through December 31, 2019, 5.50:1.00 for the fiscal quarters ending March 31, 2020 to December 31, 2020, 4.50:1.00 for the fiscal quarters ending March 31, 2021 to June 30, 2021, 4.25:1.00 for the fiscal quarters ending to September 30, 2021 to December 31, 2021, and 4.00:1.00 for fiscal quarters ending March 31, 2022 and thereafter. The $11.3 million of standby letters of credit issued by PNC Bank, National Association under the Revolver are now supported by a separate reimbursement agreement with PNC Bank, National Association. Our principal sources of liquidity are cash on-hand and cash flow from operations, both now and in the near future. In addition, the Term Loan provides us flexibility to raise additional debt, including at least $75 million secured by accounts receivable and an incremental $275 million of financing at non-guarantor subsidiaries. In December 2019, we received a commitment from PNC Bank, National Association for a new, three-year credit facility for up to $75 million. The new facility is expected to bear interest of LIBOR plus 1.75% and be secured by our U.S. accounts receivable. Interest on the Term Loan accrues at a per annum rate of either (at our option) (a) LIBOR plus a spread or (b) the alternate base rate plus a spread. The spread will vary depending on our total net leverage ratio, defined as the ratio of debt (less up to $150 million of cash) to EBITDA for the most recent four fiscal quarter period, as follows: The table below provides certain financial metrics for guarantor subsidiaries and non-guarantor subsidiaries: The Term Loan contains customary representations and warranties, affirmative covenants, negative covenants and events of default. Negative covenants include, among others, limitations on debt, liens, asset sales, mergers, consolidations and fundamental changes, dividends and repurchases of equity securities, repayments or redemptions of subordinated debt, investments, transactions with affiliates, restrictions on granting liens to secure obligations, restrictions on subsidiary distributions, changes in the conduct of the business, amendments and waivers in organizational documents and junior debt instruments and changes in the fiscal year. As of December 31, 2019, we were in compliance with all covenants in accordance with the terms of the Term Loan and are no longer required to comply with the quarterly financial ratio covenant under the Credit Agreement. The proceeds of the Term Loan were primarily used to repay certain debt of legacy Fairmount Santrol and legacy Unimin, which included additional debt incurred to fund the Cash Redemption and to pay $170 million to Fairmount Santrol stockholders as part of the Merger. See Note 14 in the consolidated financial statements included in this Report for further detail regarding the credit agreement. As of December 31, 2019, we had outstanding Term Loan borrowings of $1.57 billion and cash on-hand of $319.5 million. In the third quarter of 2019, we sold Calera and the W&W Railroad for a combined $240 million in cash. Our operations are capital intensive and short-term capital expenditures related to certain strategic projects can be substantial. As of the date of this Report, we believe that our liquidity will be sufficient to meet cash obligations, including working capital requirements, anticipated capital expenditures, and scheduled debt service over the next 12 months. Working Capital Working capital is the amount by which current assets (excluding cash and cash equivalents) exceed current liabilities (excluding current portion of long-term debt) and represents a measure of liquidity. Our working capital was $61.7 million at December 31, 2019 and $216.3 million at December 31, 2018. The decrease in working capital is primarily due to improvements in cash collections and days sales outstanding ratios of our accounts receivable portfolio, cash proceeds from the sales of Calera and the W&W Railroad, increases in days payables outstanding, decreases from the dispositions of Calera and the W&W Railroad and overall lower sales levels. The decrease in working capital is primarily offset by the current portion of operating lease liabilities as a result of the adoption of ASC 842. Cash Flow Analysis For 2019, cash and cash equivalents increased by $185.4 million, compared with a decrease of $173.9 million for 2018. Excluding the favorable impact of changes in working capital and proceeds from asset sales, cash decreased by $161.1 million in 2019, compared to an increase of $152.1 million in 2018. This $313.2 million variance was primarily due to lower earnings, noted previously. Net Cash Provided by (Used in) Operating Activities Operating activities consist primarily of net income adjusted for non-cash items, including depreciation, depletion, and amortization, and the effect of changes in working capital. Net cash provided by operating activities was $103.9 million for 2019 compared with $247.4 million in 2018. This $143.5 million variance was primarily due to lower earnings and the changes in working capital, noted previously. Net Cash Used in Investing Activities Investing activities consist primarily of capital expenditures for growth and maintenance. Capital expenditures generally are for expansions of production or terminal facilities, land and reserve acquisition or maintenance related expenditures for asset replacement and health, safety, and quality improvements. Net cash provided by investing activities was $148.4 million for 2019 compared to $356.6 million used for 2018. The $505.0 million variance was primarily related to the net proceeds of $232.2 million from the sale of Calera and the W&W Railroad, the decrease in capital expenditures, and payments made in connection with the Merger in 2018. Capital expenditures of $87.5 million, including stripping costs, in 2019 were primarily focused on growth expenditures at our Canoitas, Mexico facility and the completion of in-basin sand plants. Capital expenditures were $264.1 million in 2018 were primarily focused on construction of new facilities in West Texas and Seiling, Oklahoma, completion of the expansion of the Utica, Illinois, and Oregon facilities, and expanding capacity at the Canoitas facility in Mexico, as well as our nepheline syenite operations in Canada. For 2020, we expect capital expenditures to be in a range of $60 million to $70 million, of which $20 million to $25 million is related to the modernization and expansion of the nepheline syenite operations in Canada. We expect the remaining $40 million to $45 million is related to maintenance and growth capital expenditures at existing locations. Net Cash Provided by (Used in) Financing Activities Financing activities consist primarily of borrowings under our Term Loan, repayments of Unimin and Fairmount Santrol debt, and the Cash Redemption payment made in connection with the Merger. Net cash used in financing activities was $67.6 million in 2019 compared to $66.8 million used in 2018. The $0.8 million variance is the largely due to the various debt transactions that occurred as part of the Merger in 2018, including borrowing the $1.65 billion Term Loan, $1.11 billion in payments on Unimin and Fairmount Santrol debts, a $520.4 million Cash Redemption payment, and $41.2 million in Merger-related debt refinancing fees. In December 2019, we repurchased $62.9 million of outstanding debt on the Term Loan at a weighted average of 76.8% of par value for cash of $48.5 million. Inflation We conduct the majority of our business operations in the U.S., Canada, and Mexico and are subject to certain inflationary pressures in these countries, should they arise. Off-Balance Sheet Arrangements We have no material off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, changes in financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources. Contractual Obligations As of December 31, 2019, we have contractual obligations for long-term debt, finance leases, operating leases, terminal operating costs, capital commitments, and other long-term liabilities. Substantially all of the operating lease obligations are for railcars. In December 2019, we entered into definitive agreements with certain railcar manufacturers to restructure our railcar purchase obligations, which were scheduled to mature in 2020 and 2021. The agreements terminated railcar purchase obligations of approximately $195 million in exchange for immaterial consideration, which included cash and lease modifications to a small portion of the fleet. We no longer have any minimum railcar purchase obligations. See Notes 22 and 24 in the Notes to our Consolidated Financial Statements for further detail regarding our leases and commitments and contingencies. Environmental Matters We are subject to various federal, state and local laws and regulations governing, among other things, hazardous materials, air and water emissions, environmental contamination and reclamation and the protection of the environment and natural resources. We have made, and expect to make in the future, expenditures to comply with such laws and regulations, but cannot predict the full amount of such future expenditures. We may also incur fines and penalties from time to time associated with noncompliance with such laws and regulations. As of December 31, 2019 and 2018, we had $46.5 million and $31.2 million, respectively, accrued for Asset Retirement Obligations, which include future reclamation costs. The increase is primarily related to shortened mine lives and renewed estimates. There were no other significant changes with respect to environmental liabilities or future reclamation costs. We discuss certain environmental matters relating to our various production and other facilities, certain regulatory requirements relating to human exposure to crystalline silica and our mining activity and how such matters may affect our business in the future under the “Regulation and Legislation” section in “Item 1 - Business” and “Item 1A - Risk Factors” in Part I of this Report. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the dates of the financial statements and the reported revenues and expenses during the reporting periods. We evaluate these estimates and assumptions on an ongoing basis and base our estimates on historical experience, current conditions and various other assumptions that are believed to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities as well as identifying and assessing the accounting treatment with respect to commitments and contingencies. Our actual results may materially differ from these estimates. These critical accounting policies and estimates should be read in conjunction with our consolidated financial statements as filed in this Report. Listed below are the accounting policies we believe are critical to our financial statements due to the degree of uncertainty regarding the estimates or assumptions involved, and that we believe are critical to the understanding of our operations. Impairment of Long-Lived Assets, Definite-Lived Intangible Assets and Goodwill We periodically evaluate whether current events or circumstances indicate that the carrying value of our long-lived assets may not be recoverable. If such circumstances exist, an estimate of undiscounted future net cash flows produced by the asset group is compared to the carrying value of the asset group. If the carrying value of the asset group is greater than the undiscounted cash flows, we recognize an impairment loss equal to the amount by which the carrying value exceeds the fair value of the asset group. Factors we generally consider important in our evaluation and that could trigger a review of recoverability include expected operating trends, significant changes in the way assets are used, underutilization of our tangible assets, discontinuance of certain products by us or by our customers, and significant negative industry or economic trends. The recoverability of the carrying value of our development stage mineral properties is dependent upon the successful development, start-up and commercial production of our mineral deposits and related processing facilities. Our evaluation of mineral properties for potential impairment primarily includes assessing the existence or availability of required permits and evaluating changes in our mineral reserves, or the underlying estimates and assumptions, including estimated production costs. Assessing the economic feasibility requires certain estimates, including the prices of products to be produced and processing recovery rates, as well as operating and capital costs. Goodwill is reviewed for impairment annually as of October 31, or more frequently if events and circumstances indicate that the reporting unit to which goodwill has been allocated might be impaired. In testing goodwill for impairment, we have the option to perform a qualitative assessment to determine whether the existence of events or circumstances indicate that it is more-likely-than-not (more than 50%) that the fair value of a reporting unit is less than its carrying amount. When performing a qualitative assessment, we evaluate factors such as a sustained decrease in our share price; macroeconomic conditions; industry and market considerations; cost factors; overall financial performance; events affecting the reporting unit, such as the sale of all or a portion of the reporting unit and other relevant entity-specific events. If the qualitative assessment indicates that it is more-likely-than-not that the fair value of the reporting unit is less than its carrying amount, or if we choose not to perform the qualitative assessment, then a quantitative assessment is performed to determine the reporting unit’s fair value. If the reporting unit’s carrying value exceeds its fair value, then an impairment loss is recognized for the amount of the excess of the carrying amount over the reporting unit’s fair value, not to exceed the total amount of goodwill allocated to the reporting unit. The evaluation of goodwill for impairment includes estimating fair value using one or a combination of valuation techniques, such as discounted cash flows or comparable companies’ earnings multiples or transactions. These valuations require us to make estimates and assumptions regarding future operating results, cash flows, changes in working capital, future capital expenditures, selling prices, profitability, and the cost of capital. Although we believe our assumptions and estimates are reasonable, deviations from the assumptions and estimates could produce a materially different result. As a result of declining market conditions in the Energy segment, we recorded goodwill and other asset impairments in the years ended December 31, 2019 and 2018. See Note 11 in the consolidated financial statements for further detail. Asset Retirement Obligations We estimate the future cost of dismantling, restoring, and reclaiming operating excavation sites and related facilities in accordance with federal, state, and local regulatory requirements. We record the initial estimated present value of these costs as a liability in other non-current liabilities and increase the carrying amount of the related asset by a corresponding amount on the Consolidated Balance Sheets. The accretion of the liability is recorded as other operating expense (income), net and the related asset is classified as property, plant, and equipment and amortized over the estimated life of the mine or site. We adjust the related asset and liability for changes resulting from the passage of time and revisions to either the timing or amount of the original present value estimate. Future cost estimates are escalated for inflation and market risk premium, then discounted at the credit adjusted risk free rate. If the asset retirement obligation is settled for more or less than the carrying amount of the liability, a loss or gain will be recognized in the period the obligation is settled. Employee Benefit Plans We provide a range of benefits to our employees and retired employees, including pensions and post-retirement healthcare and life insurance benefits. We record annual amounts relating to these plans based on calculations specified by GAAP, which include various actuarial assumptions, including discount rates, assumed rates of returns, compensation increases, turnover rates, mortality rates and healthcare cost trend rates. We review the actuarial assumptions on an annual basis and makes modifications to the assumptions based on current rates and trends when it is deemed appropriate to do so. As required by GAAP, the effect of changes in assumptions are generally recorded or amortized over future periods. We believe that the assumptions utilized in recording our obligations under the plans are reasonable based on advice from actuaries. In 2019, the assumptions included discount rates from 3.10% to 7.05% and rates of return from 2.90% to 7.05%. Fair Value of Derivatives Due to our variable-rate indebtedness, we are exposed to fluctuations in interest rates. We enter into interest rate swap agreements as a means to partially hedge our variable interest rate risk. The derivative instruments are reported at fair value in accrued expenses and other non-current liabilities. Changes in the fair value of derivatives are recorded each period in accumulated other comprehensive loss. For derivatives not designated as hedges, the gain or loss is recognized in current earnings. No components of our hedging instruments were excluded from the assessment of hedge effectiveness. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for us making fixed-rate payments over the life of the agreements without exchange of the underlying notional value. The gain or loss on the interest rate swap is recorded in accumulated other comprehensive loss and subsequently reclassified into interest expense in the same period during which the hedged transaction affects earnings. Taxes Deferred taxes are provided on the asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carry-forwards and deferred tax liabilities are recognized for taxable temporary differences. This approach requires recognition of deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the financial statements or tax returns. Under this method, deferred tax liabilities and assets are determined based upon the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the expenses are expected to reverse. Valuation allowances are provided if, based on the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. We recognize a tax benefit associated with an uncertain tax position when, in our judgment, it is more likely than not that the position will be sustained upon examination by a taxing authority. For a tax position that meets the more-likely-than-not recognition threshold, we initially and subsequently measure the tax benefit as the largest amount that we judge to have a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority. The liability associated with unrecognized tax benefits is adjusted periodically due to changing circumstances, such as the progress of tax audits, case law developments and new or emerging legislation. Such adjustments are recognized entirely in the period in which they are identified. The effective tax rate includes the net impact of changes in the liability for unrecognized tax benefits and subsequent adjustments as considered appropriate by management. We evaluate quarterly the realizability of our deferred tax assets by assessing the need for a valuation allowance and by adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization are our forecast of future taxable income in the appropriate jurisdiction to utilize the asset, the reversal of taxable temporary differences, and available tax planning strategies that could be implemented to realize the net deferred tax assets. Failure to achieve forecasted taxable income might affect the ultimate realization of the net deferred tax assets. Factors that may affect our ability to achieve sufficient forecasted taxable income include, but are not limited to, the following: a decline in sales or margins, increased competition or loss of market share. In addition, we operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended time to resolve. We believe that adequate provisions for income taxes have been made for all years. Typically, the largest permanent item in computing both our effective rate and taxable income is the deduction for statutory depletion. The depletion deduction is dependent upon a mine-by-mine computation of both gross income from mining and taxable income. The Tax Act subjects us to current tax on our global intangible low-taxed income (“GILTI”). To the extent that tax expense is incurred under the GILTI provisions, it will be treated as a component of income tax expense in the period incurred.

<s>[INST] Overview We are an applicationfocused minerals company providing materials solutions to customers drawing from a diversified product portfolio. We produce a wide range of specialized silica sand, feldspar, nepheline syenite, calcium carbonate, clay, and kaolin products for use in the Industrial and Energy markets in North America and around the world. We have 36 active mining facilities with over 40 million tons of annual processing capacity and significant proven and probable mineral reserves that serve both the Industrial and Energy markets and six active coating facilities with more than two million tons of annual coating capacity. Our mining and coating facilities span North America and also include operations in China and Denmark. We believe our U.S., Mexico, and Canada operations are among the largest, most flexible, and costefficient facilities in the industry with close proximity to our customer base. Our operations are organized into two segments based on the primary end markets we serve Industrial and Energy. Our Energy segment offers the oil and gas industry a comprehensive portfolio of raw frac sand, valueadded proppants, wellcementing additives, gravelpacking media and drilling mud additives that meet or exceed the API standards. Our products serve hydraulic fracturing operations in the U.S., Canada, Argentina, Mexico, China, and northern Europe. Our Industrial segment provides raw, valueadded, and customblended products to the glass, construction, ceramics, foundry, coatings, polymers, sports and recreation, filtration and various other industries primarily in North America. We believe our segments are complementary. Our ability to sell to a wide range of customers across multiple end markets allows us to maximize the recovery of our reserve base within our mining operations and to mitigate the cyclicality of our earnings. Our Strategy Our strategy is centered on three objectives repositioning our Energy segment, growing our Industrial segment’s profitability and strengthening our balance sheet. During 2019, we made significant progress executing on these three areas. Repositioning our Energy Segment. In response to a customer shift in demand toward inbasin sand, from late 2018 through 2019, we idled approximately 15 million tons of our Northern White or regional sand production capacity. The remaining production capacity of Northern White sand is located at our lowercost plants. We also commissioned three inbasin sand production plants to meet growing customer demand for this product. The market shift in demand toward inbasin sand also resulted in a reduction in demand for the railcars and terminals that are used to transport Northern White sand to an oil and gas basin. This resulted in an industry oversupply of railcars, including within our own fleet. In response, we negotiated with railcar builders to terminate approximately $195 million in future railcar purchase commitments in exchange for immaterial consideration, which included cash and lease modifications to a small portion of the fleet. Additionally, we exited leases from terminals which were no longer necessary to serve customers. Growing our Industrial Segment’s Profitability. During 2019, we successfully lowered unit production costs in our Industrial segment, which served as a tailwind to Industrial segment profitability. We also made capital investments within our Industrial segment to target specific growth opportunities. These investments included expanding our Canoitas, Mexico silica plant and expanding and modernizing our nepheline syenite plant in Nephton, Ontario. The Canoitas expansion was completed in 2019 and is expected to add additional capacity to meet growing customer demand in Mexico. The Nephton expansion and modernization is expected to be completed in 2021 and reduce costs and maintenance capital, as well as add production capacity to meet forecasted growth in demand for nepheline syenite. Strengthening our Balance Sheet. To improve our liquidity and strengthen our balance sheet, in 2019 we successfully divested several noncore assets, including our Calera, Alabama lime processing facility and Winchester & Western Railroad, which collectively generated over $240 million in proceeds. Additionally, we took advantage of favorable trading conditions to repurchase $63 million of face value of our Term Loan for $48 million. Other actions we took to improve our balance sheet in 2019 included improving working capital by more than $100 million and securing a commitment for a $75 million stand [/INST] Negative. </s>

AVEDRO INC

2019-03-21

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the related notes to those statements included elsewhere in this Annual Report on Form 10-K, or Annual Report. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. These statements are often identified by the use of words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “project,” “will,” “would” or the negative or plural of these words or similar expressions or variations and such forward-looking statements include, but are not limited to, statements with respect to our future financial and business performance. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under Item 1A. “Risk Factors,” “Special Note Regarding Forward-Looking Statements” and elsewhere in this Annual Report. Overview We are a leading commercial-stage ophthalmic medical technology company focused on treating corneal ectatic disorders and improving vision to reduce dependency on eyeglasses or contact lenses. Our proprietary Avedro Corneal Remodeling Platform is designed to strengthen, stabilize and reshape the cornea utilizing corneal cross-linking in minimally invasive and non-invasive outpatient procedures to treat corneal ectatic disorders and correct refractive conditions, which are caused by changes in the shape of the eye that prevent light from focusing on the retina, causing blurred vision. Our Avedro Corneal Remodeling Platform is comprised of our KXL and Mosaic systems, each of which delivers ultraviolet A, or UVA, light, and a suite of proprietary single-use riboflavin drug formulations, which, when applied together to the cornea, induce a biochemical reaction called corneal collagen cross-linking, or corneal cross-linking. Our KXL system in combination with our Photrexa drug formulations, which we launched in the United States in September 2016, is the first and only minimally invasive product offering approved by the U.S. Food and Drug Administration, or the FDA, indicated for the treatment of progressive keratoconus and corneal ectasia following refractive surgery. Additionally, the FDA granted us orphan drug designations and we have orphan drug exclusivity until 2023 that covers our Photrexa formulations used with our KXL system for our approved indications. We have obtained a Conformité Européene, or CE, mark for our Mosaic system, which allows it to be marketed throughout the European Union. The Mosaic System is capable of performing vision correction procedures and treating corneal ectatic disorders and we began a targeted international launch in late 2017. We sell our products primarily to ophthalmologists, hospitals and ambulatory surgery centers, or ASCs. The physicians primarily involved in corneal cross-linking are ophthalmologists who are either corneal specialists or trained in refractive procedures. According to Market Scope estimates, there are approximately 1,100 corneal refractive centers in the United States. Of these centers, we estimate there are approximately 800 centers in which a majority of cataract and refractive surgeons, as well as corneal specialists who treat keratoconus, are located. As of December 31, 2018, our KXL systems were placed in 312 centers. In the United States, we sell our products through a direct sales team that, as of December 31, 2018, consisted of ten sales professionals. If we are able to obtain FDA approval for our Mosaic system and its associated drug formulations for the treatment of presbyopia, we expect to leverage our existing sales force to cross-sell our KXL and Mosaic systems and their respective drug formulations, as they share the same target customers. In addition to the approximately 800 centers we are targeting for keratoconus, we expect to sell the Mosaic system and its associated drug formulations, if approved, to the remaining 300 corneal refractive centers that focus exclusively on refractive procedures. Outside the United States, we sell our products through a broad network of distribution partners located in markets where we see the greatest potential for corneal cross-linking procedures. We have invested heavily in our research and development activities, including product development and clinical studies to demonstrate the safety and efficacy of our corneal cross-linking platform to support regulatory submissions. We intend to continue to make significant investments in research and development efforts to support our pivotal Phase 3 clinical trial of the Epi-On procedure using our KXL system, its associated drug formulations and our Boost Goggles for the treatment of progressive keratoconus and the Phase 2a clinical trial of our Mosaic system and its associated drug formulations for the treatment of presbyopia. We also intend to make significant investments in our commercial organization by increasing the number of sales personnel and reimbursement specialists to support the establishment of consistent and favorable payment policies. Because of these and other factors, we expect to continue to incur net losses for the next several years and we expect to require substantial additional funding, which may include future equity and debt financings. On February 19, 2019, we closed our initial public offering, or IPO, of common stock, which resulted in the issuance and sale of 5,000,000 shares of common stock at a public offering price of $14.00 per share, resulting in net proceeds of approximately $61.3 million after deducting underwriting discounts and other offering costs. To date, we have financed our operations primarily through sales of our convertible preferred stock, debt financings and, more recently, sales of our proprietary Photrexa formulations and our KXL system and from our IPO, and have devoted substantially all of our resources to the research, development and engineering of our products, seeking regulatory approval of our products and the commercial launch of our KXL system and its associated drug formulations. For the years ended December 31, 2018 and 2017, we generated revenue of $27.7 million and $20.2 million, respectively. For the years ended December 31, 2018 and 2017, we had net losses of $25.1 million and $21.3 million, respectively. As of December 31, 2018, we had an accumulated deficit of $182.1 million. We believe that our existing cash and cash equivalents will enable us to fund our current projected operating expenses and capital expenditures for at least the next twelve months. We have based these estimates on assumptions that may prove to be imprecise, and we may use our available capital resources sooner than we currently expect. See “Liquidity and Capital Resources.” Adequate additional funds may not be available to us on acceptable terms, or at all. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interests of our shareholders will be diluted, and the terms of these securities may include liquidation or other preferences that adversely affect rights as a shareholder. Any future debt financing or preferred equity or other financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring additional debt, making capital expenditures or declaring dividends and may require the issuance of warrants, which could potentially dilute the ownership interests of our shareholders. Reverse Stock Split On January 31, 2019, our board of directors approved an amended and restated certificate of incorporation to (1) effect a reverse split on the outstanding shares of our common stock and convertible preferred stock on a one-for-4.45 basis, which we refer to as the Reverse Stock Split, and (2) authorize us to issue up to 200,000,000 shares of common stock, $0.00001 par value per share and 10,815,632 shares of convertible preferred stock, $0.00001 par value per share, which we refer to collectively as the Charter Amendment. The par values of our common stock and convertible preferred stock were not adjusted as a result of the Reverse Stock Split. The Charter Amendment was approved by our stockholders on January 31, 2019 and became effective upon the filing of the Charter Amendment with the State of Delaware on February 1, 2019. All issued and outstanding common stock and convertible preferred stock and related share and per share amounts contained in this Annual Report have been retroactively adjusted to reflect the Reverse Stock Split for all periods presented. Components of Our Results of Operations Revenue We generate revenue from sales of our single-use riboflavin drug formulations and our KXL and Mosaic systems. Recent revenue growth in single-use riboflavin drug formulations has been favorably impacted primarily by an increase in the average selling price in the United States, which took effect in July 2017, and we expect continued revenue growth as a result of increased patient and physician adoption of our products. The recent decrease in our U.S. device revenue has been driven by early market adoption due to significant market demand upon the U.S. commercial launch of our KXL system in September 2016, which normalized in 2018. We expect our revenue growth may be impacted to the extent we are able to support the establishment of consistent and favorable payment policies, increase patient and physician awareness of our products and continue to drive device placements in existing geographies and expansion of sales to additional corneal refractive centers in the United States. We intend to continue to expand our sales, reimbursement and marketing organization to help us drive and support revenue growth and further penetrate the market. The single-use riboflavin drug formulations represent disposable items that are used on a treatment-by-treatment basis. As we sell more devices, we expect the number of treatments performed by ophthalmologists and, correspondingly, sales of our single-use riboflavin drug formulations, to grow. As demand for new products can fluctuate significantly and delays in market adoption and healthcare reimbursement policies may occur, we anticipate that our revenue, expense and operating losses will be difficult to predict. Our revenue may also fluctuate on a quarterly basis in the future due to a variety of factors, including the impact of the buying patterns of our distributors. Cost of Goods Sold and Gross Margin We manufacture our KXL and Mosaic systems at our manufacturing facilities in Burlington, Massachusetts and Dublin, Ireland. We contract third-party manufacturers to produce our single-use riboflavin drug formulations. Cost of goods sold primarily consist of manufacturing overhead costs, material costs and direct labor. Our material costs include raw materials, reserves for expected warranty costs, scrap and inventory obsolescence. Our manufacturing overhead costs include the cost of quality assurance, material procurement, inventory control, facilities, equipment, operations supervision and management, depreciation expense for production equipment, amortization of leasehold improvements, shipping costs and royalty expense payable in connection with sales of certain products. Our labor costs include salaries, bonus, benefits and stock-based compensation. We expect cost of goods sold to increase in absolute dollars primarily as, and to the extent, our revenue grows. We expect our overall gross margin, which is calculated as revenue less cost of goods sold for a given period divided by revenue, to improve in future periods as, and to the extent, sales of our single-use riboflavin drug formulations increase and as additional medical devices are purchased. Our gross margin has been, and we expect it will continue to be, affected by a variety of factors, including product and geographic sales mix, pricing, production volumes and manufacturing costs, production yields and scrap costs, and to a lesser extent the implementation of cost-reduction strategies. We sell our products in the United States at a higher price point than what we have received historically in the international markets and therefore, as we gain market share in the United States, we believe our gross margins may be positively impacted. We believe our gross margins may be further positively improved as, and to the extent, we increase drug production volume and scale our business. As we are in the earlier stages of commercialization, we have not yet been able to take advantage of economies of scale in our manufacturing and purchasing, so gross margins may continue to be negatively impacted until such time as these efficiencies can be achieved. Selling, General and Administrative Expenses Selling, general and administrative, or SG&A, expenses are expensed as incurred and primarily consist of personnel-related expenses, including salaries, sales commissions, bonuses, fringe benefits and stock-based compensation for our executive, financial, marketing, sales and administrative functions. Other significant SG&A expenses include marketing programs, advertising, conferences and travel expenses, as well as the costs associated with obtaining and maintaining our patent portfolio and professional fees for accounting, auditing, consulting and legal services. We expect SG&A expenses to continue to grow in the foreseeable future as we increase our sales and marketing infrastructure globally and our clinical education and general administration infrastructure in the United States. In addition, we expect our general and administrative expenses will significantly increase as we increase our headcount and expand administrative personnel to support our growth and operations as a public company including finance personnel and information technology services. We also anticipate increased expenses related to audit, legal, and tax-related services, director and officer insurance premiums and investor relations costs associated with being a public company. Research and Development Expenses Research and development, or R&D, expenses are expensed as incurred and primarily consist of personnel-related expenses, including salaries, bonuses, fringe benefits and stock-based compensation for our R&D employees. Other significant R&D expenses include new product development projects and the cost of conducting our ongoing clinical trials, including the pivotal Phase 3 clinical trial of the Epi-On procedure using our KXL system, its associated drug formulations and our Boost Goggles for the treatment of progressive keratoconus and the Phase 2a clinical trial of our Mosaic system and its associated drug formulations for the treatment of presbyopia, which may include payments to investigational sites and investigators, clinical research organizations, consultants and other outside technical services and the costs of materials, supplies and travel. We expect our R&D expenses to increase as we initiate and advance our development programs and clinical trials. Other Expense, Net Other expense, net, consists primarily of (1) changes in fair value of our derivative and convertible preferred stock warrant liabilities, (2) interest expense, which includes cash and non-cash interest related to our outstanding debt owed to outside lenders associated with debt facilities including accretion of debt discount on the debt facilities and (3) interest income from interest earned on our cash equivalents. In connection with our IPO, our convertible preferred stock warrants converted into common stock warrants and we expect the liability will be reclassified as additional paid-in capital. Results of Operations Comparison of the Years Ended December 31, 2018 and 2017 Revenue Revenue for the year ended December 31, 2018 increased by $7.5 million, or 37.3%, to $27.7 million as compared to $20.2 million for the year ended December 31, 2017. The increase was primarily a result of a $7.8 million, or 72.3%, increase in sales in the United States, offset by a decrease of $0.3 million, or 3.5%, in sales outside of the United States. The increase in revenue within the United States was primarily attributable to a $10.6 million increase in drug revenue, partially offset by a $3.2 million decrease in device revenue. The increase in U.S. drug revenue was due to an increase in the average selling price of single-use riboflavin drug formulation, which was partially offset by a decrease in volume of single-use riboflavin drug formulations sold. In July 2017, we increased the price of our single-use riboflavin drug formulation sold in the United States. The decrease in U.S. device revenue was due to a decrease in volume of device sales. We sold 51 KXL systems in the United States in the year ended December 31, 2018 as compared to 92 KXL systems in the year ended December 31, 2017. The decrease in revenue outside the United States was primarily attributable to a $0.8 million decrease in drug revenue, partially offset by a $0.5 million increase in device revenue. The decrease in drug revenue was due to a decrease in volume of single-use riboflavin drug formulations sold, while the increase in device revenue was due to an increase in volume of device sales. Cost of Goods Sold and Gross Margin Our cost of goods sold for the year ended December 31, 2018 increased by $1.0 million, or 10.4%, to $10.9 million as compared to $9.9 million for the year ended December 31, 2017. The increase was primarily due to scrap costs related to expired drug product. Gross profit for the year ended December 31, 2018 increased $6.5 million as compared to the year ended December 31, 2017, and gross margin increased from 51.1% during the year ended December 31, 2017 to 60.7% during the year ended December 31, 2018. This increase in gross margin was primarily due to an increase in the average selling price of single-use riboflavin drug formulation. Selling, General and Administrative Expenses SG&A expenses for the year ended December 31, 2018 increased by $7.0 million, or 36.9%, to $26.0 million as compared to $19.0 million for the year ended December 31, 2017. The increase was driven primarily by increased employee-related costs and professional fees to support our growing business and increased commercial efforts. We incurred increased personnel and related costs of $4.3 million and increased professional fees of $0.6 million for accounting, audit, legal and tax services incurred as we increased our headcount and expand personnel and services to support our commercial growth. Additionally, marketing costs increased by $1.8 million in support of our commercial efforts, and rent and utilities increased by $0.1 million. Research and Development Expenses R&D expenses for the year ended December 31, 2018 increased by $1.7 million, or 17.1%, to $12.0 million as compared to $10.3 million for the year ended December 31, 2017. R&D headcount increased which resulted in a $1.2 million increase in personnel and related expenses. The increase was also due to $0.4 million of increased product development and clinical research costs and $0.1 million of increased depreciation expense. Other Expense, Net Other expense, net increased by $1.6 million for the year ended December 31, 2018, or 68.1%, as compared to the year ended December 31, 2017. The increase was primarily due to $0.5 million of increased interest expense, net resulting from the borrowings under our credit facility entered into in March 2017, and $1.6 million of increased expense during the year ended December 31, 2018 due to the change in fair value of our warrant liability. This was offset by a $0.2 million decrease in loss on extinguishment of debt, as the extinguishment occurred during the year ended December 31, 2017 and there were no similar changes recorded during the year ended December 31, 2018. The increase in other expense, net was also offset by a $0.2 million increase in interest income, and a $0.2 million decrease in expense due to the change in fair value of our derivative liability. Liquidity and Capital Resources As of December 31, 2018, our principal source of liquidity was cash and cash equivalents of $9.8 million. We believe that the net proceeds from our IPO, along with our existing cash and cash equivalents, will be sufficient to fund our projected liquidity requirements for at least the next twelve months. Historically, our sources of cash have included private placements of equity securities, debt financings and cash generated from operations, primarily from the collection of accounts receivable resulting from product sales. Our historical cash outflows have primarily been associated with cash payments to service our debt, in addition to cash used for operating activities, such as the purchase and growth of inventory, expansion of our sales, marketing, research and development activities, and other working capital needs; and expenditures related to equipment and improvements used to increase our manufacturing capacity, to improve our manufacturing efficiency, and for overall facility expansion. If our sources of cash are insufficient to satisfy our liquidity requirements, however, we may seek to sell additional equity or make additional borrowings under a new credit facility. If we raise additional funds by issuing equity securities, our stockholders would experience dilution. Debt financing, if available, may involve covenants restricting our operations or our ability to incur additional debt. Any additional debt financing or additional equity that we raise may contain terms that are not favorable to us or our stockholders. Additional financing may not be available at all, or in amounts or on terms unacceptable to us. If we are unable to obtain additional financing, we may be required to delay the development, commercialization and marketing of our products. Initial Public Offering On February 19, 2019, we closed our IPO in which we sold 5,000,000 shares of common stock, at a public offering price of $14.00 per share, for aggregate gross proceeds of $70.0 million. The net offering proceeds to us, after deducting underwriting discounts and commissions of $4.9 million and estimated offering expenses of approximately $3.8 million, were approximately $61.3 million. See Notes 2 and 17 to our audited financial statements included elsewhere in this Annual Report for more information. Debt Facility On March 20, 2017, we entered into a credit agreement, or the Credit Agreement, with OrbiMed Royalty Opportunities II, L.P., or OrbiMed, which is affiliated with OrbiMed Private Investments VI, LP, or OrbiMed Private Investments. The Credit Agreement made available to us two loans, one in the amount of $20.0 million, which we borrowed in March 2017, and the second in the amount of $10.0 million, which was available through December 31, 2017, based on a revenue milestone, but never drawn. Under the Credit Agreement, cash interest accrues until maturity at the rate of 10% per annum, or the Applicable Margin. Additional interest, or PIK interest, accrues at the per annum rate equal to the higher of (1) the three-month LIBOR rate and (2) 1.00%. Such PIK interest is added to the outstanding principal amounts outstanding under the Credit Agreement on the last day of each calendar quarter until the maturity date. Outstanding principal amounts plus all accrued and unpaid PIK interest are due in one lump sum payment on the loan maturity date, March 20, 2022. The Credit Agreement includes affirmative and negative covenants and events of default, including the following events of default: payment defaults, breaches of representations and warranties, non-performance of certain covenants and obligations, cross-acceleration with debt, judgment defaults, change in control, bankruptcy, certain events with respect to key permits, regulatory events, recalls and certain actions and settlements with governmental entities, key person events, a material impairment in the perfection or priority of OrbiMed’s security interest or in the value of the collateral, a material adverse change in the business, operations or condition of us and our subsidiaries taken as a whole and a material impairment of the prospect of repayment of the loans. Upon the occurrence of an event of default and continuing until such event of default is no longer continuing, the Applicable Margin will increase by 3.00% per annum. If we repay all or a portion of the term loans prior to maturity, we will pay OrbiMed a prepayment fee as follows: for amounts repaid after March 20, 2018 but on or prior to March 20, 2019, 9% of the portion of principal repaid; for amounts repaid after March 20, 2019 but on or prior to March 20, 2020, 5% of the portion of principal repaid; and for amounts repaid after March 20, 2020 but on or prior to March 20, 2021, 3% of the portion of the principal repaid. No prepayment fee will be required for amounts repaid after March 20, 2021 but prior to March 20, 2022. Our obligations under the Credit Agreement are secured by a security interest in substantially all of our assets, including our intellectual property. In connection with the Credit Agreement and the close of the first draw in March 2017, we issued to OrbiMed warrants to purchase 106,617 shares of Series AA convertible preferred stock at an exercise price of $4.45 per share. Each warrant is exercisable for a period of ten years from the date of issuance and may be exercised on a cashless basis in whole or in part. During March 2017, we repaid in full a loan and security agreement we entered into in September 2014 with an outside lender for $12.5 million, with the proceeds from the Credit Agreement. As of December 31, 2018, we have borrowed and have outstanding $20.0 million of debt under the Credit Agreement. As of December 31, 2018, we have recorded a long-term debt obligation of $19.9 million for the Credit Agreement, which includes borrowings outstanding of $20.0 million and accrued PIK interest of $0.6 million, net of debt discount of $0.7 million. Historical Cash Flows The following table shows a summary of our cash flows for the periods presented: Operating Activities Net cash used in operating activities was $22.2 million for the year ended December 31, 2018, reflecting a net loss of $25.1 million and net changes in operating assets and liabilities of $0.8 million, partially offset by non-cash charges of $3.8 million primarily for stock-based compensation expense and a change in assets and liabilities held at fair value. Net cash used in operating activities was $24.0 million for the year ended December 31, 2017, reflecting a net loss of $21.3 million, net changes in operating assets and liabilities of $4.7 million and partially offset by non-cash charges of $2.0 million primarily for stock-based compensation expense and depreciation. Investing Activities Net cash used in investing activities was $0.4 million and $0.8 million for the years ended December 31, 2018 and 2017, respectively, and resulted from the purchase of property and equipment. Financing Activities Net cash provided by financing activities totaling $23.5 million for the year ended December 31, 2018 was primarily due to net proceeds of $24.8 million from the issuance of Series CC convertible preferred stock, offset by deferred offering costs of $1.2 million. Net cash provided by financing activities totaling $21.0 million for the year ended December 31, 2017 was primarily due to net proceeds of $11.8 million from the issuance of Series BB convertible preferred stock, proceeds of $20.0 million from borrowings under our Credit Agreement, offset by payments on long-term debt of $9.8 million, representing repayment of our prior credit agreement. Contractual Obligations and Commitments Our contractual obligations and commitments consist of obligations under our outstanding debt facilities, leases for our office space, and our supplier and manufacturing agreements. The following table summarizes these contractual obligations as of December 31, 2018: Long-term debt obligation represents fixed amounts due under our Credit Agreement. The table above includes the $20.0 million maturity payment and PIK interest accrued as of December 31, 2018. We have not included an estimate of the additional PIK interest, which will accrue quarterly and is due on maturity, as the amount of accrued PIK interest will vary based on three month LIBOR. We pay 10% interest quarterly on the aggregate of the $20.0 million maturing payment and accrued PIK interest, which we have not included an estimate of due to the variable PIK interest rates that are dependent on market interest rates. Operating lease obligations represent future minimum lease payments under non-cancelable operating leases in effect as of December 31, 2018, including remaining lease payments for our current facilities in Waltham and Burlington, Massachusetts. Purchase obligations include minimum committed and non-cancelable amounts due under our supplier and manufacturing agreements. In addition, we have a $0.3 million final milestone payment due under a license agreement. The payment is contingent on the issuance of a patent and therefore is not reflected in the table above. Off-Balance Sheet Arrangements During the periods presented, we did not and do not currently have any off-balance sheet arrangements as defined under SEC rules, such as relationships with unconsolidated entities or financial partnerships, including entities sometimes referred to as structured finance or special purpose entities that were established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Critical Accounting Policies and Estimates Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States, or U.S. GAAP, requires management to make estimates and assumptions that impact the reported amounts of assets, liabilities, revenues, and expenses and the disclosure of contingent assets and liabilities in our financial statements and accompanying notes. The most significant assumptions used in the financial statements are the underlying assumptions used in revenue recognition, product warranties, inventory valuation and valuing share-based compensation including the fair value of our common stock. We base estimates and assumptions on historical experience when available and on various factors that it determined to be reasonable under the circumstances. We evaluate our estimates and assumptions on an ongoing basis. Our actual results may differ from these estimates under different assumptions or conditions. Significant areas requiring management estimates or judgments include the following key financial areas: Revenue Recognition We derive our revenue principally from sales of our medical devices and related single-use riboflavin drug formulations. We recognize revenue when all four of the following criteria are met: (1) persuasive evidence that an agreement exists; (2) delivery of the products and/or services has occurred; (3) the selling price is fixed or determinable and (4) collectability is reasonably assured. U.S. Product Revenue We sell single-use riboflavin drug formulations and medical devices directly to customers, which are typically physician clinics or hospitals, through our direct sales force. In each arrangement, we are responsible for installation and calibration of the medical devices and initial user training, which are deemed essential to the functionality of the medical device. Each medical device is sold with a standard one-year warranty from the date of shipment, which provides that the medical device will function as intended during that one-year period or we will either replace the product, or a portion thereof, or provide the necessary repair service during our normal service hours. The single-use riboflavin drug formulations are shipped with a minimum shelf life remaining until their sterility expiration, which is generally six to 12 months. We generally enter into multiple element arrangements with our new customers, which include the sale of a medical device with an initial order of related single-use riboflavin drug formulations, and may include an extended warranty. Therefore, we recognize device revenue when the initial order of the related single-use riboflavin drug formulations is delivered, user training is completed and the medical device is delivered, installed and accepted by the end user customer. The customers have no right of return or inventory swap-out provisions. In the event we enter into a contract in which the deliverables are required to be separated, we will allocate arrangement consideration to each deliverable in an arrangement based on its relative selling price. We will determine the selling price using vendor-specific objective evidence, or VSOE, if it exists; otherwise, we will use third-party evidence, or TPE. If neither VSOE nor TPE of selling price exists for a deliverable, we will use best estimated selling price to allocate the arrangement consideration. We will apply appropriate revenue recognition guidance to each unit of accounting. The assessment of multiple-deliverable arrangements requires judgment in order to determine the appropriate unit of accounting, the estimated selling price of each unit of accounting and the point in time that, or the period over which, revenue should be recognized. Single-use riboflavin drug formulations have a warranty period up to sterility expiration, which is generally six to twelve months. Through June 30, 2017, we recognized revenue of subsequent single-use riboflavin drug formulations orders upon shipment as all four revenue criteria are met. In July 2017, we began offering extended payment terms to our customers in which a portion of the purchase price of the single-use riboflavin drug formulations would be payable in 30 days and the remainder payable in 180 days. Under these new payment terms, we were not able to reasonably assure the fees are fixed and determinable or collectability is reasonably assured on the shipment date. Therefore, we recognize revenue on the single-use riboflavin drug formulations when the payment becomes due from the customer and collectability is reasonably assured, which is generally 30 to 180 days from the invoice date. Although the amounts charged per treatment are invoiced to the customer on the shipment date, we do not record deferred revenue or accounts receivable for the amounts charged under extended payment terms since collectability cannot be reasonably assured. $5.5 million and $2.4 million of single-use riboflavin drug formulations amounts were invoiced to customers under extended payment terms, and were excluded from our balance sheet at December 31, 2018 and 2017, respectively. Product Revenue Outside the United States We have established distributor agreements with various distributors throughout the world. Inventory title transfers to the distributor at the time of shipment. The payment from the distributor is due in accordance with our standard payment terms. These payments are not contingent upon the distributor’s sale of products to its customers. The distributors have no right of return or inventory swap-out provisions. Medical devices sold are generally covered by a one year warranty. The related single-use riboflavin drug formulations are shipped with a minimum shelf life remaining until their sterility expiration, which is generally six to 12 months. Once the products are shipped to the distributor we have no further obligation except for the warranty provision. As such, revenue and cost of revenue are recognized upon shipment. The term of the distributor agreements is typically two years, with each option of renewal not exceeding one year. Multiple-deliverable arrangements are analyzed to determine whether the deliverables can be separated or whether they must be accounted for as a single unit of accounting. When deliverables are separable, consideration received is allocated to the separate units of accounting based on the relative selling price method and the appropriate revenue recognition principles are applied to each unit. When we determine that an arrangement should be accounted for as a single unit of accounting, we must determine the period over which the performance obligations will be performed and revenue will be recognized. Product Warranty Our medical devices are covered by a standard warranty which outside the United States is for 15 months following shipment or 12 months following installation at the end-customer site, and inside the United States is 12 months following installation. We record our estimated contractual obligations at the time of shipment since installations are within 30 days of shipment and returns are not accepted. We consider the 12-month rolling average of actual warranty claims associated with its medical devices and related single-use riboflavin drug formulations when determining the warranty accrual estimate. Inventories We state inventories at the lower of first-in, first-out cost, or net realizable value. We adjust our cost basis for excess, expired and obsolete inventories primarily on estimates of forecasted net sales. We capitalize inventories in preparation for sales of products when the related product candidates are considered to have a high likelihood of regulatory clearance and the related costs are expected to be recoverable through sales of the inventories. In addition, we capitalize inventories related to the manufacture of medical devices that have a high likelihood of regulatory clearance and will be retained as our assets upon determination that the instrument has alternative future uses. In determining whether or not to capitalize such inventories, we evaluate, among other factors, information regarding the product candidate’s status of regulatory submissions and communications with regulatory authorities, the outlook for commercial sales and alternative future uses of the product candidate. Costs associated with development products prior to satisfying the inventory capitalization criteria are charged to research and development expense as incurred. We classify amounts related to medical devices that we own and use in the Company’s operations, as a component of property and equipment. The cost of these commercially sellable devices is capitalized as inventory until such time we determine the instrument will be used for internal purposes. Stock-Based Compensation We maintain an equity incentive plan to provide long-term incentives for employees, consultants, and members of the board of directors. The plan allows for the issuance of stock-based incentive awards to employees or employees of our affiliates. We recognize equity-based compensation expense for awards of equity instruments to employees and non-employees based on the grant date fair value of those awards in accordance with Financial Accounting Standards Board, or FASB, Accounting Standards Codification (“ASC”) Topic 718, Stock Compensation, or ASC 718. ASC 718 requires all equity-based compensation awards to employees and nonemployee directors, including grants of restricted shares and stock options, to be recognized as expense in the statements of operations and comprehensive loss based on their grant date fair values. We estimate the fair value of stock options using the Black-Scholes option pricing model. We use the value of our common stock to determine the fair value of restricted shares. We account for restricted stock and common stock options issued to nonemployees under FASB ASC Topic 505-50, Equity-Based Payments to Non-Employees, or ASC 505-50. As such, the value of such options is periodically remeasured and income or expense is recognized over their vesting terms. Compensation cost related to awards with service-based vesting schedules is recognized using the straight-line method. We determine the fair value of the restricted stock and common stock granted to non-employees as either the fair value of the consideration received or the fair value of the equity instruments issued. We have not granted any share-based awards to our consultants. The Black-Scholes option pricing model requires the input of certain subjective assumptions, including (1) the expected share price volatility, (2) the expected term of the award, (3) the risk-free interest rate and (4) the expected dividend yield. Due to the lack of a public market for the trading of our common stock and a lack of company-specific historical and implied volatility data, we have based our estimate of expected volatility on the historical volatility of a group of similar companies that are publicly traded. The historical volatility is calculated based on a period of time commensurate with the expected term assumption. The group of representative companies have characteristics similar to us, including stage of product development and focus on the life science industry. We use the simplified method, which is the average of the final vesting tranche date and the contractual term, to calculate the expected term for options granted to employees as we do not have sufficient historical exercise data to provide a reasonable basis upon which to estimate the expected term. For options granted to non-employees, we utilize the contractual term of the arrangement as the basis for the expected term assumption. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected term of the stock options. We use an assumed dividend yield of zero as we have never paid dividends and have no current plans to pay any dividends on our common stock. We expense the fair value of our equity-based compensation awards granted to employees on a straight-line basis over the associated service period, which is generally the period in which the related services are received. We measure equity-based compensation awards granted to nonemployees at fair value as the awards vest and recognize the resulting value as compensation expense at each financial reporting period. We account for award forfeitures as they occur. Historically, the fair value of the underlying common stock was determined by the board of directors, with input from management and the assistance of a third-party valuation specialist, by determining our equity value and then allocating this value among the different classes of equity securities based on their respective rights and individual characteristics. The equity value was determined using three different methods, which includes back-solving overall equity value to the price paid by recent financing transactions, using a combination of the market-based approach and the income approach, and also utilizing a hybrid method, as discussed below. The fair value of our equity was then allocated to various securities within our capital structure by applying an option pricing method. The option pricing method estimates the fair value of each class of security based on the potential to profit from the upside of the business, while taking into account the unique characteristics of each class of security. Starting with the valuation of our common stock on December 31, 2018, we utilized the probability-weighted expected return method, or PWERM, in combination with the option pricing method, or OPM, as a hybrid method, or Hybrid Method, which is an accepted valuation method under the AICPA Practice Guide, for determining the fair value of our common stock. The PWERM is a scenario-based analysis that estimates the value per share of common stock based on the probability-weighted present value of expected future equity values for the common stock, under various possible future liquidity event scenarios, in light of the rights and preferences of each class and series of stock, discounted for a lack of marketability. The OPM values each equity class by creating a series of call options on the equity value, with exercise prices based on the liquidation preferences, participation rights and strike prices of derivatives. The Hybrid Method is appropriate for a company expecting a near term liquidity event, but where, due to market or other factors, the likelihood of completing the liquidity event is uncertain. The Hybrid Method considers a company’s going concern nature, stage of development and ability to forecast near and long-term future liquidity scenarios. Recent Accounting Pronouncements See Note 2 to our audited financial statements included elsewhere in this Annual Report for more information.

<s>[INST] Overview We are a leading commercialstage ophthalmic medical technology company focused on treating corneal ectatic disorders and improving vision to reduce dependency on eyeglasses or contact lenses. Our proprietary Avedro Corneal Remodeling Platform is designed to strengthen, stabilize and reshape the cornea utilizing corneal crosslinking in minimally invasive and noninvasive outpatient procedures to treat corneal ectatic disorders and correct refractive conditions, which are caused by changes in the shape of the eye that prevent light from focusing on the retina, causing blurred vision. Our Avedro Corneal Remodeling Platform is comprised of our KXL and Mosaic systems, each of which delivers ultraviolet A, or UVA, light, and a suite of proprietary singleuse riboflavin drug formulations, which, when applied together to the cornea, induce a biochemical reaction called corneal collagen crosslinking, or corneal crosslinking. Our KXL system in combination with our Photrexa drug formulations, which we launched in the United States in September 2016, is the first and only minimally invasive product offering approved by the U.S. Food and Drug Administration, or the FDA, indicated for the treatment of progressive keratoconus and corneal ectasia following refractive surgery. Additionally, the FDA granted us orphan drug designations and we have orphan drug exclusivity until 2023 that covers our Photrexa formulations used with our KXL system for our approved indications. We have obtained a Conformité Européene, or CE, mark for our Mosaic system, which allows it to be marketed throughout the European Union. The Mosaic System is capable of performing vision correction procedures and treating corneal ectatic disorders and we began a targeted international launch in late 2017. We sell our products primarily to ophthalmologists, hospitals and ambulatory surgery centers, or ASCs. The physicians primarily involved in corneal crosslinking are ophthalmologists who are either corneal specialists or trained in refractive procedures. According to Market Scope estimates, there are approximately 1,100 corneal refractive centers in the United States. Of these centers, we estimate there are approximately 800 centers in which a majority of cataract and refractive surgeons, as well as corneal specialists who treat keratoconus, are located. As of December 31, 2018, our KXL systems were placed in 312 centers. In the United States, we sell our products through a direct sales team that, as of December 31, 2018, consisted of ten sales professionals. If we are able to obtain FDA approval for our Mosaic system and its associated drug formulations for the treatment of presbyopia, we expect to leverage our existing sales force to crosssell our KXL and Mosaic systems and their respective drug formulations, as they share the same target customers. In addition to the approximately 800 centers we are targeting for keratoconus, we expect to sell the Mosaic system and its associated drug formulations, if approved, to the remaining 300 corneal refractive centers that focus exclusively on refractive procedures. Outside the United States, we sell our products through a broad network of distribution partners located in markets where we see the greatest potential for corneal crosslinking procedures. We have invested heavily in our research and development activities, including product development and clinical studies to demonstrate the safety and efficacy of our corneal crosslinking platform to support regulatory submissions. We intend to continue to make significant investments in research and development efforts to support our pivotal Phase 3 clinical trial of the EpiOn procedure using our KXL system, its associated drug formulations and our Boost Goggles for the treatment of progressive keratoconus and the Phase 2a clinical trial of our Mosaic system and its associated drug formulations for the treatment of presbyopia. We also intend to make significant investments in our commercial organization by increasing the number of sales personnel and reimbursement specialists to support the establishment of consistent and favorable payment policies. Because of these and other factors, we expect to continue to incur net losses for the [/INST] Positive. </s>

urban-gro, Inc.

2019-04-01

2018-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion should be read in conjunction with our audited financial statements and notes thereto included herein. In connection with, and because we desire to take advantage of, the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution readers regarding certain forward looking statements in the following discussion and elsewhere in this Report and in any other statement made by, or on our behalf, whether or not in future filings with the Securities and Exchange Commission. Forward looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Forward looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on our behalf. We disclaim any obligation to update forward looking statements. Overview We were originally formed on March 20, 2014, as a Colorado limited liability company. In March 2017, we converted to a corporation and issued 193.3936722 shares of our Common Stock for every Member Interest issued and outstanding on the date of conversion. We are an agricultural technology systems integrator that provides full design and expertise on climate and automated control of fertigation/irrigation systems, lighting systems, environmental, substrate and inventory monitoring, water treatment systems, integrated pest management solutions, and a complete line of cultivation equipment targeting growers of the world’s highest value crops including cannabis, tomatoes, strawberries, chilies and peppers, and leaf lettuce. While it is our intention to expand our operations to additional applications, to date, all of our revenues have been generated in the cannabis industry. We engage directly in the business of manufacturing, distributing and selling lighting, pest management, fertigation, water and other products to the medical and recreational cannabis industry in states where operation of a cannabis production facility has been legalized. We have and will continue to work with grow operations and production facilities to pursue strategies to provide services, products, and other potential revenue-producing opportunities with respect to the cannabis industry in those states where the same is lawful. We engage directly with the ownership groups and growers at large indoor and outdoor greenhouse cultivation facilities and strategically work with them to provide value-added services and industry best products that assist them in lowering production costs and increasing crop yields. While earmarking the emerging cannabis market as our principal target market, we are also marketing to customers outside of the cannabis industry to diversify our operations. Our executive office is located at 1751 Panorama Point, Unit G, Lafayette, CO 80026, and our phone number is (720) 390-3880. We also maintain offices in Denver, CO. Our Company website is www.urban-gro.com, which contain a description of our Company and products, but such websites and the information contained on our websites are not part of this Report. In addition, we also maintain branded product websites of www.soleiltech.ag and www.opti-dura.com. RESULTS OF OPERATIONS Comparison of Results of Operations for the years ended December 31, 2018 compared to 2017 During the year ended December 31, 2018, we generated revenues of $20,050,776, compared to revenues of $12,298,015 during the year ended December 31, 2017, an increase of $7,752,761 (63%). This increase in revenues is attributable to sales of cultivation technology systems, which increased by $2,520,960. We generate revenue both from (i) working with facility owners to design and build out new facilities, and (ii) selling consumable products once existing facilities are operational. While this increase may be attributable to the general growth of the cannabis industry in North America which has provided us with additional sales opportunities, we also believe that this increase in revenue occurred primarily as a result of our increased emphasis on our cultivation technologies segment. Revenue in this revenue stream increased by $2,520,960(138%) compared to the years ended December 31, 2017, as a result of increased sales in water treatment systems, fans and benches. During the years ended December 31, 2018, our fertigation revenue also increased by $3,286,894(87.5%), from the comparable period in 2017, which we attribute to the continued expansion of the cannabis industry in both the US and Canada. As cannabis cultivation projects increase in size there is a larger demand for fertigation controls, which we meet through the sale of our Argus line of products. Our sales of consumables also increased by $876,749 (35.7%) during the year ended December 31, 2018 compared to 2017. As we have previously disclosed, in 2016 we began diversifying our business, moving from a lighting distribution company to emphasizing cultivation technologies. In 2015, we were considered a value added reseller of P.L. grow light systems, with 97% of our revenues generated from lighting related product sales. In order to grow our business we made a strategic decision to: · focus on building/positioning our brand as an ancillary national market leader delivering best in class value-added product solutions to Cannabis cultivators; · expand our sales reach to extend across the US; and · expand our product offering to include a full line of other cultivation equipment and products used by cannabis cultivators. Today, we believe we are a leading systems integrator that provides commercial cannabis cultivators with a one-stop, complete “turnkey” solution covering (i) engineering / MEP & System design, (ii) project management, (iii) systems sales, (iv) project commissioning, and (v) re-occurring consumable product sales. Cost of sales increased to $13,892,025 during the years ended December 31, 2018, compared to $9,244,329 during 2017, an increase of $4,647,696. These increases are directly related to our increased revenues. Operating expenses also increased during the years ended December 31, 2018 compared to 2017 by $4,542,506, from $5,416,829 in the years ended December 31, 2017, to $9,959,335 in 2018. Marketing expense increased by $666,008 due to increases in advertising expenses, business development and costs of attendance at trade shows. General and administrative expense increased by $2,715,511 due to our expanding work force. During 2018 our number of employees increased by 20, including additional members of management, which increased compensation expense. Additional expenses were incurred arising out of increased technology professional staffing in anticipation of launching our Soleil® sensor platform. Professional fees also increased by $18,125, from $603,466 during the year ended December 31, 2017, to $621,591 in 2018 due to increased legal and accounting fees and general business consultants. Travel expense increased by $82,531 due to our expanding sales and marketing to additional jurisdictions. Stock compensation expense for the years ended December 31, 2018 and 2017 was $1,245,826 and $84,839, respectively, based on the vesting schedule of the stock grants. Through repayment of debt and conversion of previously existing debt to equity, interest expense in the years ended December 31, 2018 decreased to $119,961, compared to $216,576 incurred during 2017. As a result, we incurred a net loss of $3,895,873 during the year ended December 31, 2018 ($0.16 per share), compared to a net loss of $2,577,395 during the year ended December 31, 2017 ($0.11 per share). Liquidity and Capital Resources As of December 31, 2018, we had cash or cash equivalents of $1,178,852. Net cash used in operating activities was $2,285,136 in 2018, compared to cash provided by operating activities of $244,661 in 2017. We anticipate that overhead costs and other expenses will increase in the future as we continue to expand our operations. Cash flows used in investing activities were $1,264,803 in 2018 compared to $612,543 used in 2017. Cash flows provided by financing activities were $3,072,000 in 2018, compared to $2,007,210 provided by financing activities during the year ended December 31, 2017. During the year ended December 31, 2018, 558,833 shares of Common Stock previously reserved for issuance to employees, vested and were issued. The significant increase in customer deposits was due to an increase in customer orders. Customer orders require prepayments before the design work is commenced and before any material is ordered from the vendor. Prepayments are booked the customer deposits liability account when received. When the product ships to the customer, the customer is invoiced and an accounts receivable balance is created for the customer. The deposit is then moved from the customer deposit account to the customer accounts receivable account to clear the receivable. Our standard policy is to collect the following before action is taken: a 10% design deposit, 40% order deposit, and a 50% shipping deposit. We expect customer deposits to be relieved from the deposits account no longer than 12 months for each project. The net cash used in operations for prepayments and advances are for payments made to vendors for prepayments on orders. Due to the increase in projects, we increased our prepayments to order materials from our vendors. In May 2017, we commenced a private offering of our Common Stock wherein we received aggregate subscriptions of $2,546,000 from the sale of 2,546,000 shares, at $1 per share, to 76 investors, including 58 “accredited” investors, as that term is defined under the Securities Act of 1933, as amended. These funds were used to repay debt, expansion of our existing business operations, new investment opportunities and working capital. We currently have five other notes outstanding, four of which are unsecured. Two of the note holders agreed to convert $300,000 and $200,000 of their respective notes into shares of our Common Stock as part of our private placement of Common Stock in 2017, leaving a balance of $80,000 and $100,000, respectively. Interest accrues at 20.4% and 18% per annual on these notes. Both are unsecured and due June 30, 2019. The third note has a principal balance of $300,000, accrues interest at the rate of 19.8% per annual and was due to mature March 23, 2018. In March 2018 this note was extended for one year. In consideration for the lender’s agreement to extend this note we issued 6,000 warrants, each exercisable to purchase one share of our Common Stock at a price of $1 per share for a term of five years. Interest is paid twice monthly. In March 2019, we paid the lender $35,000 to reduce the principal balance to $265,000 and extended the maturity to April 30, 2019. In October 2018, we received a $1 million unsecured loan from James Lowe, a director, which is due on or before April 30, 2019. The loan has a one-time origination fee of $12,500. Interest accrues at the rate of 12% per annum and is paid monthly. As additional consideration for the loan we granted Mr. Lowe an option to purchase 30,000 shares of our common stock at an exercise price of $1.20 per share, which option is exercisable for a period of five (5) years. The loan is guaranteed by Messrs. Nattrass and Gutierrez, two of our officers, directors and our principal shareholders. Effective November 20, 2018, we entered into a letter of intent (“LOI”) with Hydrofarm Holdings Group, Inc. (“Hydrofarm”) whereby Hydrofarm would acquire all of our issued and outstanding common stock (the “Merger”). The LOI provided that Hydrofarm would extend to us a secured, interest only, note payable upon execution of the LOI. The note is secured by all of our currently existing and future assets. Interest accrues at 8% per year and is paid quarterly. The note matures on the earlier of: (a) 90 days after the date of abandonment of the Merger; (b) acceleration of the note payable due to our being in default; or (c) December 2023. Although the Merger has not been abandoned and the LOI has not been terminated by either party, there are currently no discussions between the parties pertaining to the Merger and we believe the note payable should be classified as a current maturity. The Hydrofarm note requires us to obtain the permission of Hydrofarm to engage in various activities, including additional financing. In February 2019 we provided applicable notice of our agreement with 4Front discussed herein to raise additional debt and/or equity. Hydrofarm provided their consent, which reaffirms our belief that the relevant note remains in good standing. Our management estimates that we will need up to an additional $5 million in capital to fully implement our current business plan. We estimate we will need approximately $2.5 million for advanced inventory purchases and $1 million for expanding operations, including retaining additional professionals in technology, design and engineering and in commissioning services. While no assurances can be provided we anticipate that a portion of these funds will be provided from our cash flow. However, if we do not generate sufficient cash flow, or if additional expenditures and acquisitions are identified and we cannot use our securities as compensation, we will need additional capital to continue to implement our business plan. While we believe we will be able to raise these funds in either debt or equity, we have no agreement with any third party to provide us the same and there can be no assurances that we will be able to raise any capital on commercially reasonable terms, or at all. If we require additional capital and are unable to raise the same, it could have a material negative impact on our results of operations. Subsequent Event Effective January 9, 2019, we executed a letter agreement with 4Front Capital Partners, Inc., Toronto, Canada (“4Front), whereby 4Front agreed to act as our exclusive placement agent in connection with a proposed private offering of up to $6 million of either debt or equity securities, or a combination of the same, at a price to be determined, on a “best efforts” basis. Inflation Although our operations are influenced by general economic conditions, we do not believe that inflation had a material effect on our results of operations during the year ended December 31, 2018. Critical Accounting Policies and Estimates Critical Accounting Estimates Our financial statements and accompanying notes have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires management to make estimates, judgments and assumptions that affect reported amounts of assets, liabilities, revenues and expenses. We continually evaluate the accounting policies and estimates used to prepare the financial statements. The estimates are based on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual amounts and results could differ from these estimates made by management. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS From time to time, the FASB or other standards setting bodies issue new accounting pronouncements. Updates to the FASB ASCs are communicated through issuance of an Accounting Standards Update ("ASU"). Unless otherwise discussed, we believe that the impact of recently issued guidance, whether adopted or to be adopted in the future, is not expected to have a material impact on our financial statements upon adoption. In February 2016, the FASB issued ASU 2016-02 “Leases”, which together with subsequent amendments is included in ASC 842, “Leases”. Most significantly, ASC 842 requires a lessee to recognize on the statement of financial position a liability to make lease payments and an asset with respect to its right to use the underlying asset for the lease term. Leases are classified as either financing or operating, with classification affecting the pattern of expense recognition in the statements of operations. ASC 842 also requires improved disclosures to help users of financial statements better understand the amount, timing and uncertainty of cash flows arising from leases. The update is effective for fiscal years beginning after December 15, 2018, including interim reporting periods within that reporting period. Early adoption is permitted. The Company is adopting ASC 2016-02 effective January 1, 2019 under the modified retrospective method with respect to lease contracts in effect as of the adoption date. The adoption of ASC 2016-02 will increase our assets and liabilities by approximately $139,000 as of January 1, 2019 due to the recognition of right-of-use assets and lease liabilities with respect to operating leases. The Company does not believe the adoption of ASC 842 will have a material effect on its financial position, results of operations or cash flows In June 2018, the FASB issued ASU 2018-07, “Compensation - Stock Compensation (Topic 718): Improvements in Nonemployee Share-Based Payment Accounting” which simplifies the accounting for share-based payments to nonemployees by aligning it with the accounting for share-based payments to employees, with certain exceptions. Under the guidance, the measurement of equity-classified nonemployee awards will be fixed at the grant date, which may lower their cost and reduce volatility in the income statement. The update is effective for fiscal years beginning after December 31, 2018, including interim reporting periods within that reporting period. Early adoption is permitted. The Company is adopting ASU 2018-07 effective January 1, 2019 and does not believe the adoption of ASU 2018-07 will have a material effect on its financial position, results of operations or cash flows. There are other various updates recently issued by the FASB, most of which represented technical corrections to the accounting literature or application to specific industries and are not expected to have a material impact on the Company's financial position, results of operations or cash flows. Management has reviewed all other recently issued, but not yet effective, accounting pronouncements and do not believe the future adoption of any such pronouncements may be expected to cause a material impact on our financial condition or the results of our operations. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources and would be considered material to investors.

<s>[INST] Overview We were originally formed on March 20, 2014, as a Colorado limited liability company. In March 2017, we converted to a corporation and issued 193.3936722 shares of our Common Stock for every Member Interest issued and outstanding on the date of conversion. We are an agricultural technology systems integrator that provides full design and expertise on climate and automated control of fertigation/irrigation systems, lighting systems, environmental, substrate and inventory monitoring, water treatment systems, integrated pest management solutions, and a complete line of cultivation equipment targeting growers of the world’s highest value crops including cannabis, tomatoes, strawberries, chilies and peppers, and leaf lettuce. While it is our intention to expand our operations to additional applications, to date, all of our revenues have been generated in the cannabis industry. We engage directly in the business of manufacturing, distributing and selling lighting, pest management, fertigation, water and other products to the medical and recreational cannabis industry in states where operation of a cannabis production facility has been legalized. We have and will continue to work with grow operations and production facilities to pursue strategies to provide services, products, and other potential revenueproducing opportunities with respect to the cannabis industry in those states where the same is lawful. We engage directly with the ownership groups and growers at large indoor and outdoor greenhouse cultivation facilities and strategically work with them to provide valueadded services and industry best products that assist them in lowering production costs and increasing crop yields. While earmarking the emerging cannabis market as our principal target market, we are also marketing to customers outside of the cannabis industry to diversify our operations. Our executive office is located at 1751 Panorama Point, Unit G, Lafayette, CO 80026, and our phone number is (720) 3903880. We also maintain offices in Denver, CO. Our Company website is www.urbangro.com, which contain a description of our Company and products, but such websites and the information contained on our websites are not part of this Report. In addition, we also maintain branded product websites of www.soleiltech.ag and www.optidura.com. RESULTS OF OPERATIONS Comparison of Results of Operations for the years ended December 31, 2018 compared to 2017 During the year ended December 31, 2018, we generated revenues of $20,050,776, compared to revenues of $12,298,015 during the year ended December 31, 2017, an increase of $7,752,761 (63%). This increase in revenues is attributable to sales of cultivation technology systems, which increased by $2,520,960. We generate revenue both from (i) working with facility owners to design and build out new facilities, and (ii) selling consumable products once existing facilities are operational. While this increase may be attributable to the general growth of the cannabis industry in North America which has provided us with additional sales opportunities, we also believe that this increase in revenue occurred primarily as a result of our increased emphasis on our cultivation technologies segment. Revenue in this revenue stream increased by $2,520,960(138%) compared to the years ended December 31, 2017, as a result of increased sales in water treatment systems, fans and benches. During the years ended December 31, 2018, our fertigation revenue also increased by $3,286,894(87.5%), from the comparable period in 2017, which we attribute to the continued expansion of the cannabis industry in both the US and Canada. As cannabis cultivation projects increase in size there is a larger demand for fertigation controls, which we meet through the sale of our Argus line of products. Our sales of consumables also increased by $876,749 (35.7%) during the year ended December 31, 2018 compared to 2017. As we have previously disclosed, in 2016 we began diversifying our business [/INST] Negative. </s>

urban-gro, Inc.

2020-05-18

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion should be read in conjunction with our consolidated financial statements and notes thereto included herein. In connection with, and because we desire to take advantage of, the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we caution readers regarding certain forward looking statements in the following discussion and elsewhere in this report and in any other statement made by, or on our behalf, whether or not in future filings with the Securities and Exchange Commission. Forward looking statements are statements not based on historical information and which relate to future operations, strategies, financial results or other developments. Forward looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and many of which, with respect to future business decisions, are subject to change. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on our behalf. We disclaim any obligation to update forward looking statements. Overview urban-gro is a leading engineering design services company that integrates complex environmental equipment systems to create high-performance indoor cultivation facilities for the global commercial horticulture market. Our custom tailored, plant-centric approach to design, procurement, and integration provides a single point of accountability across all aspects of indoor growing operations. Our solution offers functionality that helps customers manage the entire cultivation lifecycle, from facility engineering and design to operation and day-to-day management. We offer a full range of custom services that are integrated with select cultivation equipment and product solutions, which we primarily source from third party technology and manufacturing partners but also develop in-house. Our service offerings include full facility programming, engineering and design services, start-up facility and equipment commissioning services, facility optimization services and IPM planning and strategy services. Complementing these services, we work with customers to source an integrated suite of select cultivation equipment systems and crop management products, which include: (1) environmental controls, fertigation, and irrigation distribution systems; (2) freshwater, wastewater, and condensation treatment systems; (3) purpose-built HVAC solutions; (4) light emitting diode (“LED”), high-pressure sodium (“HPS”) and ceramic metal halide (“CMH”) lighting systems; (5) rolltop, multi-tier, and automated container benching systems; (6) odor mitigation & microbial reduction systems; (7) air flow systems; (8) industrial spray applicators; (9) pesticides and bio-controls; (10) plant nutrition products; (11) substrate and coco bag solutions; and (12) our Soleil® technology data analytics platform that includes wireless environmental & substrate sensing and remote monitoring and support. We primarily market and sell our products and services to operators of commercial indoor cultivation facilities in the United States and Canada. To date, our primary customer base has been comprised of indoor commercial cultivators seeking to grow high-quality cannabis crops. Since launching the engineering and design division in 2018, we have designed and assisted in the build-out of over 200+ projects for some of the largest independent and multi-state operators (MSOs) in both the United States and Canada. With Grow2Guys’ experience on over 300 projects, our engineering and design teams have combined experience of over 500 projects. Although the rapidly expanding cannabis market has been our target market and substantially all of our revenues to date have been generated from customers in the cannabis industry, we are seeking to diversify our customer base by expanding into other segments of the indoor horticultural market, including targeting cultivators of high value crops such as tomatoes, strawberries, chilies, peppers, and leaf lettuce. During 2019, we also began exploring the potential demand for our solutions in select countries, including those within Latin America and Europe. RECENT DEVELOPMENTS As the cannabis industry has matured, so has the scrutiny by the capital markets. Both investors and analysts are evaluating companies and their focus on profitability. In August 2019, due to liquidity constraints, we commenced targeted cost reduction initiatives to focus on our company’s core services. We believe these targeted efforts will reduce our ongoing operating expenses, including general and administrative costs, as follows: · Reduced employee headcount by 15, which we expect to result in future annual savings of up to $1.8 million, including benefits and travel; · Reduced annual marketing expenditures by $0.5 million by limiting participation in tradeshows and outsourced marketing functions; · Eliminated outsourced product development, which we spent approximately $0.3 million on during the year ended December 31, 2019; and · Reduced corporate functions and activities, which is expected to result in future annual savings of up to $0.2 million. Credit Agreement On February 21, 2020, we entered into a letter agreement (the “Credit Agreement”) by and among the Company, as borrower, urban-gro Canada Technologies Inc. and Impact Engineering, Inc., as guarantors, the lenders party thereto (the “Lenders”), and Bridging Finance Inc., as administrative agent for the Lenders (the “Agent”). The Credit Agreement, which is denominated in Canadian dollars (C$), is comprised of (i) a 12-month senior secured demand term loan facility in the amount of C$2.7 million ($2.0 million), which was funded in its entirety on the closing date (the “Term Loan”); and (ii) a 12-month demand revolving credit facility of up to C$5.4 million ($4.0 million), which may be drawn from time to time, subject to the terms and conditions set forth in the Credit Agreement and described further below (the “Revolving Facility,” and together with the Term Loan, “the Facilities”). The final maturity date of the Facilities is the earlier of (i) demand, and (ii) the date that is 12 months after the closing date, with a potential extension to the date that is 24 months after the closing date (the “Maturity Date”). The Facilities bear interest at the annual rate established and designated by the Bank of Nova Scotia as the prime rate, plus 11% per annum. Accrued interest on the outstanding principal amount of the Facilities will be due and payable monthly in arrears, on the last business day of each month, and on the Maturity Date. The Revolving Facility may be borrowed and re-borrowed on a revolving basis by us during the term of the Facilities, provided that borrowings under the Revolving Facility will be limited by a loan availability formula equal to the sum of (i) 90% of insured accounts receivable, (ii) 85% of investment grade receivables, (iii) 75% of other accounts receivable, (iv) 50% of eligible inventory, and (v) the lesser of C$4.05 million ($3.0 million) and (A) 75% of uncollected amounts on eligible signed equipment orders for equipment systems contracts and (B) 85% of uncollected amounts on eligible signed professional services order forms for design contracts. The Revolving Facility may be prepaid in part or in full without a penalty at any time during the term of the Facilities, and the Term Loan may be prepaid in full or in part without penalty subject to 60 days prior notice in each case subject to certain customary conditions. As of April 30, 2020, C$0.4 million ($0.3 million) of the Revolving Facility was available for future borrowings. We used a portion of the proceeds from the Term Loan to pay the Agent a commitment fee in the amount of C$162,000 ($116,000). Pursuant to the Credit Agreement, we will be required to pay the Agent an annual administration and monitoring fee in the amount of C$32,400 ($23,000) plus applicable taxes. As additional consideration for the entering into the Credit Agreement, we issued 500,000 shares of Common Stock on the closing date to the Agent, or the Lenders or their nominee, in each case as directed by the Agent. In addition, we utilized a portion of the proceeds from the Term Loan to refinance existing indebtedness, including a $2.0 million loan with Hydrofarm Holdings Group, Inc., dated December 6, 2018. We terminated the Hydrofarm Loan Agreement concurrently with the closing of the transactions contemplated by the Credit Agreement. Remaining proceeds from the Facilities are expected to be used (i) to pay down existing debt obligations and (ii) for general working capital purposes. The obligations of the Company under the Facilities are secured on a first lien basis (subject to certain permitted liens as set forth in the Credit Agreement) by substantially all of the assets of the Company and certain wholly-owned subsidiaries of the Company, as well as a limited recourse personal guarantee of Bradley Nattrass, our Chief Executive Officer (“CEO”). The Credit Agreement also contains customary provisions, representations, warranties and events of default for facilities of this nature and affirmative and negative covenants, including without limitation, covenants relating to maintenance of collateral, reorganization and change of control transactions, creation of liens and incurrence of indebtedness. Amendment of Promissory Note and Subordination Agreement In connection with the execution of the Credit Agreement, on February 21, 2020, we entered into an agreement to amend the promissory note (the “Promissory Note”) dated October 18, 2018, as amended on May 20, 2019, between the Company and Cloud9 Support Inc. (“Cloud9”), an entity owned by James Lowe, a director of the Company (the “Amending Agreement”). Pursuant to the Amending Agreement, Cloud9 agreed to extend the maturity date of the promissory note from December 31, 2019 to the date which is the earlier of 60 days following the date: (a) on which demand for repayment is made by the Lender under the Credit Agreement; or (b) which is the Maturity Date of the Credit Agreement. In addition, on February 25, 2020, the Company entered into a subordination, postponement and standstill agreement with Cloud9 (the “Subordination Agreement”) pursuant to which Cloud9 agreed to postpone and subordinate all payments due under the Promissory Note until the Facilities have been fully and finally repaid. The term for the Subordination Agreement will continue in force as long as the Company is indebted to the Agent or Lenders under the Credit Agreement. In consideration for Cloud9’s agreement to extend the maturity date of the Promissory Note and to enter into the Subordination Agreement, we issued 100,000 shares of common stock to Mr. Lowe as designee of Cloud9. COVID-19 Pandemic In December 2019, a novel strain of coronavirus, COVID-19, was reported to have surfaced in Wuhan, China. In January 2020, this coronavirus spread to other countries, including the United States, and efforts to contain the spread of this coronavirus intensified. In March 2020, the World Health Organization declared the outbreak of the coronavirus a pandemic. We are a business that supplies other essential businesses with support and supplies necessary to operate and we therefore believe we are an essential business allowed to continue operating under the Stay-At-Home Orders issued by many states and cities. However, the extent to which the COVID-19 pandemic impacts our results will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of COVID-19 and the actions to contain COVID-19 or treat its impact. The outbreak and any preventative or protective actions that governments or we may take in respect of COVID-19 may result in a period of business disruption, reduced customer business and reduced operations. Due to the uncertainty and adverse impact on our operations and financial condition resulting from the outbreak of COVID-19, we took the following actions: · In March 2020, we began executing a substantial reduction in discretionary marketing and general & administrative expenses; · On March 30, 2020, we reduced our headcount by 13 people (27%), from 48 to 35, by terminating ten employees and furloughing three other employees, including one member of our leadership team; · Effective April 6, 2020, we reduced compensation for almost every remaining employee, including a 20% reduction for the senior members of our leadership team. The effects from the COVID-19 pandemic began in the latter portion of the first quarter of 2020; therefore, there was no impact to our 2019 results of operations, financial condition and cash flows discussed in more detail herein. Any resulting financial impact cannot be reasonably estimated at this time but may materially affect our business, financial condition, results of operations, and cash flows. Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) On March 27, 2020, the CARES Act was enacted. The CARES Act is an approximate $2 trillion emergency economic stimulus package passed in response to the coronavirus outbreak. The CARES Act, among other things, includes broad sweeping provisions such as direct financial assistance to Americans in the form of one-time payments to individuals; aid to businesses in the form of loans and grants; and efforts to stabilize the U.S. economy and keep Americans employed in general. On April 16, 2020, we received a loan in the amount of $1,020,600 under the Paycheck Protection Program (“PPP”) of the CARES Act. The PPP provides for loans to qualifying businesses for amounts up to 2.5 times the average monthly payroll expenses of the qualifying business. The PPP provides a mechanism for forgiveness of up to the full amount borrowed after eight weeks as long as the borrower uses the loan proceeds during the eight-week period after the loan origination for eligible purposes, including payroll costs, certain benefits costs, rent and utilities costs or other permitted purposes, and maintains its payroll levels, subject to certain other requirements and limitations. The amount of loan forgiveness is subject to reduction, among other reasons, if the borrower terminates employees or reduces salaries during the eight-week period. The interest rate on the loan is 1.0% per annum. Payments of principal and interest are deferred for seven months from the date of the loan (the “Deferral Period”). Any unforgiven portion of the PPP Loan is payable over the two-year term, with payments deferred during the Deferral Period. The Company is permitted to prepay the loan at any time without payment of any premium. RESULTS OF OPERATIONS We generate revenue from (i) engineering design service fees received for the engineering and design of cultivation facilities and complex equipment systems, (ii) the sale, integration, and commissioning of these equipment systems, and (iii) selling consumable products and professional consulting services once facilities are operational. Comparison of Results of Operations for the years ended December 31, 2019 compared to 2018 During the year ended December 31, 2019, we generated revenues of $24.2 million compared to revenues of $20.1 million during the year ended December 31, 2018, an increase of $4.1 million (21%). While this increase is partially attributable to the general growth of the cannabis industry in North America, and a corresponding increase in the demand for our solutions, we believe that our increased marketing efforts and industry demand for large, environmentally controlled, grow facilities primarily contributed to the increase in our revenues. The increase in revenue primarily resulted from an increase of $4.3 million in sales of cultivation equipment, an increase of $2.2 million in professional services, an increase of $0.8 million in environmental sciences revenues offset by a decrease in sales of complex equipment systems and other revenue of $3.2 million. The overall increase in our revenues was primarily driven by an increase in the number of sales that we generated. In 2019, we implemented a strategic initiative to more closely align with our customers and sell an all-encompassing enterprise platform solution. This solution is a full service consultative integrated facility package for interior cultivation design. Supporting this directive, for the year ended December 31, 2019, the Company secured engineering design service contracts for 76 projects, totaling 1,914,030 square feet. Cost of sales increased to $17.6 million during the year ended December 31, 2019, compared to $13.9 million during the year ended December 31, 2018, an increase of $3.7 million (27%). This increase was directly related to an increase in revenue from our lower margin equipment sales, change in salary allocation, and an increase in payables for contractors related to our design services. Gross profit increased to $6.6 million (27% of revenue) during the year ended December 31, 2019, compared to $6.2 million (31% of revenue) during the year ended December 31, 2018. Gross profit as a percentage of revenue decreased due to increased sales of lower margin products, primarily lighting systems, during 2019. Operating expenses increased to $12.5 million for the year ended December 31, 2019, compared to $10.0 million for the year ended December 31, 2018, an increase of $2.5 million (25%). General and administrative expense, excluding amortization of broker issuing costs and broker warrants associated with our offering of convertible debentures of $0.4 million, increased by $1.5 million (19%), due primarily to our expanding work force. Many of our new employees are members of management, hold advanced degrees, and are experts in their area of focus, which increased compensation expense. Stock compensation expense increased by $0.6 million primarily as a result of the timing of vesting of stock grants and stock options previously issued under our stock grant and stock option programs. As discussed above in “Recent Developments”, beginning in August 2019, due to liquidity constraints, we implemented certain cost reduction initiatives that we anticipate will reduce our future operating expenses, including general and administrative costs. Interest expense, excluding amortization related to the convertible debentures of $1.3 million in the year ended December 31, 2019, was $0.7 million compared to $0.1 million incurred during the year ended December 31, 2018, as a result of increased debt. As a result of the above, we incurred a net loss of $8.4 million for the year ended December 31, 2019 ($0.32 per share) compared to a net loss of $3.9 million for the year ended December 31, 2018 ($0.16 per share). For the year ended December 31, 2019, $4.2 million of this loss relates to non-cash expenses compared to $1.4 million of non-cash expenses incurred in the year ended December 31, 2018. Liquidity and Capital Resources As of December 31, 2019, cash or cash equivalents were $448,703, which represented a decrease of $730,149 from December 31, 2018. Since inception, we have incurred significant operating losses and have funded our operations primarily through issuances of equity securities, debt, and operating revenue. As of December 31, 2019, we had an accumulated deficit of $16,890,626, a working capital deficit of $7,318,980, and negative stockholders’ equity of $5,008,334. See “Recent Developments” above regarding certain cost reduction initiatives that we implemented in August 2019 to focus on our company’s core services and reduce our operating costs and general and administrative expenses. Notwithstanding these measures, there remain risks and uncertainties regarding our ability to generate sufficient revenues to pay our debt obligations and accounts payable when due. These risks and uncertainties raise substantial doubt about our ability to continue as a going concern within one year after the date that the consolidated financial statements in connection with this Report are issued. The consolidated financial statements included in this Report have been prepared on a going concern basis and do not include any adjustments relating to the recoverability and classification of recorded asset amounts or amounts of liabilities that might result from the outcome of this uncertainty. Our ability to continue as a going concern is dependent upon, among other things, our ability to generate revenue, control costs and raise capital. Other than the amount availability pursuant to the Revolving Facility, we do not currently have an agreement with any third party to provide us with such financing and there can be no assurances that we will be able to raise any capital on commercially reasonable terms, or at all. If we require additional capital and are unable to raise the same, it could have a material negative impact on our results of operations. Although we are not actively engaged in the production of cannabis, federal law prohibitions on the cannabis industry in the United States inhibit our ability to establish traditional banking support and opportunities. Specifically, conventional banks are currently unwilling to provide us with any financing normally available to growth stage companies similar to ourselves, including purchase order financing. As a result, we have been forced to finance our expansion primarily by raising capital privately, as well as through private debt and operating capital. This has placed a significant impediment to our cash flows. However, as described above in “Recent Developments”, on February 21, 2020, we entered into the Credit Agreement, providing for a 12-month senior secured demand term loan facility in the amount of C$2.7 million ($2.0 million) and a 12-month demand revolving credit facility of up to C$5.4 million ($4.0 million). Our failure to obtain additional debt or equity financing in the future could have a negative impact on our ability to continue as a going concern or to grow and expand our operations, which will have a negative impact on our anticipated results of operations. Effective January 9, 2019, we executed a letter agreement with 4Front Capital Partners, Inc., Toronto, Canada (“4Front”), whereby 4Front agreed to act as our exclusive placement agent in connection with a private placement offering. Beginning in March 2019, 4Front initiated an offering (the “Offering”) of up to $6.0 million from the sale of Units, with each Unit consisting of a $1,000 Convertible Debenture (the “Debentures”) and Common Stock Purchase Warrants (the “Warrants”) to purchase 207.46 shares of our Common Stock at $3.00 per share for a period of two years from the purchase date. The Debentures were due May 31, 2021 and bore interest at 8%, compounded annually, with interest due at maturity. On October 16, 2019, the $2.6 million in Debentures plus $92,037 in accrued interest were converted into 1,102,513 Common Shares at $2.41 per share pursuant to their terms as a result of our registration of the securities on a registration statement that was declared effective on such date. The Warrants contain a mandatory exercise provision if the weighted average share price of our Common Stock exceeds $5.00 per share for a period of five consecutive days. Net cash used in operating activities was $2.5 million during the year ended December 31, 2019, compared to $2.3 million for the year ended December 31, 2018. Operating cash has been positively impacted from an increase in customer deposits as our business continues to grow. At December 31, 2019, we had $2.9 million in customer deposits related to customer orders. We require prepayments from customers before any design work is commenced and before any material is ordered from the vendor. These prepayments are booked to the customer deposits liability account when received. Our standard policy is to collect the following before action is taken on a customer order: 50% deposit; and the remaining 50% payment made prior to shipping. We expect customer deposits to be relieved from the deposits account no longer than 12 months for each project. At December 31, 2019, we had $1.3 million in prepayments and advances. This is primarily comprised of prepayments to vendors to initiate orders. We do not have trade payable terms with most of our vendors and as a result, we are required to prepay a portion or all of the total order. Due to the increase in customer projects we had increased prepayments to order materials from vendors. Net cash used in investing activities was $1.1 million for the year ended December 31, 2019, compared to $1.3 million during the year ended December 31, 2018. Historically, cash has been used to increase our investments in strategic partnerships and to acquire property and equipment. We do not anticipate using significant cash in the future to invest in strategic partnerships. We will continue to have ongoing needs to purchase property and equipment to maintain our operations. We have no material commitments for capital expenditures as of December 31, 2019. Net cash provided by financing activities was $2.9 million for the year ended December 31, 2019, compared to $3.1 million during the year ended December 31, 2018. Cash provided from financing activities during the year ended December 31, 2019 primarily relates to $2.6 million in proceeds we received from our Offering of Units in addition to a short term note payable for $1.0 million. Unless we revise the terms of our existing outstanding debt, including the Facilities, we will need to make significant payments in the future to pay off these outstanding obligations. In October 2018, we issued a $1.0 million unsecured note payable to Cloud9 Support, Inc. (“Cloud9”), an entity owned by James Lowe, a director, which became due April 30, 2019. The loan had a one-time origination fee of $12,500. Interest accrued at the rate of 12% per annum and was paid monthly. As additional consideration for the loan we granted Mr. Lowe, as designee for Cloud9, an option to purchase 30,000 shares of our Common Stock at an exercise price of $1.20 per share, which option is exercisable for a period of five years. The loan is guaranteed by Mr. Nattrass, our CEO, a director and one of our principal shareholders, and by Mr. Gutierrez, one of our principal shareholders, a director, and a former officer of the Company. The due date for the note payable was extended in May 2019 to December 31, 2019 and the interest rate was decreased to 9% per year. In consideration for Cloud9 extending the maturity date of the note and reducing the interest rate, we agreed to issue 10,000 shares of our Common Stock to Mr. Lowe, as designee for Cloud9. In December 2019, in connection with our entry into the Facilities, the due date for the note payable was extended to December 31, 2021, and we agreed to issue Mr. Lowe, as designee for Cloud9, an additional 100,000 shares of Common Stock in exchange for this extension and his agreement to subordinate the loan to the obligations underlying the Facilities. Gross debt, excluding operating leases, was $3.8 million and $3.5 million as of December 31, 2019 and December 31, 2018, respectively. This represents an increase in gross debt of $0.3 million primarily due to a $0.7 million short term note payable offset by principal paydowns. Inflation Although our operations are influenced by general economic conditions, we do not believe that inflation had a material effect on our results of operations during the year ended December 31, 2019. Critical Accounting Policies and Estimates Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. See Note 2, Summary of Significant Accounting Policies, to the Notes to Consolidated Financial Statements contained in this Report for a discussion of our significant accounting policies. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS From time to time, the Financial Accounting Standards Board (“FASB”) or other standards setting bodies issue new accounting pronouncements. Updates to the FASB’s Accounting Standard Codifications (“ASCs”) are communicated through issuance of an Accounting Standards Update ("ASU"). Unless otherwise discussed, we believe that the impact of recently issued guidance, whether adopted or to be adopted in the future, is not expected to have a material impact on our financial statements upon adoption. In June 2018, the FASB issued ASU 2018-17 Consolidation (ASU 2018-17) - Targeted Improvements to Related Party Guidance for Variable Interest Entities. ASU 2018-17 broadens the scope of the private company alternative to include all common control arrangements that meet specific criteria (not just leasing arrangements). ASU 2018-17 also eliminates the requirement that entities consider indirect interests held through related parties under common control in their entirety when assessing whether a decision-making fee is a variable interest. Instead, the reporting entity will consider such indirect interests on a proportionate basis. ASU 2018-17 is effective for fiscal years beginning after December 15, 2019. The Company is currently assessing the timing and impact of adopting the updated provisions to its consolidated financial statements. In June 2016, the FASB issued ASU 2016-13, “Measurement of Credit Losses on Financial Instruments” (ASU 2016-13), creating ASC Topic 326 - Financial Instruments - Credit Losses. ASU 2016-13 is intended to improve financial reporting by requiring timelier recording of credit losses on financial assets measured at amortized cost basis (including, but not limited to loans), net investments in leases recognized as lessor and off-balance sheet credit exposures. ASU 2016-13 eliminates the probable initial recognition threshold under the current incurred loss methodology for recognizing credit losses. Instead, ASU 2016-13 requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. The Company will continue to evaluate the extent of the impact of ASU 2016-13 on the Company’s financial position, results of operations and cash flows. With the release of ASU 2019-10, the Company will monitor this impact through the effective date for fiscal years beginning after December 15, 2022. There are other various updates recently issued by the FASB, most of which represented technical corrections to the accounting literature or application to specific industries and are not expected to have a material impact on the Company's financial position, results of operations or cash flows. Management has reviewed all other recently issued, but not yet effective, accounting pronouncements and do not believe the future adoption of any such pronouncements may be expected to cause a material impact on our financial condition or the results of our operations. Off-Balance Sheet Arrangements We have not entered into any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources and would be considered material to investors.

<s>[INST] Overview urbangro is a leading engineering design services company that integrates complex environmental equipment systems to create highperformance indoor cultivation facilities for the global commercial horticulture market. Our custom tailored, plantcentric approach to design, procurement, and integration provides a single point of accountability across all aspects of indoor growing operations. Our solution offers functionality that helps customers manage the entire cultivation lifecycle, from facility engineering and design to operation and daytoday management. We offer a full range of custom services that are integrated with select cultivation equipment and product solutions, which we primarily source from third party technology and manufacturing partners but also develop inhouse. Our service offerings include full facility programming, engineering and design services, startup facility and equipment commissioning services, facility optimization services and IPM planning and strategy services. Complementing these services, we work with customers to source an integrated suite of select cultivation equipment systems and crop management products, which include: (1) environmental controls, fertigation, and irrigation distribution systems; (2) freshwater, wastewater, and condensation treatment systems; (3) purposebuilt HVAC solutions; (4) light emitting diode (“LED”), highpressure sodium (“HPS”) and ceramic metal halide (“CMH”) lighting systems; (5) rolltop, multitier, and automated container benching systems; (6) odor mitigation & microbial reduction systems; (7) air flow systems; (8) industrial spray applicators; (9) pesticides and biocontrols; (10) plant nutrition products; (11) substrate and coco bag solutions; and (12) our Soleil® technology data analytics platform that includes wireless environmental & substrate sensing and remote monitoring and support. We primarily market and sell our products and services to operators of commercial indoor cultivation facilities in the United States and Canada. To date, our primary customer base has been comprised of indoor commercial cultivators seeking to grow highquality cannabis crops. Since launching the engineering and design division in 2018, we have designed and assisted in the buildout of over 200+ projects for some of the largest independent and multistate operators (MSOs) in both the United States and Canada. With Grow2Guys’ experience on over 300 projects, our engineering and design teams have combined experience of over 500 projects. Although the rapidly expanding cannabis market has been our target market and substantially all of our revenues to date have been generated from customers in the cannabis industry, we are seeking to diversify our customer base by expanding into other segments of the indoor horticultural market, including targeting cultivators of high value crops such as tomatoes, strawberries, chilies, peppers, and leaf lettuce. During 2019, we also began exploring the potential demand for our solutions in select countries, including those within Latin America and Europe. RECENT DEVELOPMENTS As the cannabis industry has matured, so has the scrutiny by the capital markets. Both investors and analysts are evaluating companies and their focus on profitability. In August 2019, due to liquidity constraints, we commenced targeted cost reduction initiatives to focus on our company’s core services. We believe these targeted efforts will reduce our ongoing operating expenses, including general and administrative costs, as follows: · Reduced employee headcount by 15, which we expect to result in future annual savings of up to $1.8 million, including benefits and travel; · Reduced annual marketing expenditures by $0.5 million by limiting participation in tradeshows and outsourced marketing functions; · Eliminated outsourced product development, which we spent approximately $0.3 million on during the year ended December 31, 2019; and · Reduced corporate functions and activities, which is expected to result in future annual savings of up to $0.2 million. Credit Agreement On February 21, 2020, we entered into a letter agreement (the “Credit Agreement”) by and among the Company, as borrower, urbangro Canada Technologies Inc. and Impact Engineering, Inc., as guarantors, the lenders party thereto (the “Lenders”), and Bridging Finance Inc., as administrative agent for the [/INST] Negative. </s>

Provention Bio, Inc.

2019-03-19

2018-12-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview We are a clinical stage biopharmaceutical company, focused on the development and commercialization of novel therapeutics and solutions aimed at intercepting and preventing immune-mediated diseases. Since our inception, we have devoted substantially all of our efforts to business planning, research and development, recruiting management and technical staff, acquiring operating assets and raising capital. Our business is subject to significant risks and uncertainties and we will be dependent on raising substantial additional capital before it becomes profitable and it may never achieve profitability. We have not generated any revenue to date and through December 31, 2018, we had an accumulated deficit of $35.8 million. We have financed our operations through a private offering of Series A Convertible Redeemable Preferred Stock in April 2017, and our initial public offering, or IPO, which closed in July 2018. In April 2017, we completed our private placement of Series A Convertible Redeemable Preferred Stock. We issued an aggregate 11,381,999 shares of Series A Convertible Redeemable Preferred Stock at $2.50 per share. We received net proceeds of $26.7 million. In July 2018, we issued and sold an aggregate of 15,969,563 shares of common stock in our IPO at a public offering price of $4.00 per share. In connection with the IPO, we issued to MDB, the underwriter in the IPO, and its designees warrants to purchase 1,596,956 shares of Common Stock at an exercise price of $5.00 per share. We received net proceeds from the IPO of $59.3 million, after deducting underwriting discounts and commissions of approximately $3.7 million and other offering expenses of approximately $0.8 million. Upon the closing of the IPO, all of our shares of Series A Convertible Redeemable Preferred Stock outstanding at the time of the IPO were automatically converted into 11,381,999 shares of common stock. In addition, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock also converted to warrants for the purchase of 558,740 shares of our common stock. We expect that over the next several years we will continue to incur losses from operations as we increase our expenditures in research and development in connection with clinical trials and other development activities. If adequate funds are not available to us on a timely basis, or at all, we may be required to terminate or delay certain development activities. Our Focus and Pipeline Inflammation is a natural consequence of most infections, as it is the immune system’s first response to invading pathogens in the event of injury or acute illness. Most of the time, this response is beneficial and well-controlled; helping to repair tissue damage and clear pathogens from the body. In addition to directly damaging tissues and organs, an infection can sometimes result in a potentially fatal acute pathological immune reaction. In such instances, a patient’s life is at risk primarily from the excessive immune response and release of toxic immune mediators. When patients have the requisite genetic predisposition, infections can sometimes also trigger chronic autoimmune responses that persist and progress long after the original insult has subsided. These sustained responses have been linked to an increased susceptibility to chronic conditions like inflammatory bowel disease, diabetes, cancer, and certain neurological disorders. Provention’s “predict” and “preempt” therapeutic approach is to intercept the underlying pathological immune and inflammatory responses in susceptible individuals. Provention’s pipeline includes: ● PRV-031: a humanized, anti-CD3 monoclonal antibody for the interception of type 1 diabetes (T1D) in pediatric patients with early onset T1D and, potentially, for delaying and/or preventing disease progression in patients at risk of developing T1D; ● PRV-015: a human anti-interleukin 15 (IL-15) monoclonal antibody for the treatment of gluten-free diet non-responding celiac disease, intercepting the effects of contaminating gluten in the most common autoimmune disorder without any approved medication (celiac disease); ● PRV-6527: an oral small molecule CSF-1R inhibitor targeting the differentiation and activation of antigen-presenting cells to prevent chronic inflammatory responses and progression or relapse in Crohn’s disease; ● PRV-300: an anti-TLR3 antibody blocking key receptors participating in the transmission of danger signals from viral infections and damaged cells to prevent the life-threatening release of toxic inflammatory mediators in severe influenza or acute exacerbations of chronic inflammation in ulcerative colitis (UC); ● PRV-3279: a humanized bispecific scaffold molecule targeting the B-cell surface proteins, CD32B and CD79B, for the treatment of systemic lupus erythematosus (SLE); and ● PRV-101: a coxsackie virus B vaccine to prevent acute infections and, in those patients at risk, preventing the autoimmune damage to pancreatic beta cells that triggers the onset of T1D and T1D-associated celiac disease. The table below summarizes the current status and anticipated milestones for our principal product candidates: Product Candidate / Indication Status Next Expected Milestone PRV-031 (teplizumab, anti-CD3 mAb) for the interception of T1D We are designing a Phase 3 clinical trial (the PROTECT study) in approximately 300 pediatric and adolescent patients with early onset type one diabetes. The U.S. Food and Drug Administration (FDA) has designated PRV-031 as an orphan drug for the treatment of recent onset T1D. We expect to commence the pivotal Phase 3 PROTECT study in the second quarter of 2019. We expect public disclosure early in the second half of 2019 of top-line data from an NIDDK sponsored study conducted at TrialNet sites of PRV-031 for preventing disease progression in patients at high risk of developing T1D. PRV-015 (anti-IL-15 mAb) for the treatment of gluten-free diet non-responding celiac disease. We are planning a Phase 2b clinical trial (the PROACTIVE trial) in celiac patients with gluten-free diet non-responsive celiac disease and will undertake additional chronic toxicology studies to support this trial as needed. We expect to commence the Phase 2b PROACTIVE study in the first half of 2020 PRV-6527 (oral CSF-1R inhibitor) for the treatment of Crohn’s disease We are conducting a Phase 2a clinical trial (the PRINCE study) in approximately 80 patients who have moderate to severe Crohn’s disease. We expect to report top line data from the Phase 2a PRINCE study in the second half of 2019. PRV-300 (anti-TLR3 mAb) for the treatment of ulcerative colitis In the third quarter of 2018, we completed the target enrollment for a Phase 1b clinical trial (the PULSE study) in 37 patients who have moderate to severe UC. We are evaluating potential studies of PRV-300 in severe influenza, respiratory syncytial virus and emerging viral diseases. We expect to report top line data from the Phase 1b PULSE study in the second quarter of 2019. PRV-3279 (humanized anti-CD32B and CD79B bispecific) for the treatment of lupus We are designing a Phase 1b/2a study (the PREVAIL study) that will evaluate the safety and the effects of PRV-3279 in healthy volunteers and patients with lupus. We expect to commence a Phase 1b/2a study in the second half of 2019. PRV-101 (polyvalent coxsackie virus B vaccine) for the prevention of acute CVB and the prevention of T1D onset We are developing a polyvalent vaccine at Intravacc, our strategic partner in vaccine manufacturing process development. We expect to file a clinical trial application (CTA) by the end of the fourth quarter of 2019. We expect to start the First-in-Human study in the first half of 2020 Provention intends to leverage its distinctive competences and drug development strategy; advance its carefully selected portfolio of product candidates; in-license or acquire additional targeted development assets, and apply its disease interception and prevention approach to multiple autoimmune and immune-mediated inflammatory diseases. Financial operations overview Research and Development Expenses Research and development expenses consist primarily of clinical studies, other internal operating expenses, the cost of manufacturing our drug candidate for clinical study, and the cost of conducting preclinical activities. Expenses also include the cost of salaries, benefits and other related costs, including stock-based compensation, for personnel serving in our research and development functions. In addition, our research and development expenses include payments to third parties, as well as the fair value of stock issuances to third parties for the license rights to products in development (prior to marketing approval). Our expenses related to clinical trials are primarily related to activities at contract research organizations, or CROs, that design, obtain regulatory approval, and conduct clinical trials on our behalf. Our expenses related to the production of drug substance or drug product for our clinical trials and development programs are primarily related to activities performed by licensors, strategic partners or contract manufacturing organizations, or CMOs, on our behalf. Our development efforts from inception through December 31, 2018, were principally related to the acquisition and development of our six programs detailed in the Pipeline description immediately above. All research and development expenses are charged to operations as incurred in accordance with Financial Accounting Standards Board Accounting Standards Codification Topic, or ASC, 730, Research and Development. We account for non-refundable advance payments for goods and services that will be used in future research and development activities as expenses when the service has been performed or when the goods have been received, rather than when the payment is made. General and Administrative Expenses General and administrative expenses consist primarily of salaries, benefits and other related costs, including stock-based compensation, for our personnel serving in our executive and finance and accounting functions. General and administrative expenses also include professional fees for legal, including patent-related expenses, consulting, insurance, board of director fees, tax and accounting services. We anticipate that we will incur increased general and administrative expenses related to audit, legal, regulatory, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums, and investor relations costs associated with being a public company. Change in Fair Value of Warrant Liability Change in fair value of warrant liability represents the re-measurement of our liability classified warrants using the Black-Scholes option-pricing model at each financial reporting period. The fair value is affected by changes in inputs to the model including the fair value of our Series A Convertible Redeemable Preferred Stock, expected stock price volatility, the estimated term until exercise, and the risk-free interest rate. Upon the completion of the IPO in July 2018, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock converted to warrants for the purchase of 558,740 shares of our common stock. The liability associated with these warrants was revalued just prior to the completion of the IPO, with the change in the fair value of the warrant liability charged to earnings. The warrant liability was then reclassified to additional paid-in capital upon the completion of the IPO in July 2018, as the warrants no longer contain redemption provisions outside our control. Interest Income Interest income consists of interest income earned on our cash and cash equivalents. RESULTS OF OPERATIONS Comparison of years ended December 31, 2018 and 2017 Research and Development Expenses Research and development expenses were $22.6 million for the year ended December 31, 2018, an increase of $15.0 million, compared to $7.7 million for the year ended December 31, 2017. Research and development expenses for the year ended December 31, 2018 included external clinical development expenses of $10.7 million for PRV-6527, PRV-300 and PRV-031, development costs of $4.1 million for PRV-101, non-cash product acquisition costs of $4.0 million, which represented the fair value of warrants issued in connection with the acquisition of PRV-031 and PRV-3279 in May 2018, and internal personnel costs, including stock-based compensation, of $2.9 million. Research and development expenses during the year ended December 31, 2017 included non-cash product acquisition costs of $3.4 million, which represented the fair value of shares of common stock issued in connection with the Vactech License Agreement for PRV-101 in April 2017, $3.1 million in external clinical development expenses primarily related to PRV-6527 and PRV-300, and $1.1 million of internal clinical development costs consisting mostly of compensation and related expenses, including stock-based compensation. General and Administrative Expenses General and administrative expenses were $4.2 million for the year ended December 31, 2018, an increase of $2.7 million, compared to $1.5 million for the year ended December 31, 2017. General and administrative expenses for the year ended December 31, 2018 primarily included $1.6 million in personnel costs, including stock-based compensation, $1.5 million in professional fees and legal expenses and $0.7 million in insurance and other costs associated with being a public company. General and administrative expenses were $1.5 million for the year ended December 31, 2017 and were primarily comprised of $0.7 million in personnel costs, including stock-based compensation, and $0.6 million in professional fees and legal expenses. Change in fair value of warrant liability Change in fair value of warrant liability was a loss of approximately $0.5 million during the year ended December 31, 2018, compared to a loss of $0.1 million during the year ended December 31, 2017. This loss represents the change in fair value of our warrant liability using a Black-Scholes option-pricing model with updated assumptions as of July 18, 2018, the date just prior to the completion of our IPO, and was primarily impacted by a change in the fair value of our Series A Convertible Redeemable Preferred Stock. Upon the completion of the IPO in July 2018, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock converted to warrants for the purchase of 558,740 shares of our common stock. The warrant liability was then reclassified to additional paid-in capital upon the completion of the IPO in July 2018, as the warrants no longer contain redemption provisions outside our control. Interest Income Interest income was $0.7 million during the year ended December 31, 2018 compared to $0.1 million during the year ended December 31, 2017. The increase in interest income in 2018 related primarily to an increase in average cash and cash equivalents balances that resulted from the net proceeds from our IPO in July 2018. Income Tax Benefit We recorded an income tax benefit of $0.2 million during the year ended December 31, 2018, which related to the proceeds from the sale of certain of our prior year New Jersey net operating losses We did not record any income tax benefit or provision during the year ended December 31, 2017. Comparison of years ended December 31, 2017 and 2016 Research and Development Expenses Research and development expenses during the year ended December 31, 2017 included non-cash product acquisition costs of $3.4 million, which represented the fair value of shares of common stock issued in connection with the Vactech License Agreement for PRV-101 in April 2017, $3.1 million in external clinical development expenses primarily related to PRV-6527 and PRV-300, and $1.1 million of internal clinical development costs consisting mostly of compensation and related expenses, including stock-based compensation. There were no research and development expenses for the period from October 4, 2016 (inception) through December 31, 2016. General and Administrative Expenses General and administrative expenses were $1.5 million for the year ended December 31, 2017 and $0.2 million for the period from October 4, 2016 (inception) through December 31, 2016. General and administrative expenses in 2017 primarily included $0.7 million in compensation costs, including stock-based compensation, and $0.3 million in professional fees and legal expenses as compared to $0.2 million of legal expenses for the period from October 4, 2016 (inception) through December 31, 2016. Change in fair value of warrant liability Change in fair value of warrant liability was a loss of approximately $0.1 million during the year ended December 31, 2017. This loss represents the change in fair value of our warrant liability using a Black-Scholes option-pricing model with updated assumptions as of December 31, 2017 and was primarily impacted by a change in the fair value of our Series A Convertible Redeemable Preferred Stock. Interest Income Interest income was $0.1 million during the year ended December 31, 2017 and related to interest earned on our cash and cash equivalents during the period. The Company did not earn any interest during the period from October 4, 2016 (inception) through December 31, 2016. Income Tax Benefit We did not record any income tax benefit or provision during the year ended December 31, 2017 or during the period from October 4, 2016 (inception) through December 31, 2016. LIQUIDITY AND CAPITAL RESOURCES Overview There is considerable time and cost associated with developing a potential drug or pharmaceutical product to the point of regulatory approval and commercialization. We funded our operations to date through an offering of equity securities. We expect to continue to incur losses, as we plan to fund development activities. As of December 31, 2018, we had cash and cash equivalents of $58.5 million. We will need to raise additional capital to fund our operations, to develop and commercialize PRV-031, PRV-015, PRV-6527, PRV-300, PRV-3279, and PRV-101, and to develop, acquire, or in-license other products. We believe that our current cash and cash equivalents will be sufficient to fund our projected operating requirements into the middle of 2020. We plan to raise additional capital through equity offerings. Such additional funding will be necessary to continue to develop our potential product candidates, to pursue the license or purchase of other technologies, to commercialize our product candidates or to purchase other products. We may seek to sell common or preferred equity or convertible debt securities, enter into a credit facility or another form of third-party funding, or seek other debt financing. In addition, we may consider raising additional capital to fund operating activities, to expand our business, to pursue strategic investments, to take advantage of financing opportunities, or for other reasons. In the event that the we are able to raise capital, subject to certain terms and conditions set forth in the Amgen Agreement described herein, Amgen has agreed to make an equity investment of up to $20.0 million in our securities. This equity investment is expected to coincide with our potential future financing events, if any, or potential receipt of non-dilutive milestone payment from a third party including but not limited to Janssen related to our CSF-1R program. The sale of equity and convertible debt securities may result in dilution to our stockholders and those securities may have rights senior to those of our common shares. If we raise additional funds through the issuance of preferred stock, convertible debt securities or other debt financing, these securities or other debt could contain covenants that would restrict our operations. Any other third-party funding arrangement could require us to relinquish valuable rights. We may require additional capital beyond our currently anticipated amounts. Additional capital may not be available on reasonable terms, or at all. If we are unable to obtain sufficient additional funds when required, we may be forced to delay, restrict or eliminate all or a portion of our development programs, dispose of assets or technology or cease operations. Our cash requirements in 2019 will be impacted by a number of factors, the most significant of which are expenses related to the initiation of the PROTECT clinical study of PRV-031, the PRINCE clinical study of PRV-6527, the PULSE clinical study of PRV-300, the initiation of the PREVAIL clinical study of PRV-3279, and development efforts for PRV-101 and PRV-015. In April 2017, we completed a private offering of 11,381,999 shares of our Series A Convertible Redeemable Preferred Stock, at a price of $2.50 per share, resulting in net cash proceeds from the sale of the shares, after deducting the underwriter’s discount and offering expenses, of $26.7 million. In July 2018, we closed our initial public offering of 15,969,563 shares of common stock at a price of $4.00 per share. The net proceeds to the Company were $59.3 million, after deducting underwriters’ commissions and other offering expenses. In connection with the closing of the IPO, all of our shares of redeemable convertible preferred stock outstanding at the time of the IPO were automatically converted into 11,381,999 shares of common stock. In addition, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock also converted to warrants for the purchase of 558,740 shares of our common stock. Cash Flows As of December 31, 2018, we had cash and cash equivalents totaling $58.5 million. We currently have invested our cash and cash equivalents in money market funds. The following table shows a summary of our cash flows for the years ended December 31, 2018 and 2017 and for the period October 4, 2016 (inception) through December 31, 2016: Cash Flows from Operating Activities Net cash used in operating activities was $22.6 million for the year ended December 31, 2018 and primarily related to cash used to fund clinical development activities for PRV-6527, PRV-300 and PRV-031, development activities for PRV-101, and increased personnel costs to support our newly programs and our public company infrastructure. Our working capital was $59.7 million as of December 31, 2018. Net cash used in operating activities was $4.9 million for the year ended December 31, 2017 and primarily related to start-up activities for the Company’s operations, including clinical development programs for PRV-6527 and PRV-300 and the development program for PRV-101, each of which were acquired in the second quarter of 2017. Cash Flows from Investing Activities There was no cash used in or provided by investing activities for the year ended December 31, 2018, 2017 and 2016, respectively Cash Flows from Financing Activities Net cash provided by financing activities was $59.3 million for the year ended December 31, 2018 and primarily related to the net proceeds we received from the completion of our IPO in July 2018. Net cash provided by financing activities for the year ended December 31, 2017 related to the completion of a private placement of our Series A Convertible Redeemable Preferred Stock, which yielded net proceeds of approximately $26.7 million. Commitments and Contractual Obligations In April 2017, we entered into the Vactech License Agreement, pursuant to which Vactech Ltd. (Vactech) granted us exclusive global rights for the purpose of developing and commercializing the group B coxsackie virus vaccine (CVB) platform technology. In consideration of the licenses and other rights granted by Vactech, we issued two million common shares to Vactech. We paid Vactech a total of approximately $0.5 million for transition and advisory services during the first 18 months of the term of the agreement. In addition, we are obligated to make a series of contingent milestone payments to Vactech totaling up to an additional $24.5 million upon the achievement of certain clinical development and regulatory filing milestones. In addition, we have agreed to pay Vactech tiered single-digit royalties on net sales of any approved product based on the CVB platform technology and three additional payments totaling $19.0 million upon the achievement of certain annual net sales levels. In April 2017, we entered into the Janssen CSF-1R License Agreement, pursuant to which Janssen Pharmaceutica NV granted us exclusive global rights for the purpose of developing and commercializing a colony stimulating factor 1 receptor (CSF-1R) inhibitor named JNJ-40346527 (renamed PRV-6527) for inflammatory bowel diseases including Crohn’s Disease and UC. We are obligated to conduct a single Phase 2a proof-of-mechanism and proof-of-concept clinical trial for the Crohn’s Disease indication. Janssen will supply product for the clinical trial. At the conclusion of the Phase 2a study, Janssen will have an option to buy back the rights for future development for a one-time payment of $50.0 million and future single-digit royalties on future net sales for a period of 10 years from first sale or expiration of the intellectual property, whichever is shorter. If Janssen does not exercise its option to buy-back the rights, all rights will remain with us and we will be obligated to make contingent milestone payments to Janssen totaling $35.0 million upon the achievement of certain clinical and regulatory milestones for the first indication and an additional $20.0 million upon the achievement of certain clinical and regulatory milestones for a second indication. In addition, we have agreed to pay Janssen tiered single-digit royalties on net sales of any approved product based on the CSF-1R technology and three additional payments totaling $100.0 million upon the achievement of certain annual net sales levels. In April 2017, we entered into the Janssen TLR3 License Agreement, pursuant to which Janssen Sciences Ireland UC granted us exclusive global rights for the purpose of developing and commercializing an anti-TLR3 antibody named JNJ-42915925 (renamed PRV-300). We will develop PRV-300 for UC and started a Phase 1b trial in early 2018. Janssen will supply product for the clinical trial. We will be obligated to make contingent milestone payments to Janssen totaling $31.0 million upon the achievement of certain clinical and regulatory milestones for the first indication and an additional $17.0 million upon the achievement of certain clinical and regulatory milestones for a second indication. In addition, we have agreed to pay Janssen a single-digit royalty on net sales of any approved product based on the TLR3 technology and three additional payments totaling $60.0 million upon the achievement of certain annual net sales levels. In March 2018, we entered into the Intravacc Development Services Agreement with The Institute of Translational Vaccinology, pursuant to which Intravacc will provide services related to process development, non-GMP and GMP manufacturing of our polyvalent coxsackie virus B vaccine (CVB), including providing proprietary technology for manufacturing purposes. We will pay Intravacc approximately 10 million euros for their services over the development and manufacturing period which we expect will last for approximately 18 to 24 months. Each party retains its existing intellectual property and will share newly developed intellectual property via a fully-paid non-exclusive license between the parties for all development work through phase 1 clinical trials. Any future use, including commercial use, of Intravacc’s technology will be subject to a separate nonexclusive license agreement. The Intravacc Development Services Agreement may be terminated by us with ninety-days’ notice without cause and by either party upon a material breach or insolvency of the other party. As of December 31, 2018, we have paid Intravacc a total of approximately 5.0 million euros, or approximately $6.0 million, for services provided by Intravacc under the Intravacc Development Services Agreement. In May 2018, we entered into the MacroGenics License Agreement with MacroGenics, Inc., pursuant to which MacroGenics granted us exclusive global rights for the purpose of developing and commercializing MGD010 (renamed PRV-3279), a humanized protein and a potential treatment for SLE and other similar diseases. As partial consideration for the License Agreement, we granted MacroGenics a warrant to purchase 270,299 shares of our common stock at an exercise price of $2.50 per share. We are obligated to make contingent milestone payments to MacroGenics totaling $42.5 million upon the achievement of certain developmental and approval milestones for the first indication, and an additional $22.5 million upon the achievement of certain regulatory approvals for a second indication. In addition, we are obligated to make contingent milestone payments to MacroGenics totaling $225.0 million upon the achievement of certain sales milestones. We have also agreed to pay MacroGenics a single-digit royalty on net sales of the product. Further, we are required to pay MacroGenics a low double-digit percentage of certain consideration to the extent received in connection with a future grant of rights to PRV-3279 by us to a third party. We are obligated to use commercially reasonable efforts to develop and seek regulatory approval for PRV-3279. The license agreement may be terminated by either party upon a material breach or bankruptcy of the other party, by Provention without cause upon prior notice to MacroGenics, and by MacroGenics in the event that we challenge the validity of any licensed patent under the agreement, but only with respect to the challenged patent. In May 2018, we entered into the MacroGenics Asset Purchase Agreement with MacroGenics pursuant to which we acquired MacroGenics’ interest in teplizumab (renamed PRV-031), a humanized mAb for the treatment of T1D. As partial consideration for the License Agreement, we granted MacroGenics a warrant to purchase 2,162,389 shares of our common stock at an exercise price of $2.50 per share. We are obligated to pay MacroGenics contingent milestone payments totaling $170 million upon the achievement of certain regulatory approval milestones. In addition, we are obligated to make contingent milestone payments to MacroGenics totaling $225.0 million upon the achievement of certain sales milestones. We have also agreed to pay MacroGenics a single-digit royalty on net sales of the product. We have also agreed to pay third-party obligations, including low single-digit royalties, a portion of which is creditable against royalties payable to MacroGenics, aggregate milestone payments of up to approximately $1.3 million and other consideration, for certain third-party intellectual property under agreements we are assuming pursuant to the Asset Purchase Agreement. Further, we are required to pay MacroGenics a low double-digit percentage of certain consideration to the extent it is received in connection with a future grant of rights to PRV-031 by us to a third party. We are obligated to use reasonable commercial efforts to develop and seek regulatory approval for PRV-031. In November 2018, we entered into the Amgen Agreement with Amgen for PRV-015 (formerly AMG 714), a novel anti-IL-15 monoclonal antibody being developed for the treatment of gluten-free diet NRCD. Under the terms of the agreement, we will conduct and fund a Phase 2b trial in NRCD and lead the development and regulatory activities for the program. Amgen has agreed to make an equity investment of up to $20.0 million in the Company, subject to certain terms and conditions set forth in the agreement. The equity investment will coincide with our future financing events or receipt of non-dilutive milestone payment from a third party including but not limited to Janssen related to our CSF-1R program. Amgen is also responsible for the manufacturing of PRV-015. Upon completion of the Phase 2b trial, a $150.0 million milestone payment is due from Amgen to us, plus an additional regulatory milestone payment, and single digit royalties on future sales. If Amgen elects not to pay the $150.0 million milestone, AMG 714 rights will be transferred to us pursuant to a termination license agreement from Amgen and us. We will be obligated to make certain contingent milestone payments to Amgen and other third parties totaling up to $70.0 million upon the achievement of certain clinical and regulatory milestones and a low double-digit royalty on net sales of any approved product based on the IL-15 technology. The agreement may be terminated by us without cause (in which case the exclusive global rights to the technology will transfer back to Amgen) and by either party upon a material breach. The agreement expires upon the expiration of Amgen’s last obligation to make royalty payments to Provention (or, our last obligation to make royalty payments to Amgen, if the program rights are transferred to us). We also have employment agreements with certain employees which require the funding of a specific level of payments, if certain events, such as a change in control or termination without cause, occur. In addition, in the course of normal business operations, we have agreements with contract service providers to assist in the performance of our research and development and manufacturing activities. Expenditures to CROs and CMOs represent significant costs in clinical development. Subject to required notice periods and our obligations under binding purchase orders, we can elect to discontinue the work under these agreements at any time. We could also enter into additional collaborative research, contract research, manufacturing, and supplier agreements in the future, which may require upfront payments and even long-term commitments of cash. Future Funding Requirements To date, we have not generated revenue, and we do not know when, or if, we will generate revenue. We do not expect to generate revenue unless or until we obtain marketing approval of, secure reimbursement for, and commercialize, our product candidates. We will need to raise additional capital to fund our operations, to develop and commercialize our product candidates, and to develop, acquire, in-license or co-promote other products. Our future capital requirements may be substantial and will depend on many factors. Off-Balance Sheet Arrangements We did not have during the periods presented, and we do not currently have, any off-balance sheet arrangements, as defined under Securities and Exchange Commission rules. Critical Accounting Policies and Estimates Preparation of financial statements in accordance with generally accepted accounting principles in the US requires us to make estimates and assumptions affecting the reported amounts of assets, liabilities, and expenses and the disclosures of contingent assets and liabilities. We use our historical experience and other relevant factors when developing our estimates and assumptions. We continually evaluate these estimates and assumptions. The amounts of assets and liabilities reported in our balance sheets and the amounts of expenses reported in our statements of comprehensive loss are affected by estimates and assumptions, which are used for, but not limited to, the accounting for research and development, stock-based compensation, accrued expenses and both liability-classified and equity-classified warrants. The accounting policies discussed below are considered critical to an understanding of our financial statements because their application places the most significant demands on our judgment. Actual results could differ from our estimates. For additional accounting policies, see Note 3 to our Financial Statements- Summary of Significant Accounting Policies. Research and Development Research and development expenses consist primarily of salaries, benefits and other related costs, including stock-based compensation, for personnel serving our development functions, and other internal operating expenses, the cost of clinical studies, and the cost of our drug candidates for clinical study. In addition, research and development expenses include payments to third parties for the development of our product candidates and the estimated fair value for the issuance of equity for the license rights to products in development (prior to marketing approval). Our expenses related to clinical trials are primarily related to activities at contract research organizations that design, gain approval for and conduct clinical trials on our behalf. Such amounts are then recognized as an expense as the related goods are delivered or the services are performed. Stock-Based Compensation We recognize stock-based compensation expense for awards of equity instruments to employees based on the grant-date fair value of those awards. The grant-date fair value of the award is recognized as compensation expense ratably over the requisite service period, which generally equals the vesting period of the award. We also grant performance-based stock options to employees. The grant-date fair value of the performance-based stock options is recognized as compensation expense once it is probable that the performance condition will be achieved. We record actual forfeitures in the period the forfeiture occurs. Prior to the third quarter of 2018, we accounted for awards of equity instruments issued to non-employees in accordance with ASC Topic 505-50 “Equity-Based Payment to Non-Employees” and accordingly the value of the stock compensation to non-employees was based upon the measurement date as determined at either a) the date at which a performance commitment was reached, or b) at the date at which the necessary performance to earn the equity instruments was complete, which was normally the end of the vesting period. At the end of each financial reporting period prior to completion of the service, the fair value of these awards was remeasured using updated assumption inputs in the Black-Scholes option-pricing model. In June 2018, the FASB issued ASU No. 2018-07, Improvements to Nonemployee Share-Based Payment Accounting, which supersedes ASC 505-50 and expands the scope of ASC 718 to include all share-based payments arrangements related to the acquisition of goods and services from both employees and nonemployees. During the third quarter of 2018, we early adopted ASU 2018-07. After the adoption of ASU 2018-07, the measurement date for non-employee awards is the date of grant. Compensation expense for non-employees is recognized, without changes to the fair value of the award, over the requisite service period, which is the vesting period of the respective award. The adoption of ASU 2018-07 did not have a material impact our financial statements or footnote disclosures. We used the Black-Scholes option-pricing model to estimate the fair value of option awards with the following weighted-average assumptions for the period indicated: There were no stock option grants period from October 4, 2016 (inception) through December 31, 2016. The weighted-average valuation assumptions were determined as follows: ● Risk-free interest rate: we base the risk-free interest rate on the interest rate payable on U.S. Treasury securities in effect at the time of grant for a period that is commensurate with the assumed expected option term. ● Expected annual dividends: the estimate for annual dividends is 0%, because we have not historically paid, and do not expect for the foreseeable future to pay, a dividend. ● Expected stock price volatility: the expected volatility used is based on historical volatilities of similar entities within our industry which were commensurate with our expected term assumption. ● Expected term of options: the expected term of options represents the period of time options are expected to be outstanding. The expected term of the options granted to employees is derived from the “simplified” method as described in Staff Accounting Bulletin 107 relating to stock-based compensation, whereby the expected term is an average between the vesting period and contractual period due to our limited operating history. The expected term for options granted to non-employees is equal to the contractual term of the awards. Stock-based compensation expense is included in both research and development expenses and general and administrative expenses in the Statement of Operations. Determination of Fair Value of Common Stock Prior to our IPO, there was no public market for our common stock. The estimated fair value of our common stock had been determined by our board of directors as of the date of each option grant and quarter end, with input from management, considering our most recently available third-party valuations of common stock. These factors included, but were not limited to: our most recently available valuations of our common stock by an unrelated third party; the price at which we sold shares of our convertible redeemable preferred stock to outside investors in arms-length transactions; the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock; our results of operations, financial position and capital resources; current business conditions and projections; the lack of marketability of our common stock; the hiring of key personnel and the experience of management; the risk inherent in the development of our products; our stage of development and material risks related to our business; the fact that the option grants involved illiquid securities in a private company; and the likelihood of achieving a liquidity event, such as our IPO or sale, in light of prevailing market conditions. Previously, we determined the estimated fair value of our common stock at various dates using contemporaneous valuations performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, or the Practice Aid. The Practice Aid identifies various available methods for allocating enterprise value across classes and series of capital stock to determine the estimated fair value of common stock at each valuation date. In accordance with the Practice Aid, our board of directors considered the following methods: ● Current Value Method. Under the Current Value Method, or CVM, value is determined based on our balance sheet. This value is first allocated based on the liquidation preference associated with preferred stock issued as of the valuation date, and then any residual value is assigned to the common stock. ● Option-Pricing Method. Under the option-pricing method, or OPM, shares valued by creating a series of call options with exercise prices based on the liquidation preferences and conversion terms of each equity class. The estimated fair values of the preferred and common stock are inferred by analyzing these options. ● Probability-Weighted Expected Return Method. The probability-weighted expected return method, or PWERM, is a scenario-based analysis that estimates value per share based on the probability-weighted present value of expected future investment returns, considering each of the possible outcomes available to us, as well as the economic and control rights of each share class. Based on our early stage of development and other relevant factors, we determined that a PWERM was the most appropriate method for allocating our enterprise value to determine the estimated fair value of our common stock. Our common stock valuations as of April 25, 2017, June 30, 2017, September 11, 2017, September 30, 2017, December 1, 2017, December 31, 2017, March 1, 2018, May 7, 2018, June 30, 2018 and July 18, 2018 were prepared using the PWERM. Our board of directors and management develop best estimates based on application of these approaches and the assumptions underlying these valuations, giving careful consideration to the advice from our third-party valuation expert. Such estimates involve inherent uncertainties and the application of significant judgment. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our equity-based compensation could be materially different. Subsequent to the completion of our IPO, our board of directors determines the fair market value of our common stock based on its closing price as reported on the date of grant on the primary stock exchange on which our common stock is traded. Accrued Research and Development Expenses As part of the process of preparing our financial statements, we are required to estimate our accrued expenses. This process involves reviewing quotations and contracts, identifying services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed or when contractual milestones are met. We make estimates of our accrued expenses as of each balance sheet date in our financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued research and development expenses are related to expenses incurred with respect to CROs, CMOs and other vendors in connection with research and development and manufacturing activities. We base our expenses related to CROs and CMOs on our estimates of the services received and efforts expended pursuant to quotations and contracts with such vendors that conduct research and development and manufacturing activities on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the applicable research and development or manufacturing expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid expense accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and could result in us reporting amounts that are too high or too low in any particular period. There have been no material changes in estimates for the periods presented. Warrant Liability In April 2017, we issued warrants to purchase shares of Series A Convertible Redeemable Preferred Stock in connection with the issuance of the Series A Preferred Stock financing. We accounted for these warrants as a liability in the financial statements because the underlying instrument into which the warrants were exercisable contained redemption provisions that were outside our control. Upon the completion of the IPO in July 2018, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock converted to warrants for the purchase of 558,740 shares of our common stock and no longer contain these redemption provisions outside our control. The liability associated with these warrants was revalued just prior to the completion of the IPO, with the change in the fair value of the warrant liability charged to earnings. The warrant liability was then reclassified to additional paid-in capital upon the completion of the IPO in July 2018, as the warrants no longer contain redemption provisions outside our control. The fair values of the warrants at the issuance date, December 31, 2017, and July 18, 2018, the date just prior to the completion of our IPO, were determined using the Black-Scholes option-pricing model. See Note 8 to our financial statements in Part II-Item 8 of this Annual Report on Form 10-K for further information. Recent Accounting Pronouncements See Note 3, “Significant Accounting Policies”, in the accompanying notes to financial statements, which is incorporated herein by reference.

<s>[INST] We are a clinical stage biopharmaceutical company, focused on the development and commercialization of novel therapeutics and solutions aimed at intercepting and preventing immunemediated diseases. Since our inception, we have devoted substantially all of our efforts to business planning, research and development, recruiting management and technical staff, acquiring operating assets and raising capital. Our business is subject to significant risks and uncertainties and we will be dependent on raising substantial additional capital before it becomes profitable and it may never achieve profitability. We have not generated any revenue to date and through December 31, 2018, we had an accumulated deficit of $35.8 million. We have financed our operations through a private offering of Series A Convertible Redeemable Preferred Stock in April 2017, and our initial public offering, or IPO, which closed in July 2018. In April 2017, we completed our private placement of Series A Convertible Redeemable Preferred Stock. We issued an aggregate 11,381,999 shares of Series A Convertible Redeemable Preferred Stock at $2.50 per share. We received net proceeds of $26.7 million. In July 2018, we issued and sold an aggregate of 15,969,563 shares of common stock in our IPO at a public offering price of $4.00 per share. In connection with the IPO, we issued to MDB, the underwriter in the IPO, and its designees warrants to purchase 1,596,956 shares of Common Stock at an exercise price of $5.00 per share. We received net proceeds from the IPO of $59.3 million, after deducting underwriting discounts and commissions of approximately $3.7 million and other offering expenses of approximately $0.8 million. Upon the closing of the IPO, all of our shares of Series A Convertible Redeemable Preferred Stock outstanding at the time of the IPO were automatically converted into 11,381,999 shares of common stock. In addition, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock also converted to warrants for the purchase of 558,740 shares of our common stock. We expect that over the next several years we will continue to incur losses from operations as we increase our expenditures in research and development in connection with clinical trials and other development activities. If adequate funds are not available to us on a timely basis, or at all, we may be required to terminate or delay certain development activities. Our Focus and Pipeline Inflammation is a natural consequence of most infections, as it is the immune system’s first response to invading pathogens in the event of injury or acute illness. Most of the time, this response is beneficial and wellcontrolled; helping to repair tissue damage and clear pathogens from the body. In addition to directly damaging tissues and organs, an infection can sometimes result in a potentially fatal acute pathological immune reaction. In such instances, a patient’s life is at risk primarily from the excessive immune response and release of toxic immune mediators. When patients have the requisite genetic predisposition, infections can sometimes also trigger chronic autoimmune responses that persist and progress long after the original insult has subsided. These sustained responses have been linked to an increased susceptibility to chronic conditions like inflammatory bowel disease, diabetes, cancer, and certain neurological disorders. Provention’s “predict” and “preempt” therapeutic approach is to intercept the underlying pathological immune and inflammatory responses in susceptible individuals. Provention’s pipeline includes: PRV031: a humanized, antiCD3 monoclonal antibody for the interception of type 1 diabetes (T1D) in pediatric patients with early onset T1D and, potentially, for delaying and/or preventing disease progression in patients at risk of developing T1D; PRV015: a human antiinterleukin 15 (IL15) monoclonal antibody for the treatment of glutenfree diet nonresponding celiac disease, intercepting the effects of [/INST] Positive. </s>

Provention Bio, Inc.

2020-03-12

2019-12-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview We are a clinical stage biopharmaceutical company, focused on the development and commercialization of novel therapeutics and innovative approaches aimed at intercepting and preventing immune-mediated diseases. Since our inception, we have devoted substantially all of our efforts to business planning, research and development, recruiting management and technical staff, acquiring operating assets partnering and raising capital. We have not yet commenced any revenue-generating operations, do not have any positive cash flows from operations and we will need to raise additional capital to finance our operations. Our business is subject to significant risks and uncertainties and we will be dependent on raising substantial additional capital before we become profitable and we may never achieve profitability. We have not generated any revenue to date and through December 31, 2019, we had an accumulated deficit of $79.1 million. We have financed our operations through a private offering of Series A Convertible Redeemable Preferred Stock in April 2017, our initial public offering, or IPO in July 2018 and our underwritten public offering and concurrent private placement in September 2019. In April 2017, we completed our private placement of Series A Convertible Redeemable Preferred Stock. We issued an aggregate 11,381,999 shares of Series A Convertible Redeemable Preferred Stock at $2.50 per share. We received net proceeds of $26.7 million. In July 2018, we issued and sold an aggregate of 15,969,563 shares of common stock in our IPO at a public offering price of $4.00 per share. In connection with the IPO, we issued to MDB, the underwriter in the IPO, and its designees warrants to purchase 1,596,956 shares of Common Stock at an exercise price of $5.00 per share. We received net proceeds from the IPO of $59.3 million, after deducting underwriting discounts and commissions of approximately $3.7 million and other offering expenses of approximately $0.8 million. Upon the closing of the IPO, all of our shares of Series A Convertible Redeemable Preferred Stock outstanding at the time of the IPO were automatically converted into 11,381,999 shares of common stock. In addition, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock also converted to warrants for the purchase of 558,740 shares of our common stock. In September 2019, we completed an underwritten public offering in which we sold 5,750,000 shares of common stock at a public offering price of $8.00 per share. The 5,750,000 shares sold included the full exercise of the underwriters’ option to purchase 750,000 shares at a price of $8.00 per share. Concurrent with the underwritten public offering, we sold 2,500,000 shares of common stock to Amgen, Inc. at the public offering price of $8.00 per share in a private placement, pursuant to the terms of our License and Collaboration Agreement with Amgen Inc, dated as of November 5, 2018. Aggregate net proceeds from the underwritten public offering and the concurrent private placement were $62.7 million, net of approximately $2.8 million in underwriting discounts and commissions and other offering expenses of $0.5 million. We expect that over the next several years we will continue to incur losses from operations as we increase our expenditures in research and development in connection with our planned BLA submission and our commercialization efforts for PRV-031 in the At-Risk indication, as well as our ongoing and planned clinical trials and other development activities. If adequate funds are not available to us on a timely basis, or at all, we may be required to terminate or delay certain development activities. Our Focus and Pipeline Inflammation is a natural consequence of most infections as it is the immune system’s first response to invading pathogens in the event of injury or acute illness. Most of the time, this response is beneficial and well-controlled; helping to repair tissue damage and clear pathogens from the body. In addition to directly damaging tissues and organs, an infection can sometimes result in the excessive release of toxic immune mediators leading to a potentially life-threatening acute pathological immune response. When patients have the requisite genetic predisposition, infections can also trigger chronic autoimmune responses that persist and progress long after the original insult has subsided. These sustained responses have been linked to an increased susceptibility to chronic debilitating and potentially life-threatening diseases like inflammatory bowel disease, diabetes, cancer, and certain neurological disorders. Our “predict” and “preempt” therapeutic approach is to intercept the underlying pathological immune and inflammatory responses in susceptible individuals. Our pipeline includes: ● PRV-031: a humanized, anti-CD3 mAb for the interception of T1D in pediatric patients with newly-diagnosed T1D and for delaying and/or preventing disease progression in subjects at risk of developing clinical stage T1D. PRV-031 has been designated by the FDA as orphan drug for the treatment of newly-diagnosed T1D. PRV-031 was granted breakthrough therapy designation from the FDA in August 2019 and PRIME eligibility from the EMA in October 2019 for the delay or prevention of T1D; ● PRV-101: a CVB vaccine to prevent acute CVB infections and, in those patients at risk, preventing the CVB-triggered autoimmune damage to pancreatic beta cells that progress to T1D and damage to intestinal cells that lead to celiac disease; ● PRV-3279: a humanized bispecific scaffold molecule targeting the B-cell surface proteins, CD32B and CD79B, for the treatment of systemic lupus erythematosus (SLE) and for the prevention of immunogenicity of biotherapeutics such as those used in gene therapy; ● PRV-015: a human anti-interleukin 15, or IL-15, mAb for the treatment of gluten-free diet non-responsive celiac disease, or NRCD, intercepting the effects of contaminating gluten in the most common autoimmune disorder without any approved medication; and ● PRV-6527: an oral small molecule CSF-1R inhibitor targeting the differentiation and activation of antigen-presenting cells, or APCs, to prevent chronic inflammatory responses and progression or relapse in Crohn's disease. The table below summarizes the current status and anticipated milestones for our principal product candidates: Product Candidate / Indication Status Next Expected Milestone PRV-031 (teplizumab, anti-CD3 mAb) for the interception of T1D. Top-line results from a National Institute of Diabetes and Digestive and Kidney Diseases-sponsored study conducted at TrialNet sites for preventing disease progression in patients at-risk of developing T1D were publicly reported in June 2019. In August 2019, the FDA granted BTD to PRV-031 for the delay or prevention of clinical T1D in individuals at-risk of developing the disease. In October 2019, the EMA granted PRIME eligibility to teplizumab to PRV-031 for the delay or prevention of clinical T1D in individuals at-risk of developing the disease. We commenced a Phase 3 clinical trial (the PROTECT study) in approximately 300 pediatric and adolescent patients with early onset type one diabetes. The first patient was dosed in the second quarter of 2019. We expect to file a BLA for the At-Risk indication in Q4 2020. We expect to complete enrollment of the PROTECT study by the end of 2020. We expect to report top-line results from the Phase 3 PROTECT study in 2022. PRV-101 (polyvalent CVB vaccine) for the prevention of acute CVB and the prevention of CVB triggered T1D and celiac disease. We are developing a polyvalent vaccine at Intravacc, our strategic partner in vaccine manufacturing process development. We expect to commence a first-in-human safety study in the second half of 2020. We expect to report top-line first-in-human data in 2021. PRV-3279 (humanized anti-CD32B and CD79B bispecific) for the treatment of SLE and for the prevention of immunogenicity biotherapeutics such as gene therapy. We announced positive top-line results from our Phase 1b clinical trial (the PREVAIL study), which evaluated PRV-3279 in 16 healthy volunteers. We expect to commence the Phase 2a portion of the PREVAIL study in 2021. PRV-015 (anti-IL-15 mAb) for the treatment of gluten-free diet non-responding celiac disease. We designed a Phase 2b clinical trial (the PROACTIVE trial) in celiac patients with gluten-free diet non-responsive celiac disease and completed additional chronic toxicology studies to support this trial as needed. We expect to commence the Phase 2b PROACTIVE study in the second quarter of 2020. PRV-6527 (oral CSF-1R inhibitor) for the treatment of Crohn’s disease. We announced top-line results from our Phase 2a clinical trial (the PRINCE study), which evaluated PRV-6527 in 93 patients with moderate-to-severe Crohn’s disease. In December 2019, Janssen declined its option to buy back PRV-6527. We expect to engage with third parties for the potential sublicense of PRV-6527. We intend to leverage our distinctive competences and drug development strategy; advance our carefully selected portfolio of product candidates; in-license or acquire additional targeted development assets, and apply our disease interception and prevention approach to multiple autoimmune and immune-mediated inflammatory diseases. Financial operations overview Research and Development Expenses Research and development expenses consist primarily of clinical studies, the cost of manufacturing our drug candidates for clinical study, regulatory costs, other internal operating expenses, and the cost of conducting preclinical activities. Expenses also include the cost of salaries, benefits and other related costs, including stock-based compensation, for personnel serving in our research and development functions. In addition, our research and development expenses include payments to third parties, as well as the fair value of equity issuances to third parties for the license rights to products in development (prior to marketing approval). Our expenses related to clinical trials are primarily related to activities at contract research organizations, or CROs, that design, obtain regulatory approval, and conduct clinical trials on our behalf. Our expenses related to the production of drug substance or drug product for our clinical trials and development programs are primarily related to activities performed by licensors, strategic partners or contract manufacturing organizations, or CMOs, on our behalf. Our development efforts from inception through December 31, 2019, were principally related to the acquisition and development of our programs detailed in the Pipeline description immediately above. All research and development expenses are charged to operations as incurred in accordance with Financial Accounting Standards Board Accounting Standards Codification Topic, or ASC, 730, Research and Development. We account for non-refundable advance payments for goods and services that will be used in future research and development activities as expenses when the service has been performed or when the goods have been received, rather than when the payment is made. General and Administrative Expenses General and administrative expenses consist primarily of salaries, benefits and other related costs, including stock-based compensation, for our personnel serving in our executive, business development and finance and accounting functions. General and administrative expenses also include professional fees for legal, including patent-related expenses, consulting, insurance, board of director fees, tax and accounting services. We anticipate that we will incur increased general and administrative expenses related to audit, legal, regulatory, and tax-related services associated with maintaining compliance with exchange listing and SEC requirements, director and officer insurance premiums, and investor relations costs associated with being a public company. In addition, we expect that our general and administrative expenses will increase in the future as a result of the build out of our commercial organization. Interest Income Interest income consists of interest income earned on our cash, cash equivalents and marketable securities. Change in Fair Value of Warrant Liability Change in fair value of warrant liability represents the re-measurement of liability classified warrants using the Black-Scholes option-pricing model at each financial reporting period. The fair value was affected by changes in inputs to the model including the fair value of our Series A Convertible Redeemable Preferred Stock, expected stock price volatility, the estimated term until exercise, and the risk-free interest rate. Upon the completion of the IPO in July 2018, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock converted to warrants for the purchase of 558,740 shares of our common stock. The liability associated with these warrants was revalued just prior to the completion of the IPO, with the change in the fair value of the warrant liability charged to earnings. The warrant liability was then reclassified to additional paid-in capital upon the completion of the IPO in July 2018, as the warrants no longer contain redemption provisions outside our control. RESULTS OF OPERATIONS Comparison of years ended December 31, 2019 and 2018 Research and Development Expenses Research and development expenses were $36.4 million for the year ended December 31, 2019, an increase of $13.8 million, compared to $22.6 million for the year ended December 31, 2018. Research and development expenses for the year ended December 31, 2019 primarily included external clinical development expenses of $22.6 million for PRV-031, PRV-6527, PRV-300, and PRV-3279, development costs of $6.4 million for PRV-101 and internal personnel costs, including stock-based compensation, of $5.1 million. Research and development expenses for the year ended December 31, 2018 included external clinical development expenses of $10.7 million for PRV-6527, PRV-300 and PRV-031, development costs of $4.1 million for PRV-101, non-cash product acquisition costs of $4.0 million, which represented the fair value of warrants issued in connection with the acquisition of PRV-031 and PRV-3279 in May 2018, and internal personnel costs, including stock-based compensation, of $2.9 million. General and Administrative Expenses General and administrative expenses were $8.0 million for the year ended December 31, 2019, an increase of $3.8 million, compared to $4.2 million for the year ended December 31, 2018. General and administrative expenses for the year ended December 31, 2019 primarily included $2.8 million in personnel costs, including stock-based compensation, $2.7 million in professional fees and legal expenses and $2.0 million in insurance and other costs associated with being a public company. General and administrative expenses were $4.2 million for the year ended December 31, 2018 and were primarily comprised of $1.6 million in personnel costs, including stock-based compensation, $1.5 million in professional fees and legal expenses and $0.7 million in insurance and other costs associated with being a public company. Change in fair value of warrant liability Change in fair value of warrant liability was a loss of approximately $0.5 million during the year ended December 31, 2018. This loss represents the change in fair value of our warrant liability using a Black-Scholes option-pricing model with updated assumptions as of July 18, 2018, the date just prior to the completion of our IPO, and was primarily impacted by a change in the fair value of our Series A Convertible Redeemable Preferred Stock. Upon the completion of the IPO in July 2018, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock converted to warrants for the purchase of 558,740 shares of our common stock. The warrant liability was then reclassified to additional paid-in capital upon the completion of the IPO in July 2018, as the warrants no longer contain redemption provisions outside our control. As such, we did not record any gain or loss related to the warrant liability during the year ended December 31, 2019. Interest Income Interest income was $1.1 million during the year ended December 31, 2019 compared to $0.7 million during the year ended December 31, 2018. The increase in interest income in 2019 related primarily to an increase in average cash, cash equivalents and marketable securities balances that resulted from the net proceeds from our IPO in July 2018 and our underwritten public offering and concurrent private placement in September 2019. Income Tax Benefit We did not record any income tax benefit or provision during the year ended December 31, 2019. We recorded an income tax benefit of $0.2 million during the year ended December 31, 2018, which related to the proceeds from the sale of certain of our prior year New Jersey net operating losses. Comparison of years ended December 31, 2018 and 2017 Research and Development Expenses Research and development expenses were $22.6 million for the year ended December 31, 2018, an increase of $14.9 million, compared to $7.7 million for the year ended December 31, 2017. Research and development expenses for the year ended December 31, 2018 included external clinical development expenses of $10.7 million for PRV-6527, PRV-300 and PRV-031, development costs of $4.1 million for PRV-101, non-cash product acquisition costs of $4.0 million, which represented the fair value of warrants issued in connection with the acquisition of PRV-031 and PRV-3279 in May 2018, and internal personnel costs, including stock-based compensation, of $2.9 million. Research and development expenses during the year ended December 31, 2017 included non-cash product acquisition costs of $3.4 million, which represented the fair value of shares of common stock issued in connection with the Vactech License Agreement for PRV-101 in April 2017, $3.1 million in external clinical development expenses primarily related to PRV-6527 and PRV-300, and $1.1 million of internal clinical development costs consisting mostly of compensation and related expenses, including stock-based compensation. General and Administrative Expenses General and administrative expenses were $4.2 million for the year ended December 31, 2018, an increase of $2.7 million, compared to $1.5 million for the year ended December 31, 2017. General and administrative expenses for the year ended December 31, 2018 primarily included $1.6 million in personnel costs, including stock-based compensation, $1.5 million in professional fees and legal expenses and $0.7 million in insurance and other costs associated with being a public company. General and administrative expenses were $1.5 million for the year ended December 31, 2017 and were primarily comprised of $0.7 million in personnel costs, including stock-based compensation, and $0.6 million in professional fees and legal expenses. Change in fair value of warrant liability Change in fair value of warrant liability was a loss of approximately $0.5 million during the year ended December 31, 2018, compared to a loss of $0.1 million during the year ended December 31, 2017. This loss represents the change in fair value of our warrant liability using a Black-Scholes option-pricing model with updated assumptions as of July 18, 2018, the date just prior to the completion of our IPO, and was primarily impacted by a change in the fair value of our Series A Convertible Redeemable Preferred Stock. Upon the completion of the IPO in July 2018, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock converted to warrants for the purchase of 558,740 shares of our common stock. The warrant liability was then reclassified to additional paid-in capital upon the completion of the IPO in July 2018, as the warrants no longer contain redemption provisions outside our control. Interest Income Interest income was $0.7 million during the year ended December 31, 2018 compared to $0.1 million during the year ended December 31, 2017. The increase in interest income in 2018 related primarily to an increase in average cash and cash equivalents balances that resulted from the net proceeds from our IPO in July 2018. Income Tax Benefit We recorded an income tax benefit of $0.2 million during the year ended December 31, 2018, which related to the proceeds from the sale of certain of our prior year New Jersey net operating losses We did not record any income tax benefit or provision during the year ended December 31, 2017. LIQUIDITY AND CAPITAL RESOURCES Overview There is considerable time and cost associated with developing a potential drug or pharmaceutical product to the point of regulatory approval and commercialization. We have funded our operations to date through offerings of equity securities. We expect to continue to incur losses, as we plan to continue to fund development activities. As of December 31, 2019, we had cash, cash equivalents and marketable securities of $85.4 million. In September 2019, we completed an underwritten public offering of 5,750,000 shares and a concurrent private placement with Amgen of 2,500,000 of our common stock, at a price of $8.00 per share, resulting in aggregate net cash proceeds from the sale of the shares, after deducting the underwriting discounts offering expenses, of $62.7 million. We believe that our current cash, cash equivalents and marketable securities will be sufficient to fund our projected operating requirements for at least 12 months from the issuance of these financial statements. We will need to raise additional capital to fund our operations, to develop and commercialize PRV-031, PRV-015, PRV-3279 and PRV-101 and to develop, acquire, or in-license other products. We plan to raise additional capital through equity offerings. Such additional funding will be necessary to continue to develop our potential product candidates, to pursue the license or purchase of other technologies, to commercialize our product candidates or to purchase other products. We may seek to sell common or preferred equity or convertible debt securities, enter into a credit facility or another form of third-party funding, or seek other debt financing. In addition, we may consider raising additional capital to fund operating activities, to expand our business, to pursue strategic investments, to take advantage of financing opportunities, or for other reasons. The sale of equity and convertible debt securities may result in dilution to our stockholders and those securities may have rights senior to those of our common shares. If we raise additional funds through the issuance of preferred stock, convertible debt securities or other debt financing, these securities or other debt could contain covenants that would restrict our operations. Any other third-party funding arrangement could require us to relinquish valuable rights. We may require additional capital beyond our currently anticipated amounts. Additional capital may not be available on reasonable terms, or at all. If we are unable to obtain sufficient additional funds when required, we may be forced to delay, restrict or eliminate all or a portion of our development programs, dispose of assets or technology or cease operations. Our cash requirements in 2020 and beyond will be impacted by a number of factors, the most significant of which are expenses related to PRV-031, including the PROTECT clinical trial, which commenced in April 2019, CMC activities, and costs related to our expected BLA submission in the At-Risk indication. Other factors include costs related to our planned Phase 2b clinical study of PRV-015 and our continued development efforts for PRV-101. In April 2017, we completed a private offering of 11,381,999 shares of our Series A Convertible Redeemable Preferred Stock, at a price of $2.50 per share, resulting in net cash proceeds from the sale of the shares, after deducting the underwriter’s discount and offering expenses, of $26.7 million. In July 2018, we closed our initial public offering of 15,969,563 shares of common stock at a price of $4.00 per share. Our net proceeds were $59.3 million, after deducting underwriters’ commissions of approximately $3.7 million and other offering expenses of approximately $0.8 million. In connection with the closing of the IPO, all of our shares of redeemable convertible preferred stock outstanding at the time of the IPO were automatically converted into 11,381,999 shares of common stock. In addition, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock also converted to warrants for the purchase of 558,740 shares of our common stock. In August 2019, we entered into the Sales Agreement with SVB Leerink LLC (“SVBLeerink”) and Cantor Fitzgerald & Co. (“Cantor”) pursuant to which SVBLeerink and Cantor will serve as our sales agent to sell up to $50.0 million of shares of our common stock through an “at the market offering.” To date, there have been no sales under the Sales Agreement. In September 2019, we completed an underwritten public offering in which we sold 5,750,000 shares of common stock at a public offering price of $8.00 per share. The 5,750,000 shares sold included the full exercise of the underwriters’ option to purchase 750,000 shares at a price of $8.00 per share. Concurrent with the underwritten public offering, we sold 2,500,000 shares of common stock to Amgen, Inc. at the public offering price of $8.00 per share in a private placement, pursuant to the terms of our License and Collaboration Agreement with Amgen Inc, dated as of November 5, 2018. Aggregate net proceeds from the underwritten public offering and the concurrent private placement were $62.7 million, net of approximately $2.8 million in underwriting discounts and commissions and other offering expenses of $0.5 million. Cash Flows As of December 31, 2019, we had cash, cash equivalents and marketable securities totaling $85.4 million. We currently have invested our cash and cash equivalents in money market funds. The following table shows a summary of our cash flows for the years ended December 31, 2019, 2018 and 2017: Cash Flows from Operating Activities Net cash used in operating activities was $36.1 million for the year ended December 31, 2019 and primarily related to cash used to fund clinical development activities for PRV-031, PRV-6527, PRV-3279 and PRV-300, development activities for PRV-101, and increased personnel costs to support our clinical programs and our public company infrastructure. Our working capital was $82.2 million as of December 31, 2019. Net cash used in operating activities was $22.6 million for the year ended December 31, 2018 and primarily related to cash used to fund clinical development activities for PRV-6527, PRV-300 and PRV-031, development activities for PRV-101, and increased personnel costs to support our recently acquired programs and our new public company infrastructure. Our working capital was $59.7 million as of December 31, 2018. Net cash used in operating activities was $4.9 million for the year ended December 31, 2017 and primarily related to start-up activities for our operations, including clinical development programs for PRV-6527 and PRV-300 and the development program for PRV-101, each of which were acquired in the second quarter of 2017. Cash Flows from Investing Activities Net cash used in investing activities for the year ended December 31, 2019 was $46.2 million and relates to the purchase of marketable securities during the period. There was no cash used in or provided by investing activities for the year ended December 31, 2018 and 2017, respectively. Cash Flows from Financing Activities Net cash provided by financing activities was $62.9 million for the year ended December 31, 2019 and primarily related to the net proceeds we received from the completion of our underwritten public offering and concurrent private placement in September 2019. Net cash provided by financing activities was $59.3 million for the year ended December 31, 2018 and primarily related to the net proceeds we received from the completion of our IPO in July 2018. Net cash provided by financing activities for the year ended December 31, 2017 related to the completion of a private placement of our Series A Convertible Redeemable Preferred Stock, which yielded net proceeds of approximately $26.7 million. Future Funding Requirements To date, we have not generated revenue, and we do not know when, or if, we will generate revenue. We do not expect to generate revenue unless or until we obtain marketing approval of, secure reimbursement for, and commercialize, our product candidates. We will need to raise additional capital to fund our operations, to develop and commercialize our product candidates, and to develop, acquire, in-license or co-promote other products. Our future capital requirements may be substantial and will depend on many factors. Commitments and Contractual Obligations In May 2018, we entered into the MacroGenics Asset Purchase Agreement with MacroGenics pursuant to which we acquired MacroGenics’ interest in teplizumab (renamed PRV-031), a humanized mAb for the treatment of T1D. We are obligated to pay MacroGenics contingent milestone payments totaling $170.0 million upon the achievement of certain regulatory approval milestones, including $60.0 million payable upon approval of a BLA in the United States. In addition, we are obligated to make contingent milestone payments to MacroGenics totaling $225.0 million upon the achievement of certain sales milestones. We have also agreed to pay MacroGenics a single-digit royalty on net sales of the product. We have also agreed to pay third-party obligations, including low single-digit royalties, a portion of which is creditable against royalties payable to MacroGenics, aggregate milestone payments of up to approximately $1.3 million and other consideration, for certain third-party intellectual property under agreements we are assuming pursuant to the Asset Purchase Agreement. Further, we are required to pay MacroGenics a low double-digit percentage of certain consideration to the extent it is received in connection with a future grant of rights to PRV-031 by us to a third party. We are obligated to use reasonable commercial efforts to develop and seek regulatory approval for PRV-031. As of December 31, 2019, we have not achieved any milestones that would trigger payments to MacroGenics under the MacroGenics Asset Purchase Agreement. In April 2017, we entered into the Vactech License Agreement, pursuant to which Vactech Ltd. (Vactech) granted us exclusive global rights for the purpose of developing and commercializing the group B coxsackie virus vaccine (CVB) platform technology. In consideration of the licenses and other rights granted by Vactech, we issued two million common shares to Vactech. We paid Vactech a total of approximately $0.5 million for transition and advisory services during the first 18 months of the term of the agreement. In addition, we are obligated to make a series of contingent milestone payments to Vactech totaling up to an additional $24.5 million upon the achievement of certain clinical development and regulatory filing milestones. In addition, we have agreed to pay Vactech tiered single-digit royalties on net sales of any approved product based on the CVB platform technology and three additional payments totaling $19.0 million upon the achievement of certain annual net sales levels. As of December 31, 2019, we have not achieved any milestones that would trigger payments to Vactech. In March 2018, we entered into the Intravacc Development Services Agreement with The Institute of Translational Vaccinology, pursuant to which Intravacc will provide services related to process development, non-GMP and GMP manufacturing of our polyvalent coxsackie virus B vaccine (CVB), including providing proprietary technology for manufacturing purposes. We will pay Intravacc approximately 10 million euros for their services over the development and manufacturing period which we currently expect will last for approximately 24 to 30 months. Each party retains its existing intellectual property and will share newly developed intellectual property via a fully-paid non-exclusive license between the parties for all development work through phase 1 clinical trials. Any future use, including commercial use, of Intravacc’s technology will be subject to a separate nonexclusive license agreement. The Intravacc Development Services Agreement may be terminated by us with ninety-days’ notice without cause and by either party upon a material breach or insolvency of the other party. As of December 31, 2019, we have paid Intravacc a total of approximately 8.0 million euros, or approximately $9.4 million, for services provided by Intravacc under the Intravacc Development Services Agreement. In May 2018, we entered into the MacroGenics License Agreement with MacroGenics, Inc., pursuant to which MacroGenics granted us exclusive global rights for the purpose of developing and commercializing MGD010 (renamed PRV-3279), a humanized protein and a potential treatment for SLE and other similar diseases. We are obligated to make contingent milestone payments to MacroGenics totaling $42.5 million upon the achievement of certain developmental and approval milestones for the first indication, and an additional $22.5 million upon the achievement of certain regulatory approvals for a second indication. In addition, we are obligated to make contingent milestone payments to MacroGenics totaling $225.0 million upon the achievement of certain sales milestones. We have also agreed to pay MacroGenics a single-digit royalty on net sales of the product. Further, we are required to pay MacroGenics a low double-digit percentage of certain consideration to the extent received in connection with a future grant of rights to PRV-3279 by us to a third party. We are obligated to use commercially reasonable efforts to develop and seek regulatory approval for PRV-3279. The license agreement may be terminated by either party upon a material breach or bankruptcy of the other party, by Provention without cause upon prior notice to MacroGenics, and by MacroGenics in the event that we challenge the validity of any licensed patent under the agreement, but only with respect to the challenged patent. As of December 31, 2019, we have not achieved any milestones that would trigger payments to MacroGenics under the MacroGenics License Agreement. In November 2018, we entered into the Amgen Agreement with Amgen for PRV-015 (formerly AMG 714), a novel anti-IL-15 monoclonal antibody being developed for the treatment of gluten-free diet NRCD. Under the terms of the agreement, we will conduct and fund a Phase 2b trial in NRCD and lead the development and regulatory activities for the program. Amgen has agreed to make an equity investment of up to $20.0 million in us, which was completed in September 2019. See Note 5 - License and Other Agreements for further details. Amgen is also responsible for the manufacturing of PRV-015. Upon completion of the Phase 2b trial, a $150.0 million milestone payment is due from Amgen to us, plus an additional regulatory milestone payment, and single digit royalties on future sales. If Amgen elects not to pay the $150.0 million milestone, AMG 714 rights will be transferred to us pursuant to a termination license agreement from Amgen and us. We will be obligated to make certain contingent milestone payments to Amgen and other third parties totaling up to $70.0 million upon the achievement of certain clinical and regulatory milestones and a low double-digit royalty on net sales of any approved product based on the IL-15 technology. We may terminate the agreement without cause (in which case the exclusive global rights to the technology will transfer back to Amgen) and by either party upon a material breach. The agreement expires upon the expiration of Amgen’s last obligation to make royalty payments to Provention (or, our last obligation to make royalty payments to Amgen, if the program rights are transferred to us). As of December 31, 2019, we have not achieved any milestones that would trigger payments to Amgen under the Amgen Agreement. In April 2017, we entered into the Janssen CSF-1R License Agreement, pursuant to which Janssen Pharmaceutica NV granted us exclusive global rights for the purpose of developing and commercializing a colony stimulating factor 1 receptor (CSF-1R) inhibitor named JNJ-40346527 (renamed PRV-6527) for inflammatory bowel diseases including Crohn’s disease and UC. We evaluated PRV-6527 for Crohn’s disease in a recently completed Phase 2a clinical trial (the PRINCE study). See Item 1 - Business, Recent Developments for the announcement of top-line results of the PRINCE study. In December 2019, Janssen declined its option to buy back the rights to PRV-6527. and as such, all rights will remain with us. We will be obligated to make contingent milestone payments to Janssen totaling $35.0 million upon the achievement of certain clinical and regulatory milestones for the first indication and an additional $20.0 million upon the achievement of certain clinical and regulatory milestones for a second indication. In addition, we have agreed to pay Janssen tiered single-digit royalties on net sales of any approved product based on the CSF-1R technology and three additional payments totaling $100.0 million upon the achievement of certain annual net sales levels. As of December 31, 2019, no milestones have been achieved that would trigger payments to Janssen under the CSF-1R License Agreement. In February 2019, we entered into a services agreement with AGC Biologics (“AGC”) to manufacture and supply teplizumab, PRV-031, for our anticipated clinical supply needs. We may terminate the agreement or any statement of work thereunder with approximately12 months’ prior written notice to AGC. If we provide less than 12 months’ notice of termination, we may incur a cancellation fee depending on the timing of such notice. AGC may terminate the agreement if we do not, over a specified period, purchase and take delivery from AGC of a specified minimum quantity of API for teplizumab. Each party also has the right to terminate the agreement for other customary reasons such as material breach and bankruptcy. The agreement contains provisions relating to compliance by AGC with current Good Manufacturing Practices, cooperation by AGC in connection with potential marketing applications for PRV-031, indemnification, confidentiality, dispute resolution and other customary matters for an agreement of this kind. The table below presents a summary of our contractual obligations as of December 31, 2019: (1) Purchase obligations represent our commitments under binding forecasts, and purchase orders (inclusive of cancellation fees), including those provided under our agreement(s) with AGC. The actual amounts incurred will be determined based on the amount of goods purchased and the pricing then in effect under the applicable arrangement. (2) This table does not include (a) any milestone payments which may become payable to third parties under license agreements as the timing and likelihood of such payments are not known with certainty, (b) any royalty payments to third parties as the amounts, timing and likelihood of such payments are not known, and (c) contracts that are entered into in the ordinary course of business that are not material in the aggregate in any period presented above. In addition, in the course of normal business operations, we have agreements with contract service providers to assist in the performance of our research and development and manufacturing activities. Expenditures to CROs, CMOs and other clinical development related vendors represent significant costs in clinical development. Subject to required notice periods and our obligations under binding purchase orders, we can elect to discontinue the work under these agreements at any time. We could also enter into additional collaborative research, contract research, manufacturing, and supplier agreements in the future, which may require upfront payments and even long-term commitments of cash. We also have employment agreements with certain employees which require the funding of a specific level of payments, if certain events, such as a change in control or termination without cause, occur. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. We do not have any interest in special purpose entities, structured finance entities or other variable interest entities. Critical Accounting Policies and Estimates Preparation of financial statements in accordance with generally accepted accounting principles in the US requires us to make estimates and assumptions affecting the reported amounts of assets, liabilities, and expenses and the disclosures of contingent assets and liabilities. We use our historical experience and other relevant factors when developing our estimates and assumptions. We continually evaluate these estimates and assumptions. The amounts of assets and liabilities reported in our balance sheets and the amounts of expenses reported in our statements of comprehensive loss are affected by estimates and assumptions, which are used for, but not limited to, the accounting for research and development, stock-based compensation, accrued expenses and both liability-classified and equity-classified warrants. The accounting policies discussed below are considered critical to an understanding of our financial statements because their application places the most significant demands on our judgment. Actual results could differ from our estimates. For additional accounting policies, see Note 3 to our Financial Statements- Summary of Significant Accounting Policies. Research and Development Research and development expenses consist primarily of salaries, benefits and other related costs, including stock-based compensation, for personnel serving our development functions, and other internal operating expenses, the cost of clinical studies, and the cost of our drug candidates for clinical study. In addition, research and development expenses include payments to third parties for the development of our product candidates and the estimated fair value for the issuance of equity for the license rights to products in development (prior to marketing approval). Our expenses related to clinical trials are primarily related to activities at contract research organizations that design, gain approval for and conduct clinical trials on our behalf. Such amounts are then recognized as an expense as the related goods are delivered or the services are performed. Stock-Based Compensation We recognize stock-based compensation expense for awards of equity instruments based on the grant-date fair value of those awards. The grant-date fair value of the award is recognized as compensation expense ratably over the requisite service period, which generally equals the vesting period of the award. We also grant performance-based stock options. The grant-date fair value of the performance-based stock options is recognized as compensation expense once it is probable that the performance condition will be achieved. We record actual forfeitures in the period the forfeiture occurs. In June 2018, the FASB issued ASU No. 2018-07, Improvements to Nonemployee Share-Based Payment Accounting, which supersedes ASC 505-50 and expands the scope of ASC 718 to include all share-based payments arrangements related to the acquisition of goods and services from both employees and nonemployees. During the third quarter of 2018, we early adopted ASU 2018-07. After the adoption of ASU 2018-07, the measurement date for non-employee awards is the date of grant. Compensation expense for non-employees is recognized, without changes to the fair value of the award, over the requisite service period, which is the vesting period of the respective award. The adoption of ASU 2018-07 did not have a material impact our financial statements or footnote disclosures. Prior to the third quarter of 2018, we accounted for awards of equity instruments issued to non-employees in accordance with ASC Topic 505-50 “Equity-Based Payment to Non-Employees” and accordingly the value of the stock compensation to non-employees was based upon the measurement date as determined at either a) the date at which a performance commitment was reached, or b) at the date at which the necessary performance to earn the equity instruments was complete, which was normally the end of the vesting period. At the end of each financial reporting period prior to completion of the service, the fair value of these awards was remeasured using updated assumption inputs in the Black-Scholes option-pricing model. We used the Black-Scholes option-pricing model to estimate the fair value of option awards with the following weighted-average assumptions for the period indicated: The weighted-average valuation assumptions were determined as follows: ● Risk-free interest rate: we base the risk-free interest rate on the interest rate payable on U.S. Treasury securities in effect at the time of grant for a period that is commensurate with the assumed expected option term. ● Expected annual dividends: the estimate for annual dividends is 0%, because we have not historically paid, and do not expect for the foreseeable future to pay, a dividend. ● Expected stock price volatility: the expected volatility used is based on historical volatilities of similar entities within our industry which were commensurate with our expected term assumption. ● Expected term of options: the expected term of options represents the period of time options are expected to be outstanding. The expected term of the options granted to employees is derived from the “simplified” method as described in Staff Accounting Bulletin 107 relating to stock-based compensation, whereby the expected term is an average between the vesting period and contractual period due to our limited operating history. The expected term for options granted to non-employees is equal to the contractual term of the awards. Stock-based compensation expense is included in both research and development expenses and general and administrative expenses in the Statement of Operations. Determination of Fair Value of Common Stock Prior to our IPO, there was no public market for our common stock. The estimated fair value of our common stock had been determined by our board of directors as of the date of each option grant and quarter end, with input from management, considering our most recently available third-party valuations of common stock. These factors included, but were not limited to: our most recently available valuations of our common stock by an unrelated third party; the price at which we sold shares of our convertible redeemable preferred stock to outside investors in arms-length transactions; the rights, preferences and privileges of our convertible preferred stock relative to those of our common stock; our results of operations, financial position and capital resources; current business conditions and projections; the lack of marketability of our common stock; the hiring of key personnel and the experience of management; the risk inherent in the development of our products; our stage of development and material risks related to our business; the fact that the option grants involved illiquid securities in a private company; and the likelihood of achieving a liquidity event, such as our IPO or sale, in light of prevailing market conditions. Previously, we determined the estimated fair value of our common stock at various dates using contemporaneous valuations performed in accordance with the guidance outlined in the American Institute of Certified Public Accountants’ Accounting and Valuation Guide, Valuation of Privately-Held-Company Equity Securities Issued as Compensation, or the Practice Aid. The Practice Aid identifies various available methods for allocating enterprise value across classes and series of capital stock to determine the estimated fair value of common stock at each valuation date. In accordance with the Practice Aid, our board of directors considered the following methods: ● Current Value Method. Under the Current Value Method, or CVM, value is determined based on our balance sheet. This value is first allocated based on the liquidation preference associated with preferred stock issued as of the valuation date, and then any residual value is assigned to the common stock. ● Option-Pricing Method. Under the option-pricing method, or OPM, shares valued by creating a series of call options with exercise prices based on the liquidation preferences and conversion terms of each equity class. The estimated fair values of the preferred and common stock are inferred by analyzing these options. ● Probability-Weighted Expected Return Method. The probability-weighted expected return method, or PWERM, is a scenario-based analysis that estimates value per share based on the probability-weighted present value of expected future investment returns, considering each of the possible outcomes available to us, as well as the economic and control rights of each share class. Prior to our IPO, we determined that a PWERM was the most appropriate method for allocating our enterprise value to determine the estimated fair value of our common stock. Our common stock valuations as of April 25, 2017, June 30, 2017, September 11, 2017, September 30, 2017, December 1, 2017, December 31, 2017, March 1, 2018, March 31, 2018, May 7, 2018, June 30, 2018 and July 18, 2018 were prepared using the PWERM. Our board of directors and management developed best estimates based on application of these approaches and the assumptions underlying these valuations, giving careful consideration to the advice from our third-party valuation expert. Such estimates involved inherent uncertainties and the application of significant judgment. As a result, if factors or expected outcomes change and we use significantly different assumptions or estimates, our equity-based compensation could be materially different. Subsequent to the completion of our IPO, our board of directors determines the fair market value of our common stock based on its closing price as reported on the date of grant on the primary stock exchange on which our common stock is traded. Accrued Research and Development Expenses As part of the process of preparing our financial statements, we are required to estimate our accrued expenses. This process involves reviewing quotations and contracts, identifying services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of the actual cost. The majority of our service providers invoice us monthly in arrears for services performed or when contractual milestones are met. We make estimates of our accrued expenses as of each balance sheet date in our financial statements based on facts and circumstances known to us at that time. We periodically confirm the accuracy of our estimates with the service providers and make adjustments if necessary. The significant estimates in our accrued research and development expenses are related to expenses incurred with respect to CROs, CMOs and other vendors in connection with research and development and manufacturing activities. We base our expenses related to CROs and CMOs on our estimates of the services received and efforts expended pursuant to quotations and contracts with such vendors that conduct research and development and manufacturing activities on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. There may be instances in which payments made to our vendors will exceed the level of services provided and result in a prepayment of the applicable research and development or manufacturing expense. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual or prepaid expense accordingly. Although we do not expect our estimates to be materially different from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and could result in us reporting amounts that are too high or too low in any particular period. There have been no material changes in estimates for the periods presented. Warrant Liability In April 2017, we issued warrants to purchase shares of Series A Convertible Redeemable Preferred Stock in connection with the issuance of the Series A Preferred Stock financing. We accounted for these warrants as a liability in the financial statements because the underlying instrument into which the warrants were exercisable contained redemption provisions that were outside our control. Upon the completion of the IPO in July 2018, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock converted to warrants for the purchase of 558,740 shares of our common stock and no longer contain these redemption provisions outside our control. The liability associated with these warrants was revalued just prior to the completion of the IPO, with the change in the fair value of the warrant liability charged to earnings. The warrant liability was then reclassified to additional paid-in capital upon the completion of the IPO in July 2018, as the warrants no longer contain redemption provisions outside our control. The fair value of the warrants was determined using the Black-Scholes option-pricing model and were re-measured to fair value at each financial reporting period date with any changes in fair value recognized in the statements of operations. See Note 8 to our financial statements in Part II-Item 8 of this Annual Report on Form 10-K for further information. Recent Accounting Pronouncements See Note 3, “Significant Accounting Policies”, in the accompanying notes to financial statements, which is incorporated herein by reference.

<s>[INST] We are a clinical stage biopharmaceutical company, focused on the development and commercialization of novel therapeutics and innovative approaches aimed at intercepting and preventing immunemediated diseases. Since our inception, we have devoted substantially all of our efforts to business planning, research and development, recruiting management and technical staff, acquiring operating assets partnering and raising capital. We have not yet commenced any revenuegenerating operations, do not have any positive cash flows from operations and we will need to raise additional capital to finance our operations. Our business is subject to significant risks and uncertainties and we will be dependent on raising substantial additional capital before we become profitable and we may never achieve profitability. We have not generated any revenue to date and through December 31, 2019, we had an accumulated deficit of $79.1 million. We have financed our operations through a private offering of Series A Convertible Redeemable Preferred Stock in April 2017, our initial public offering, or IPO in July 2018 and our underwritten public offering and concurrent private placement in September 2019. In April 2017, we completed our private placement of Series A Convertible Redeemable Preferred Stock. We issued an aggregate 11,381,999 shares of Series A Convertible Redeemable Preferred Stock at $2.50 per share. We received net proceeds of $26.7 million. In July 2018, we issued and sold an aggregate of 15,969,563 shares of common stock in our IPO at a public offering price of $4.00 per share. In connection with the IPO, we issued to MDB, the underwriter in the IPO, and its designees warrants to purchase 1,596,956 shares of Common Stock at an exercise price of $5.00 per share. We received net proceeds from the IPO of $59.3 million, after deducting underwriting discounts and commissions of approximately $3.7 million and other offering expenses of approximately $0.8 million. Upon the closing of the IPO, all of our shares of Series A Convertible Redeemable Preferred Stock outstanding at the time of the IPO were automatically converted into 11,381,999 shares of common stock. In addition, the warrants issued in connection with the Series A Convertible Redeemable Preferred Stock also converted to warrants for the purchase of 558,740 shares of our common stock. In September 2019, we completed an underwritten public offering in which we sold 5,750,000 shares of common stock at a public offering price of $8.00 per share. The 5,750,000 shares sold included the full exercise of the underwriters’ option to purchase 750,000 shares at a price of $8.00 per share. Concurrent with the underwritten public offering, we sold 2,500,000 shares of common stock to Amgen, Inc. at the public offering price of $8.00 per share in a private placement, pursuant to the terms of our License and Collaboration Agreement with Amgen Inc, dated as of November 5, 2018. Aggregate net proceeds from the underwritten public offering and the concurrent private placement were $62.7 million, net of approximately $2.8 million in underwriting discounts and commissions and other offering expenses of $0.5 million. We expect that over the next several years we will continue to incur losses from operations as we increase our expenditures in research and development in connection with our planned BLA submission and our commercialization efforts for PRV031 in the AtRisk indication, as well as our ongoing and planned clinical trials and other development activities. If adequate funds are not available to us on a timely basis, or at all, we may be required to terminate or delay certain development activities. Our Focus and Pipeline Inflammation is a natural consequence of most infections as it is the immune system’s first response to invading pathogens in the event of injury or acute illness. Most of the time, this response is beneficial and wellcontrolled; helping to repair tissue damage [/INST] Negative. </s>

Legacy Housing Corp

2019-04-09

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion should be read in conjunction with the financial statements and accompanying notes and the information contained in other sections of this Form 10-K. It contains forward-looking statements that involve risks and uncertainties, and is based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Our actual results could differ materially from those anticipated by our management in these forward-looking statements as a result of various factors, including those discussed in this Form 10-K and in our Registration Statement on Form S-1, particularly under the heading “Risk Factors.” Overview Legacy Housing Corporation builds, sells and finances manufactured homes and “tiny houses” that are distributed through a network of independent retailers and company-owned stores and are sold directly to manufactured housing communities. We are the fourth largest producer of manufactured homes in the United States as ranked by number of homes manufactured based on information available from the Manufactured Housing Institute and IBTS for the second quarter of 2018. With current operations focused primarily in the southern United States, we offer our customers an array of quality homes ranging in size from approximately 390 to 2,667 square feet consisting of 1 to 5 bedrooms, with 1 to 31/2 bathrooms. Our homes range in price, at retail, from approximately $22,000 to $95,000. During 2018, we sold 3,950 home sections (which are entire homes or single floors that are combined to create complete homes) and in 2017, we sold 3,274 home sections. We commenced operations in 2005 and have experienced strong sales growth and increased our equity holders’ capital at a compound annual growth rate of approximately 28% between 2009 and 2018. The Company has one reportable segment. All of our activities are interrelated, and each activity is dependent and assessed based on how each of the activities of Company supports the others. For example, the sale of manufactured homes includes providing transportation and consignment arrangements with dealers. We also provide financing options to the customers to facilitate such sale of homes. In addition, the sale of homes is directly related to financing provided by us. Accordingly, all significant operating and strategic decisions by the chief operating decision-maker, the Executive Chairman of the Board, are based upon analyses of our company as one segment or unit. We believe our company is one of the most vertically integrated in the manufactured housing industry, allowing us to offer a complete solution to our customers, from manufacturing custom-made homes using quality materials and distributing those homes through our expansive network of independent retailers and company-owned distribution locations, to providing tailored financing solutions for our customers. Our homes are constructed in the United States at one of our three manufacturing facilities in accordance with the construction and safety standards of the U.S. Department of Housing and Urban Development (“HUD”). Our factories employ high-volume production techniques that allow us to produce, on average, approximately 75 home sections, or 62 fully-completed homes depending on product mix, in total per week. We use quality materials and operate our own component manufacturing facilities for many of the items used in the construction of our homes. Each home can be configured according to a variety of floor plans and equipped with such features as fireplaces, central air conditioning and state-of-the-art kitchens. Our homes are marketed under our premier “Legacy” brand name and currently are sold primarily across 15 states through a network of 114 independent retail locations, 12 company-owned retail locations and through direct sales to owners of manufactured home communities. Our 12 company-owned retail locations, including ten Heritage Housing stores and two Tiny House Outlet stores exclusively sell our homes. During 2018, approximately 56% of our manufactured homes were sold in Texas, followed by 13% in Georgia, 11% in Louisiana, and 4% in Oklahoma. During 2017, 62% of our manufactured homes were sold in Texas, followed by 8% in Georgia, 8% in Colorado, 5% in Oklahoma, and 4% in Louisiana. We plan to deepen our distribution channel by using a portion of the net proceeds from the IPO to expand our company-owned retail locations in new and existing markets. We offer three types of financing solutions to our customers. We provide floor plan financing for our independent retailers, which takes the form of a consignment arrangement between the retailer and us. We also provide consumer financing for our products which are sold to end-users through both independent and company-owned retail locations, and we provide financing solutions to manufactured housing community owners that buy our products for use in their manufactured housing communities. Our ability to offer competitive financing options at our retail locations provides us with several competitive advantages and allows us to capture sales which may not have otherwise occurred without our ability to offer consumer financing. Factors Affecting Our Performance We believe that the growth of our business and our future success depend on various opportunities, challenges, trends and other factors, including the following: · Consistent with our long-term strategy of conservatively deploying our capital to achieve above average rates of return, we intend to expand our retail presence in the geographic markets we now serve, particularly in the southern United States. Each retail center requires between $1,000,000 and $2,000,000 to acquire the location, situate an office, provide inventory, and provide the initial working capital. We expect to open 8 to 12 additional retail centers by the end of 2020. · We also expect to provide financing solutions to a select group of our manufactured housing community-owner customers in a manner that includes developing new sites for products in or near urban locations where there is a shortage of sites to place our products. These solutions will be structured to give us an attractive return on investment when coupled with the gross margin we expect to make on products specifically targeted for sale to these new manufactured housing communities. · Finally, our financial performance will be impacted by our ability to fulfill current orders for our manufactured homes from dealers and customers. Currently, our two Texas manufacturing facilities are operating at near peak capacity, with limited ability to increase the volume of homes produced at those plants. Our Georgia manufacturing facility has unutilized square footage available and with additional investment can add capacity to increase the number of homes that can be manufactured. We intend to increase production at the Georgia facility over time, particularly in response to orders increasingly being generated from new markets in Florida and the Carolinas. In order to maintain our growth, we will need to be able to continue to properly estimate anticipated future volumes when making commitments regarding the level of business that we will seek and accept, the mix of products that we intend to manufacture, the timing of production schedules and the levels and utilization of inventory, equipment and personnel. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management believes the following accounting policies are critical to our operating results or may affect significant judgments and estimates used in the preparation of our financial statements. Allowance for Loan Losses-Consumer Loan Receivable The allowance for loan losses reflects management’s estimate of losses inherent in the consumer loans that may be uncollectible based upon review and evaluation of the consumer loan portfolio as of the date of the balance sheet. A reserve is calculated after giving consideration to, among other things, the loan characteristics, including the financial condition of borrowers, the value and liquidity of collateral, delinquency and historical loss experience. The allowance for loan losses is comprised of two components: the general reserve and specific reserves. Our calculation of the general reserve considers the historical loss rate for the last three years, adjusted for the estimated loss discovery period and any qualitative factors both internal and external to our company. Specific reserves are determined based on probable losses on specific classified impaired loans. Our policy is to place a loan on nonaccrual status when there is a clear indication that the borrower’s cash flow may not be sufficient to meet payments as they become due, which is normally when either principal or interest is past due and remains unpaid for more than 90 days. Management implemented this policy based on an analysis of historical data and performance of loans and the likelihood of recovery once principal or interest payments became delinquent and were aged more than 90 days. Payments received on nonaccrual loans are accounted for on a cash basis, first to interest and then to principal, as long as the remaining book balance of the asset is deemed to be collectible. The accrual of interest resumes when the past due principal or interest payments are brought within 90 days of being current. Impaired loans are those loans where it is probable we will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impaired loans, or portions thereof, are charged-off when deemed uncollectible. A loan is generally deemed impaired if it is more than 90 days past due on principal or interest, is in bankruptcy proceedings, or is in the process of repossession. A specific reserve is created for impaired loans based on fair value of underlying collateral value, less estimated selling costs. We used certain factors to determine to the value of the underlying collateral for impaired loans. These factors were: (1) the length of time the unit was unsold after construction; (2) the amount of time the house was occupied; (3) the cooperation level of the borrowers, i.e., loans requiring legal action or extensive field collection efforts will reduce the value; (4) units located on private property present additional value loss because it tends to be more expensive to remove units from private property as opposed to a manufactured home park; (5) the length of time the borrower has lived in the house without making payments; (6) location and size, including market conditions; and (7) the experience and expertise of the particular dealer assisting in collection efforts. Collateral for repossessed loans is acquired through foreclosure or similar proceedings and is recorded at the estimated fair value of the home, less the costs to sell. At repossession, the fair value of the collateral is computed based on the historical recovery rates of previously charged-off loans; the loan is charged off and the loss is charged to the allowance for loan losses. At each reporting period, the fair value of the collateral is adjusted to the lower of the amount recorded at repossession or the estimated sales price less estimated costs to sell, based on current information. Allowance for Loan Losses-MHP Notes MHP Notes are stated at amounts due from customers net of allowance for loan losses. We determine the allowance by considering several factors including the aging of the past due balance, the customer’s payment history, and our previous loss history. We establish an allowance reserve composed of specific and general reserve amounts that are deemed to be uncollectible. Historically we have not experienced any losses on the MHP Notes. Inventories Inventories consist of raw materials, work-in-process, and finished goods and are stated at the lower of cost or net realizable value. Raw materials cost approximates the first-in first-out method. Finished goods and work-in-process are based on a standard cost system that approximates actual costs using the specific identification method. Estimates of the lower of cost and net realizable value of inventory are determined by comparing the actual cost of the product to the estimated selling prices in the ordinary course of business based on current market and economic conditions, less reasonably predictable costs of completion, disposal, and transportation of the inventory. We evaluate inventory based on historical experience to estimate our inventory not expected to be sold in less than a year. We classify our inventory not expected to be sold in one year as non-current. Property, Plant and Equipment Property, plant and equipment are carried at cost less accumulated depreciation. Depreciation expense is calculated using the straight-line method over the estimated useful lives of each asset. Estimated useful lives for significant classes of assets are as follows: buildings and improvements, 30 to 39 years; vehicles, 5 years; machinery and equipment, 7 years; and furniture and fixtures, 7 years. Repair and maintenance charges are expensed as incurred. Expenditures for major renewals or betterments which extend the useful lives of existing property, plant, and equipment are capitalized and depreciated. We periodically evaluate the carrying value of long-lived assets to be held and used and when events and circumstances warrant such a review. The carrying value of long-lived assets is considered impaired when the anticipated undiscounted cash flow from such assets is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the long-lived assets. Fair value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that the fair values are based primarily on independent appraisals and preliminary or definitive contractual arrangements less costs to dispose. Revenue Recognition Direct Sales Revenue from homes sold to independent retailers that are not financed and not under a consignment arrangement are generally recognized upon execution of a sales contract and when the home is shipped, at which time title passes to the independent retailer and collectability is reasonably assured. These types of homes are generally either paid for prior to shipment or floor plan financed through a third party lender by the independent retailer through standard industry arrangements, which can include repurchase agreements. Commercial Sales Revenue from homes sold to mobile home parks under commercial loan programs involving funds provided by our company is recognized when the home is shipped, at which time title passes to the customer and a sales and financing contract is executed, down payment received, and collectability is reasonably assured. Consignment Sales We provide floor plan financing for independent retailers, which takes the form of a consignment arrangement. Sales under a consignment agreement are recognized as revenue when we enter into a sales contract and receive full payment for cash sales, and title passes; or, upon execution of a sales and financing contract, with a down payment received from and upon delivery of the home to the final individual customer, at which time title passes and collectability is reasonably assured. For homes sold to customers through independent retailers under consignment arrangements and financed by us, a percentage of profit is paid to the independent retailer up front as a commission for sale and also reimburses certain direct expenses incurred by the independent retailer for each transaction. Such payments are recorded as cost of product sales in our statement of operations. Retail Store Sales Revenue from direct retail sales through company-owned retail locations are generally recognized when the customer has entered into a legally binding sales contract, and payment received, the home is delivered at the customer’s site, title has transferred, and collection is reasonably assured. Retail sales financed by us are recognized as revenue upon the execution of a sales and financing contract with a down payment received and upon delivery of the home to the final customer, at which time title passes and collectability is reasonably assured. Revenue is recognized net of sales taxes. Product Warranties We provide retail home buyers with a one-year warranty from the date of purchase on manufactured inventory. Product warranty costs are accrued when the covered homes are sold to customers. Product warranty expense is recognized based on the terms of the product warranty and the related estimated costs. Factors used to determine the warranty liability include the number of homes under warranty and the historical costs incurred in servicing the warranties. The accrued warranty liability is reduced as costs are incurred and warranty liability balance is included as part of accrued liabilities in our balance sheet. Results of Operations The following discussion should be read in conjunction with the information set forth in the financial statements and the accompanying notes appearing elsewhere in this Form 10-K. Comparison of Years ended December 31, 2018 and 2017 (in thousands) We were a partnership in 2017 and, therefore a pass-through entity with respect to taxes. However, the pro forma tax provision for 2017 reflects pro forma income tax expense of $9.4 million and pro forma net income of $16.9 million as if we had been taxed as a corporation in 2017. Product sales primarily consist of direct sales, commercial sales, consignment sales and retail store sales. Product sales increased $29.4 million, or 26.8%, in 2018 as compared to 2017. This change was driven by a 17.0% increase in volume of homes sold, as well as a series of price increases. Direct sales, including sales as a subcontractor operating under a contract with FEMA to provide housing for victims of Hurricane Harvey, increased $15.0 million to $33.6 million in 2018 from $18.6 million in 2017. Commercial sales increased $10.0 million to $33.1 million in 2018 from $23.1 million in 2017. Likewise, our company-owned retail stores sales increased $2.8 million to $13.2 million in 2018 from $10.4 million in 2017. The remaining increase of $1.6 million is primarily related to sales of used product and miscellaneous parts. Net revenue attributable to our factory-built housing consisted of the following in 2018 and 2017: In 2018, our net revenue per product sold increased in part because of increased sales to manufactured home communities and increased sales through our company-owned stores, all of which carry higher margins. In addition, there were multiple price increases to our product prices due to rising material and labor costs, which resulted in higher home sales prices and more revenue generated per home sold. Additionally, sales and production volumes increased, driven by greater demand for our products. Consumer and MHP loans interest income grew $3.1 million, or 19.9%, in 2018 as compared to 2017 and is related to our increase in outstanding MHP Note portfolio and consumer loan portfolio. Between December 31, 2018 and December 31, 2017 our consumer loan portfolio increased by $10.5 million and the MHP Note portfolio increased by $8.4 million, primarily as a result of our increase in products sold during 2018. In addition, other revenue increased $0.6 million and is primarily related to a $0.4 million increase in consignment fees and a $0.2 increase in other miscellaneous income. The cost of product sales increased $24.7 million, or 30.0%, in 2018 as compared to 2017. These additional costs were primarily related to the production of a greater volume of homes in 2018, increased material costs and the continued and expanded operations of our company-owned stores. Selling, general and administrative expenses increased $3.9 million, or 22.9%, in 2018 as compared to 2017. This increase was primarily due to increased operations of our company-owned retail lots, the opening of a corporate office in Bedford, Texas and a sales office in Norcross, Georgia and non-capitalizable costs related to our IPO. In addition, dealer incentive expense decreased $0.2 million, or 20.1% in 2018 as compared to 2017. This decrease was the result of our decline in consignment sales. Other income (expense), net was a loss of $2.2 million in 2018, as compared to a loss of $1.6 million in 2017. This additional expense was primarily due to an increase in interest rates and an increase of $8.7 million in our average borrowings outstanding on our lines of credit prior to the completion of our IPO. Following the completion of our IPO, we paid off over $40.0 million borrowed aginst our lines of credit. Income tax expense for 2018 was $9.1 million compared to $0.1 million for 2017. This increase in tax expense was primarily due to a structural change of our tax status from a partnership to a subchapter C corporation subject to federal income tax. The change in tax status required the recognition of a deferred tax liability between the historical cost basis and tax basis of our assets and liabilities. The resulting net deferred tax liability was recorded as a one-time income tax expense of $2.1 million. Our effective tax rate was 29.8% for the year ended December 31, 2018. The effective tax rate, before the net impact of discrete items relating to net deferred tax expense associated with the corporate reorganization, was 23.1% and differs from the statutory rate of 21% due to state income taxes and other permanent differences between book and tax accounting. Liquidity and Capital Resources Cash and Cash Equivalents We consider all cash and highly liquid investments with an original maturity of three months or less to be cash equivalents. We maintain cash balances in bank accounts that may, at times, exceed federally insured limits. We have not incurred any losses from such accounts and management considers the risk of loss to be minimal. We believe that cash and cash equivalents at December 31, 2018, together with cash flow from operations and the proceeds from the IPO, will be sufficient to fund our operations and provide for growth for the next 12 to 18 months and into the foreseeable future. As of December 31, 2018, we had approximately $2.6 million in cash and cash equivalents, compared to $0.4 million as of December 31, 2017. Subsequent to December 31, 2018, we recived gross proceeds of $7.2 million from the exercise of the underwriters’ option to purchase additional shares to cover over-allotments in connection with the IPO. Cash Flow Activities Comparison of Cash Flow Activities from 2018 to 2017 Net cash provided by operating activities decreased $1.6 million during the year ended December 31, 2018, compared to the year ended December 31, 2017, primarily as a result of cash generated by operating income before non-cash adjustments, an increase in net working capital used for additional loan originations associated with higher demand for home sales to MHPs, an increase in inventory purchases and a decrease in operating cash flow attributed to net cash used for operating liabilities. The decrease in operating cash flows described above was offset by cash collections on accounts receivable and an increase in accrued liabilities including increases in income taxes payable due to the incorporation of the company. Net cash used in investing activities of $ 4.5 million in 2018 was primarily attributable to $5.1 million used for the acquisition of land for development, $1.4 million used to purchase consumer loans and $1.2 million used for loans to third parties for the development of manufactured housing parks. In addition, we had capital expenditures of $0.8 million for machinery and equipment and $0.2 million for building and leasehold improvements. These were offset by collections of $4.1 million of loans we made to third parties for the development of manufactured housing parks and collections of $0.2 million from our purchased consumer loans. Net cash provided by financing activities of $3.8 million in 2018 was primarily attributable to proceeds of $43.5 million from the issuance of our common stock offset by net payments of $39.4 million on our lines of credit. In addition, the January 2018 change in our structure from a partnership to a corporation eliminated partner distributions and we paid off an affiliate note payable of $1.5 million in October 2018. Indebtedness Capital One Revolver. We have a revolving line of credit (“Revolver 1”) with Capital One, N.A. with a maximum credit limit of $45,000,000 as of December 31, 2018. On May 12, 2017, Revolver 1 was amended to extend the maturity date to May 11, 2020 and increase the maximum borrowing availability under Revolver 1 to $45,000,000. For the years ended December 31, 2018 and 2017, Revolver 1 accrued interest at one month LIBOR plus 2.40%. The interest rates in effect as of December 31, 2018 and 2017 were 4.78% and 3.78%, respectively. Amounts available under Revolver 1 are subject to a formula based on eligible consumer loans and MHP Notes and are secured by all accounts receivable and a percentage of the consumer loans receivable and MHP Notes. The amount of available credit under Revolver 1 was $41,321,000 and $6,906,000 at December 31, 2018 and 2017, respectively. For the years ended December 31, 2018 and 2017, interest expense was $1,701,000 and $1,223,000, respectively. The outstanding balance as of December 31, 2018 and 2017 was $3,679,000 and $38,094,000, respectively. We were in compliance with all financial covenants as of December 31, 2018, including that we maintain a tangible net worth of at least $90,000,000 and that we maintain a ratio of debt to EBITDA of 4-to-1, or less. Veritex Community Bank Revolver. In April 2016, we entered into an agreement with Veritex Community Bank to secure an additional revolving line of credit of $15,000,000 (“Revolver 2”). Revolver 2 accrues interest at one month LIBOR plus 2.50% and all unpaid principal and interest is due at maturity on April 4, 2021. Revolver 2 is secured by all finished goods inventory excluding repossessed homes. Amounts available under Revolver 2 are subject to a formula based on eligible inventory. The interest rates in effect as of December 31, 2018 and 2017 was 4.85% and 3.87%, respectively. On May 12, 2017, we entered into an agreement to increase the maximum borrowing availability under Revolver 2 to $20,000,000. On October 15, 2018, Revolver 2 was amended to extend the maturity date from April 4, 2019 to April 4, 2021. The amount of available credit under Revolver 2 was $10,000,000 and $5,000,000 at December 31, 2018 and 2017, respectively. For the years ended December 31, 2018 and 2017, interest expense was $700,000 and 527,000, respectively. The outstanding balance as of December 31, 2018 and 2017 was $10,000,000 and $15,000,000, respectively. We were in compliance with all financial covenants as of December 31, 2018, including that we maintain a tangible net worth of at least $80,000,000. Notes Payable. We have a promissory note with Woodhaven Bank. The amount due under the promissory note accrued interest at an annual rate of 3.85% through February 2, 2017 and then at the prime interest rate plus 0.60% through maturity on April 7, 2018. The loan was subsequently renewed through April 7, 2033. The promissory note calls for monthly principal and interest payments of $30,000 with a final payment due at maturity. The interest rates in effect as of December 31, 2018 and 2017 were 4.25% and 4.35%, respectively. The note is secured by certain of our real property. Interest paid on the note payable was $159,000 and $166,000 for the years ended December 31, 2018 and 2017, respectively. The balance outstanding on the note payable at December 31, 2018 and 2017 was $3,552,000 and $3,734,000, respectively. On May 24, 2016, we signed a promissory note for $515,000 with Eagle One, LLC collateralized by the purchase of real property located in Oklahoma City, Oklahoma. The amount due under the promissory note accrues interest at an annual rate of 6.00%. The promissory note calls for monthly principal and interest payments of $6,000 until June 1, 2026. Interest paid on the note payable was $26,000 and $28,000 for the years ended December 31, 2018 and 2017, respectively. The balance outstanding on the note payable at December 31, 2018 and 2017 was $414,000 and $453,000, respectively. In January 2019, this note was paid in full. Notes Payable to an Affiliate. On February 2, 2016, we entered into a $1,500,000 note payable agreement with stated annual interest rates of 3.75% with Shipley & Sons, Ltd., a related party through the common ownership of Kenneth E. Shipley, a significant shareholder of our company and our President and Chief Executive Officer. The note was due on demand. Interest paid on the note payable was $47,000 and $56,000 for the years ended December 31, 2018 and 2017, respectively. The balance outstanding on the note payable at December 31, 2017 was $1,500,000. On October 18, 2018, this note payable was paid in full. PILOT Agreement. In December 2016, we entered into a Payment in Lieu of Taxes (“PILOT”) agreement commonly offered in Georgia by local community development programs to encourage industry development. The net effect of the PILOT agreement is to provide us with incentives through the abatement of local, city and county property taxes and to provide financing for improvements to our Georgia plant (the “Project”). In connection with the PILOT agreement, the Putman County Development Authority provides a credit facility for up to $10,000,000, which can be drawn upon to fund Project improvements and capital expenditures as defined in the agreement. If funds are drawn, we would pay transactions costs and debt service payments. The PILOT agreement requires interest payments of 6.00% per annum on outstanding balances, which are due each December 1 through maturity on December 1, 2021, at which time all unpaid principal and interest are due. The PILOT agreement is collateralized by the assets of the Project. As of December 31, 2018, we had not drawn down on this credit facility. Contractual Obligations The following table is a summary of contractual cash obligations as of December 31, 2018: Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, net sales, results of operations, liquidity or capital expenditures. However, we do have a repurchase agreement with a financial institution providing inventory financing for independent retailers of our products. Under this agreement, we have agreed to repurchase homes at declining prices over the term of the agreement (24 months). Our obligation under this repurchase agreement ceases upon the purchase of the home by the retail customer. The maximum amount of our contingent obligations under such repurchase agreements was approximately $2,186,000 and $1,765,000 as of December 31, 2018 and 2017, respectively, without reduction for the resale value of the homes. We may be required to honor contingent repurchase obligations in the future and may incur additional expense as a consequence of these repurchase agreements. We consider our obligations on current contracts to be immaterial and accordingly we have not recorded any reserve for repurchase commitment as of December 31, 2018. Recent Accounting Pronouncements For information regarding recently issued and adopted accounting pronouncements, see Note 2, Summary of Significant Accounting Policies, to our December 31, 2018 financial statements included in Part II, Item 8, Financial Statements and Supplementary Data, of this Form-10K. Emerging Growth Company Status We are an “emerging growth company,” as defined in the JOBS Act. Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to take advantage of these exemptions until we are no longer an emerging growth company or until we affirmatively and irrevocably opt out of this exemption.

<s>[INST] Overview Legacy Housing Corporation builds, sells and finances manufactured homes and “tiny houses” that are distributed through a network of independent retailers and companyowned stores and are sold directly to manufactured housing communities. We are the fourth largest producer of manufactured homes in the United States as ranked by number of homes manufactured based on information available from the Manufactured Housing Institute and IBTS for the second quarter of 2018. With current operations focused primarily in the southern United States, we offer our customers an array of quality homes ranging in size from approximately 390 to 2,667 square feet consisting of 1 to 5 bedrooms, with 1 to 31/2 bathrooms. Our homes range in price, at retail, from approximately $22,000 to $95,000. During 2018, we sold 3,950 home sections (which are entire homes or single floors that are combined to create complete homes) and in 2017, we sold 3,274 home sections. We commenced operations in 2005 and have experienced strong sales growth and increased our equity holders’ capital at a compound annual growth rate of approximately 28% between 2009 and 2018. The Company has one reportable segment. All of our activities are interrelated, and each activity is dependent and assessed based on how each of the activities of Company supports the others. For example, the sale of manufactured homes includes providing transportation and consignment arrangements with dealers. We also provide financing options to the customers to facilitate such sale of homes. In addition, the sale of homes is directly related to financing provided by us. Accordingly, all significant operating and strategic decisions by the chief operating decisionmaker, the Executive Chairman of the Board, are based upon analyses of our company as one segment or unit. We believe our company is one of the most vertically integrated in the manufactured housing industry, allowing us to offer a complete solution to our customers, from manufacturing custommade homes using quality materials and distributing those homes through our expansive network of independent retailers and companyowned distribution locations, to providing tailored financing solutions for our customers. Our homes are constructed in the United States at one of our three manufacturing facilities in accordance with the construction and safety standards of the U.S. Department of Housing and Urban Development (“HUD”). Our factories employ highvolume production techniques that allow us to produce, on average, approximately 75 home sections, or 62 fullycompleted homes depending on product mix, in total per week. We use quality materials and operate our own component manufacturing facilities for many of the items used in the construction of our homes. Each home can be configured according to a variety of floor plans and equipped with such features as fireplaces, central air conditioning and stateoftheart kitchens. Our homes are marketed under our premier “Legacy” brand name and currently are sold primarily across 15 states through a network of 114 independent retail locations, 12 companyowned retail locations and through direct sales to owners of manufactured home communities. Our 12 companyowned retail locations, including ten Heritage Housing stores and two Tiny House Outlet stores exclusively sell our homes. During 2018, approximately 56% of our manufactured homes were sold in Texas, followed by 13% in Georgia, 11% in Louisiana, and 4% in Oklahoma. During 2017, 62% of our manufactured homes were sold in Texas, followed by 8% in Georgia, 8% in Colorado, 5% in Oklahoma, and 4% in Louisiana. We plan to deepen our distribution channel by using a portion of the net proceeds from the IPO to expand our companyowned retail locations in new and existing markets. We offer three types of financing solutions to our customers. We provide floor plan financing for our independent retailers, which takes the form of a consignment arrangement between the retailer and us. We also provide consumer financing for our products which are sold to endusers through both independent and companyowned retail locations, and we provide financing solutions to manufactured housing community owners that buy our products for use in their manufactured housing communities. Our ability to offer competitive financing options at our retail locations provides us with several competitive advantages and allows us to capture sales which may not have otherwise occurred without our ability to offer consumer financing. Factors Affect [/INST] Negative. </s>

Legacy Housing Corp

2020-03-30

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. The following discussion should be read in conjunction with the financial statements and accompanying notes and the information contained in other sections of this Form 10-K. It contains forward-looking statements that involve risks and uncertainties, and is based on the beliefs of our management, as well as assumptions made by, and information currently available to, our management. Our actual results could differ materially from those anticipated by our management in these forward-looking statements as a result of various factors, including those discussed in this Form 10-K and in our Registration Statement on Form S-1, particularly under the heading “Risk Factors.” Overview Legacy Housing Corporation builds, sells and finances manufactured homes and “tiny houses” that are distributed through a network of independent retailers and company-owned stores and are sold directly to manufactured housing communities. We are the fourth largest producer of manufactured homes in the United States as ranked by number of homes manufactured based on information available from the Manufactured Housing Institute and IBTS for 2019. With current operations focused primarily in the southern United States, we offer our customers an array of quality homes ranging in size from approximately 390 to 2,667 square feet consisting of 1 to 5 bedrooms, with 1 to 31/2 bathrooms. Our homes range in price, at retail, from approximately $18,000 to $140,000. During 2019, we sold 3,904 home sections (which are entire homes or single floors that are combined to create complete homes) and in 2018, we sold 3,950 home sections. The Company has one reportable segment. All of our activities are interrelated, and each activity is dependent and assessed based on how each of the activities of Company supports the others. For example, the sale of manufactured homes includes providing transportation and consignment arrangements with dealers. We also provide financing options to the customers to facilitate such sale of homes. In addition, the sale of homes is directly related to financing provided by us. Accordingly, all significant operating and strategic decisions by the chief operating decision-maker, the Executive Chairman of the Board, are based upon analyses of our company as one segment or unit. We believe our company is one of the most vertically integrated in the manufactured housing industry, allowing us to offer a complete solution to our customers, from manufacturing custom-made homes using quality materials and distributing those homes through our expansive network of independent retailers and company-owned distribution locations, to providing tailored financing solutions for our customers. Our homes are constructed in the United States at one of our three manufacturing facilities in accordance with the construction and safety standards of the U.S. Department of Housing and Urban Development (“HUD”). Our factories employ high-volume production techniques that allow us to produce, on average, approximately 75 home sections, or 62 fully-completed homes depending on product mix, in total per week. We use quality materials and operate our own component manufacturing facilities for many of the items used in the construction of our homes. Each home can be configured according to a variety of floor plans and equipped with such features as fireplaces, central air conditioning and state-of-the-art kitchens. Our homes are marketed under our premier “Legacy” brand name and currently are sold primarily across 15 states through a network of 90 independent retail locations, 13 company-owned retail locations and through direct sales to owners of manufactured home communities. Our 13 company-owned retail locations, including 11 Heritage Housing stores and two Tiny House Outlet stores exclusively sell our homes. During 2019, approximately 48% of our manufactured homes were sold in Texas, followed by 8% in Georgia, 6% in Kansas, 5% in Oklahoma and 5% in Florida. During 2018, 56% of our manufactured homes were sold in Texas, followed by 13% in Georgia, 11% in Louisiana and 4% in Oklahoma. We plan to deepen our distribution channel by using a portion of the net proceeds from the IPO to expand our company-owned retail locations in new and existing markets. We offer three types of financing solutions to our customers. We provide floor plan financing for our independent retailers, which takes the form of a consignment arrangement between the retailer and us. We also provide consumer financing for our products which are sold to end-users through both independent and company-owned retail locations, and we provide financing solutions to manufactured housing community owners that buy our products for use in their manufactured housing communities. Our ability to offer competitive financing options at our retail locations provides us with several competitive advantages and allows us to capture sales which may not have otherwise occurred without our ability to offer consumer financing. Factors Affecting Our Performance We believe that the growth of our business and our future success depend on various opportunities, challenges, trends and other factors, including the following: · Consistent with our long-term strategy of conservatively deploying our capital to achieve above average rates of return, we intend to expand our retail presence in the geographic markets we now serve, particularly in the southern United States. Each retail center requires between $500,000 and $1,500,000 to acquire the location, situate an office, provide inventory, and provide the initial working capital. We expect to open 2 to 4 additional retail centers by the end of 2020. · We have purchased several properties in our market area for the purpose of developing manufactured housing communities and subdivisions. As of December 31, 2019, these properties include the following: · We also expect to provide financing solutions to a select group of our manufactured housing community-owner customers in a manner that includes developing new sites for products in or near urban locations where there is a shortage of sites to place our products. These solutions will be structured to give us an attractive return on investment when coupled with the gross margin we expect to make on products specifically targeted for sale to these new manufactured housing communities. · Our financial performance will be impacted by our ability to fulfill current orders for our manufactured homes from dealers and customers. Currently, our two Texas manufacturing facilities are operating at or near peak capacity, with limited ability to increase the volume of homes produced at those plants. Our Georgia manufacturing facility has unutilized square footage available and with additional investment can add capacity to increase the number of homes that can be manufactured. We intend to increase production at the Georgia facility over time, particularly in response to orders increasingly being generated from new markets in Florida and the Carolinas. In order to maintain our growth, we will need to be able to continue to properly estimate anticipated future volumes when making commitments regarding the level of business that we will seek and accept, the mix of products that we intend to manufacture, the timing of production schedules and the levels and utilization of inventory, equipment and personnel. · The coronavirus pandemic is an evolving threat to the economy and all businesses. At this time both the duration of the pandemic and the magnitude of the economic consequences are unknown. Risks to the Company include but are not limited to: o increased loan losses or deferred loan payments as loan obligors suffer cash flow issues resulting from reduced employment, reduced rental income or unit sales, or other factors; o reduced sales volume as potential customers are unable to shop for new homes or cannot qualify for a home purchase, retail dealers or company stores reduce or stop operations, or MHP owners reduce their future home purchases; o reduced production resulting from factors such as the spread of the illness through the Company’s workforce, reduced product demand, or government-mandated closures of our factories, company-owned stores, or retail lots of independent dealers who carry our products; o delays in development projects as zoning, regulatory, and permitting decisions are likely to be postponed and the expected negative impact of the pandemic on the construction industry; o reduced raw material availability related to global supply chain disruption from the pandemic, including possible border closures; o decreased cash flow from operations which could negatively affect our liquidity; o an outbreak of illness among our management and accounting staff could negatively affect our ability to maintain operations, operate our financial systems, delay our statutory reporting, and reduce our internal control of financial reporting. We continue to monitor government responses to support the economy and evaluate how those actions might mitigate the risks noted above. At this time, we believe that the pandemic will have a negative effect on our financial results that could range from minor to material. Management has taken a number of actions in recent weeks, including stimulating demand by offering discounts and modified purchase terms, reducing production labor, suspending overtime, and reducing rates of pay for non-production workers. Additionally, the Company has negotiated a new credit agreement with its primary bank that will expand and extend our credit facility. Management expects to close and execute the new agreement in the near future. Critical Accounting Policies and Estimates Our management’s discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management believes the following accounting policies are critical to our operating results or may affect significant judgments and estimates used in the preparation of our financial statements. Allowance for Loan Losses-Consumer Loan Receivable The allowance for loan losses reflects management’s estimate of losses inherent in the consumer loans that may be uncollectible based upon review and evaluation of the consumer loan portfolio as of the date of the balance sheet. A reserve is calculated after considering, among other things, the loan characteristics, including the financial condition of borrowers, the value and liquidity of collateral, delinquency and historical loss experience. The allowance for loan losses is comprised of two components: the general reserve and specific reserves. Our calculation of the general reserve considers the historical loss rate for the last three years, adjusted for the estimated loss discovery period and any qualitative factors both internal and external to our company. Specific reserves are determined based on probable losses on specific classified impaired loans. Our policy is to place a loan on nonaccrual status when there is a clear indication that the borrower’s cash flow may not be sufficient to meet payments as they become due, which is normally when either principal or interest is past due and remains unpaid for more than 90 days. Management implemented this policy based on an analysis of historical data and performance of loans and the likelihood of recovery once principal or interest payments became delinquent and were aged more than 90 days. Payments received on nonaccrual loans are accounted for on a cash basis, first to interest and then to principal, as long as the remaining book balance of the asset is deemed to be collectible. The accrual of interest resumes when the past due principal or interest payments are brought within 90 days of being current. Impaired loans are those loans where it is probable we will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. Impaired loans, or portions thereof, are charged-off when deemed uncollectible. A loan is generally deemed impaired if it is more than 90 days past due on principal or interest, is in bankruptcy proceedings, or is in the process of repossession. A specific reserve is created for impaired loans based on fair value of underlying collateral value, less estimated selling costs. We used certain factors to determine to the value of the underlying collateral for impaired loans. These factors were: (1) the length of time the unit was unsold after construction; (2) the amount of time the house was occupied; (3) the cooperation level of the borrowers, i.e., loans requiring legal action or extensive field collection efforts will reduce the value; (4) units located on private property present additional value loss because it tends to be more expensive to remove units from private property as opposed to a manufactured home park; (5) the length of time the borrower has lived in the house without making payments; (6) location and size, including market conditions; and (7) the experience and expertise of the particular dealer assisting in collection efforts. Collateral for repossessed loans is acquired through foreclosure or similar proceedings and is recorded at the estimated fair value of the home, less the costs to sell. At repossession, the fair value of the collateral is computed based on the historical recovery rates of previously charged-off loans; the loan is charged off and the loss is charged to the allowance for loan losses. At each reporting period, the fair value of the collateral is adjusted to the lower of the amount recorded at repossession or the estimated sales price less estimated costs to sell, based on current information. Allowance for Loan Losses-MHP Notes MHP Notes are stated at amounts due from customers net of allowance for loan losses. We determine the allowance by considering several factors including the aging of the past due balance, the customer’s payment history, and our previous loss history. We establish an allowance reserve composed of specific and general reserve amounts that are deemed to be uncollectible. Historically we have not experienced material losses on the MHP Notes. Inventories Inventories consist of raw materials, work-in-process, and finished goods and are stated at the lower of cost or net realizable value. Raw materials cost approximates the first-in first-out method. Finished goods and work-in-process are based on a standard cost system that approximates actual costs using the specific identification method. Estimates of the lower of cost and net realizable value of inventory are determined by comparing the actual cost of the product to the estimated selling prices in the ordinary course of business based on current market and economic conditions, less reasonably predictable costs of completion, disposal, and transportation of the inventory. We evaluate inventory based on historical experience to estimate our inventory not expected to be sold in less than a year. We classify our inventory not expected to be sold in one year as non-current. Property, Plant and Equipment Property, plant and equipment are carried at cost less accumulated depreciation. Depreciation expense is calculated using the straight-line method over the estimated useful lives of each asset. Estimated useful lives for significant classes of assets are as follows: buildings and improvements, 30 to 39 years; vehicles, 5 years; machinery and equipment, 7 years; and furniture and fixtures, 7 years. Repair and maintenance charges are expensed as incurred. Expenditures for major renewals or betterments which extend the useful lives of existing property, plant, and equipment are capitalized and depreciated. We periodically evaluate the carrying value of long-lived assets to be held and used and when events and circumstances warrant such a review. The carrying value of long-lived assets is considered impaired when the anticipated undiscounted cash flow from such assets is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the long-lived assets. Fair value is determined primarily using the anticipated cash flows discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of are determined in a similar manner, except that the fair values are based primarily on independent appraisals and preliminary or definitive contractual arrangements less costs to dispose. Revenue Recognition Direct Sales Revenue from homes sold to independent retailers that are not financed and not under a consignment arrangement are generally recognized upon execution of a sales contract and when the home is shipped, at which time title passes to the independent retailer and collectability is reasonably assured. These types of homes are generally either paid for prior to shipment or floor plan financed through a third party lender by the independent retailer through standard industry arrangements, which can include repurchase agreements. Commercial Sales Revenue from homes sold to mobile home parks under commercial loan programs involving funds provided by our company is recognized when the home is shipped, at which time title passes to the customer and a sales and financing contract is executed, down payment received, and collectability is reasonably assured. Consignment Sales We provide floor plan financing for independent retailers, which takes the form of a consignment arrangement. Sales under a consignment agreement are recognized as revenue when we enter into a sales contract and receive full payment for cash sales, and title passes; or, upon execution of a sales and financing contract, with a down payment received from and upon delivery of the home to the final individual customer, at which time title passes and collectability is reasonably assured. For homes sold to customers through independent retailers under consignment arrangements and financed by us, a percentage of profit is paid to the independent retailer up front as a commission for sale and also reimburses certain direct expenses incurred by the independent retailer for each transaction. Such payments are recorded as cost of product sales in our statement of operations. Retail Store Sales Revenue from direct retail sales through company-owned retail locations are generally recognized when the customer has entered into a legally binding sales contract, payment is received, the home is delivered at the customer’s site, title has transferred, and collection is reasonably assured. Retail sales financed by us are recognized as revenue upon the execution of a sales and financing contract with a down payment received and upon delivery of the home to the final customer, at which time title passes and collectability is reasonably assured. Revenue is recognized net of sales taxes. Product Warranties We provide retail home buyers with a one-year warranty from the date of purchase on manufactured inventory. Product warranty costs are accrued when the covered homes are sold to customers. Product warranty expense is recognized based on the terms of the product warranty and the related estimated costs. Factors used to determine the warranty liability include the number of homes under warranty and the historical costs incurred in servicing the warranties. The accrued warranty liability is reduced as costs are incurred and warranty liability balance is included as part of accrued liabilities in our balance sheet. Results of Operations The following discussion should be read in conjunction with the information set forth in the financial statements and the accompanying notes appearing elsewhere in this Form 10-K. Comparison of Years ended December 31, 2019 and 2018 (in thousands) Product sales primarily consist of direct sales, commercial sales, consignment sales and retail store sales. Product sales increased $4.0 million, or 2.9%, in 2019 as compared to 2018 even though the volume of homes sold remained flat. This change was driven by an increase in commercial sales and retail stores sales partially offset by a decline in direct sales, consignment sales and other product sales. The first quarter of 2018 included $8.9 million of sales as a subcontractor operating under a contract with FEMA to provide housing for victims of Hurricane Harvey. Direct sales decreased $17.5 million to $15.2 million in 2019 from $32.7 million in 2018 primarily due to the nonrecurring sales to FEMA. Commercial sales increased $31.3 million to $64.4 million in 2019 from $33.1 million in 2018, and our company-owned retail stores sales increased $3.0 million to $16.1 million in 2019 from $13.1 million in 2018. These increases were offset by a net $11.9 million decrease in consignment sales to $42.9 million from $54.8 million in 2018. Other product sales decreased $0.8 million to $4.6 million in 2019 from $5.4 million in 2018 and is primarily due to a $1.3 million decline in direct freight related to the 2018 FEMA sales and a $0.9 million decline in used units partially offset by a $1.4 million increase in other miscellaneous product sales. Net revenue attributable to our factory-built housing consisted of the following in 2019 and 2018: In 2019, our net revenue per product sold increased because of changes in our product sales mix. We had increases in sales to manufactured home communities and through our company-owned retail stores. These increases were partially offset by declines in direct sales and consignment sales. Sales through our company-owned retail stores and sales to manufactured home communities have higher margins than our direct sales and consignment sales. In addition, there were price increases to our product prices due to rising material and labor costs, which resulted in higher home sales prices and more revenue generated per home sold. Consumer and MHP loans interest income grew $3.4 million, or 18.3%, in 2019 as compared to 2018 and is related to our increase in outstanding MHP Note portfolio and consumer loan portfolio. Between December 31, 2019 and December 31, 2018 our MHP Note portfolio increased by $34.4 million and the consumer loan portfolio increased by $7.9 million. Other revenue primarily consists of service fees and consignment fees. Other revenue decreased $0.4 million or 9.7% and is primarily due to a $0.3 million decrease in setup and service fees and a $0.1 decrease in consignment fees. The cost of product sales decreased $2.3 million, or 2.2%, in 2019 as compared to 2018. The reduction in costs is primarily related to the shift in our product sales mix, including the decline in product sales to FEMA. Selling, general and administrative expenses increased $4.5 million, or 21.2%, in 2019 as compared to 2018. This increase resulted from a $1.8 million increase in salaries and incentive costs primarily related to our operations as a public company, a $1.2 million increase in salaries related to the operations of our company-owned retail lots, a $1.1 million increase in expense for services performed by outside contractors, a $0.8 million increase in loan loss reserve and a $0.4 million increase in advertising and promotions. These increases were partially offset by a net decrease of $0.6 million in warranty costs related to the decline in product sales to FEMA. In addition, dealer incentive expense decreased $0.1 million, or 11.8% in 2019 as compared to 2018. This decrease was the result of the decline in consignment sales. Other income (expense), net was a loss of $0.3 million in 2019, as compared to a loss of $2.2 million in 2018. This decline was primarily due to a decrease of $41.4 million in our average borrowings outstanding on our lines of credit after the completion of our IPO. Following the completion of our IPO, we paid off over $40.0 million borrowed against our lines of credit. Income tax expense for 2019 was $8.7 million compared to $9.1 million for 2018. The effective tax rate for the year ended December 31, 2019 was 23.3% and differs from the federal statutory rate of 21% primarily due to state income taxes. The effective tax rate for the year ended December 31, 2018 was 29.8% and differs from the federal statutory rate of 21% due to recognition of a deferred tax expense associated with the corporate reorganization, state income taxes and other permanent differences between book and tax basis. Liquidity and Capital Resources Cash and Cash Equivalents We consider all cash and highly liquid investments with an original maturity of three months or less to be cash equivalents. We maintain cash balances in bank accounts that may, at times, exceed federally insured limits. We have not incurred any losses from such accounts and management considers the risk of loss to be minimal. We believe that cash flow from operations, cash and cash equivalents at December 31, 2019, and availability on our lines of credit will be sufficient to fund our operations and provide for growth for the next 12 to 18 months and into the foreseeable future. We have negotiated a new credit agreement with Capital One, N.A. that will replace, expand and extend our credit availability. We expect to close and execute the new agreement in the near future. As of December 31, 2019, we had approximately $1.7 million in cash and cash equivalents, compared to $2.6 million as of December 31, 2018. In January 2019, we received gross proceeds of $7.2 million from the exercise of the underwriters’ option to purchase additional shares to cover over-allotments in connection with the IPO. These proceeds were primarily used for payments to reduce our borrowings under the lines of credit. Cash Flow Activities Comparison of Cash Flow Activities from 2019 to 2018 Net cash provided by operating activities decreased $7.0 million during the year ended December 31, 2019, compared to the year ended December 31, 2018, primarily as a result of increased volume of loan originations supporting sales to MHPs net of principal collections, growth in our portfolio of home units leased to MHPs, and reduced growth in non-loan current liabilities. The decrease in operating cash flows described above was partially offset by reduced inventories, cash generated by operating income before non-cash adjustments, and reduced growth in consumer loan originations net of principal collections. Net cash used in investing activities of $15.1 million in 2019 was primarily attributable to $11.9 million used for loans to third parties for the development of manufactured housing parks, $3.6 million used for the acquisition of land for development and $0.4 million used to purchase consumer loans. In addition, we had capital expenditures of $1.2 million for property plant and equipment and $0.1 million for transportation equipment. These were offset by collections of $0.4 million of loans we made to third parties for the development of manufactured housing parks and collections of $1.0 million from our purchased consumer loans. Net cash provided by financing activities of $18.4 million in 2019 was primarily attributable to net proceeds of $17.2 million on our lines of credit, net proceeds of $6.7 million from the issuance of our common stock and a $1.6 million increase in escrow deposits received by the company offset by $3.1 million for the purchase of treasury stock and $4.0 million of payments on our notes payable. Indebtedness Capital One Revolver. We have a revolving line of credit (“Revolver 1”) with Capital One, N.A. with a maximum credit limit of $45,000,000 as of December 31, 2019. On May 12, 2017, Revolver 1 was amended to extend the maturity date to May 11, 2020 and increase the maximum borrowing availability under Revolver 1 to $45,000,000. For the years ended December 31, 2019 and 2018, Revolver 1 accrued interest at one-month LIBOR plus 2.40%. The interest rates in effect as of December 31, 2019 and 2018 were 4.09% and 4.78%, respectively. Amounts available under Revolver 1 are subject to a formula based on eligible consumer loans and MHP Notes and are secured by all accounts receivable and a percentage of the consumer loans receivable and MHP Notes. The amount of available credit under Revolver 1 was $16,140,000 and $41,321,000 at December 31, 2019 and 2018, respectively. For the years ended December 31, 2019 and 2018, interest expense was $396,000 and $1,701,000, respectively. The outstanding balance as of December 31, 2019 and 2018 was $28,860,000 and $3,679,000, respectively. We were in compliance with all financial covenants as of December 31, 2019, including that we maintain a tangible net worth of at least $90,000,000 and that we maintain a ratio of debt to EBITDA of 4-to-1, or less. The Company has negotiated a new credit agreement with Capital One, N.A. that will replace, expand, and extend our credit availability. Management expects to close and execute the new agreement in the near future. Veritex Community Bank Revolver. In April 2016, we entered into an agreement with Veritex Community Bank to secure an additional revolving line of credit of $15,000,000 (“Revolver 2”). Revolver 2 accrues interest at one- month LIBOR plus 2.50% and all unpaid principal and interest is due at maturity on April 4, 2021. Revolver 2 is secured by all finished goods inventory excluding repossessed homes. Amounts available under Revolver 2 are subject to a formula based on eligible inventory. The interest rates in effect as of December 31, 2019 and 2018 were 4.19% and 4.85%, respectively. On May 12, 2017, we entered into an agreement to increase the maximum borrowing availability under Revolver 2 to $20,000,000. On October 15, 2018, Revolver 2 was amended to extend the maturity date from April 4, 2019 to April 4, 2021. The amount of available credit under Revolver 2 was $11,262,000 and $9,906,000 at December 31, 2019 and 2018, respectively. For the years ended December 31, 2019 and 2018, interest expense was $131,000 and $700,000, respectively. The outstanding balance as of December 31, 2019 and 2018 was $2,001,000 and $10,000,000, respectively. We were in compliance with all financial covenants as of December 31, 2019, including that we maintain a tangible net worth of at least $80,000,000. Notes Payable. We have a promissory note with Woodhaven Bank. The amount due under the promissory note accrues interest at an annual rate of 3.85% through February 2, 2017 and then at the prime interest rate plus 0.60% through maturity on April 7, 2018. The loan was subsequently renewed through April 7, 2033. The promissory note calls for monthly principal and interest payments of $30,000 with a final payment due at maturity. The interest rates in effect as of December 31, 2018 was 4.25%. The note is secured by certain of our real property. Interest paid on the note payable was $135,000 and $159,000 for the years ended December 31, 2019 and 2018, respectively. The balance outstanding on the note payable at December 31, 2018 was $3,552,000. In October 2019, this note was paid in full. On May 24, 2016, we signed a promissory note for $515,000 with Eagle One, LLC collateralized by the purchase of real property located in Oklahoma City, Oklahoma. The amount due under the promissory note accrues interest at an annual rate of 6.00%. The promissory note calls for monthly principal and interest payments of $6,000 until June 1, 2026. Interest paid on the note payable was $1,000 and $26,000 for the years ended December 31, 2019 and 2018, respectively. The balance outstanding on the note payable at December 31, 2018 was $414,000. In January 2019, this note was paid in full. Notes Payable to an Affiliate. On February 2, 2016, we entered into a $1,500,000 note payable agreement with stated annual interest rates of 3.75% with Shipley & Sons, Ltd., a related party through the common ownership of Kenneth E. Shipley, a significant shareholder of our company and our President and Chief Executive Officer. The note was due on demand. Interest paid on the note payable was $47,000 for the year ended December 31, 2018. On October 18, 2018, this note payable was paid in full. PILOT Agreement. In December 2016, we entered into a Payment in Lieu of Taxes (“PILOT”) agreement commonly offered in Georgia by local community development programs to encourage industry development. The net effect of the PILOT agreement is to provide us with incentives through the abatement of local, city and county property taxes and to provide financing for improvements to our Georgia plant (the “Project”). In connection with the PILOT agreement, the Putman County Development Authority provides a credit facility for up to $10,000,000, which can be drawn upon to fund Project improvements and capital expenditures as defined in the agreement. If funds are drawn, we would pay transactions costs and debt service payments. The PILOT agreement requires interest payments of 6.00% per annum on outstanding balances, which are due each December 1 through maturity on December 1, 2021, at which time all unpaid principal and interest are due. The PILOT agreement is collateralized by the assets of the Project. As of December 31, 2019, we had not drawn down on this credit facility. Contractual Obligations The following table is a summary of contractual cash obligations as of December 31, 2019: Off-Balance Sheet Arrangements We did not have any off-balance sheet arrangements that are reasonably likely to have a current or future effect on our financial condition, net sales, results of operations, liquidity or capital expenditures. However, we do have a repurchase agreement with a financial institution providing inventory financing for independent retailers of our products. Under this agreement, we have agreed to repurchase homes at declining prices over the term of the agreement (24 months). Our obligation under this repurchase agreement ceases upon the purchase of the home by the retail customer. The maximum amount of our contingent obligations under such repurchase agreements was approximately $260,000 and $2,186,000 as of December 31, 2019 and 2018, respectively, without reduction for the resale value of the homes. We may be required to honor contingent repurchase obligations in the future and may incur additional expense as a consequence of these repurchase agreements. We consider our obligations on current contracts to be immaterial and accordingly we have not recorded any reserve for repurchase commitment as of December 31, 2019. Recent Accounting Pronouncements For information regarding recently issued and adopted accounting pronouncements, see Note 2, Summary of Significant Accounting Policies, to our December 31, 2019 financial statements included in Part II, Item 8, Financial Statements and Supplementary Data, of this Form-10K. Emerging Growth Company Status We are an “emerging growth company,” as defined in the JOBS Act. Section 107 of the JOBS Act provides that an “emerging growth company” can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to take advantage of these exemptions until we are no longer an emerging growth company or until we affirmatively and irrevocably opt out of this exemption.

<s>[INST] Overview Legacy Housing Corporation builds, sells and finances manufactured homes and “tiny houses” that are distributed through a network of independent retailers and companyowned stores and are sold directly to manufactured housing communities. We are the fourth largest producer of manufactured homes in the United States as ranked by number of homes manufactured based on information available from the Manufactured Housing Institute and IBTS for 2019. With current operations focused primarily in the southern United States, we offer our customers an array of quality homes ranging in size from approximately 390 to 2,667 square feet consisting of 1 to 5 bedrooms, with 1 to 31/2 bathrooms. Our homes range in price, at retail, from approximately $18,000 to $140,000. During 2019, we sold 3,904 home sections (which are entire homes or single floors that are combined to create complete homes) and in 2018, we sold 3,950 home sections. The Company has one reportable segment. All of our activities are interrelated, and each activity is dependent and assessed based on how each of the activities of Company supports the others. For example, the sale of manufactured homes includes providing transportation and consignment arrangements with dealers. We also provide financing options to the customers to facilitate such sale of homes. In addition, the sale of homes is directly related to financing provided by us. Accordingly, all significant operating and strategic decisions by the chief operating decisionmaker, the Executive Chairman of the Board, are based upon analyses of our company as one segment or unit. We believe our company is one of the most vertically integrated in the manufactured housing industry, allowing us to offer a complete solution to our customers, from manufacturing custommade homes using quality materials and distributing those homes through our expansive network of independent retailers and companyowned distribution locations, to providing tailored financing solutions for our customers. Our homes are constructed in the United States at one of our three manufacturing facilities in accordance with the construction and safety standards of the U.S. Department of Housing and Urban Development (“HUD”). Our factories employ highvolume production techniques that allow us to produce, on average, approximately 75 home sections, or 62 fullycompleted homes depending on product mix, in total per week. We use quality materials and operate our own component manufacturing facilities for many of the items used in the construction of our homes. Each home can be configured according to a variety of floor plans and equipped with such features as fireplaces, central air conditioning and stateoftheart kitchens. Our homes are marketed under our premier “Legacy” brand name and currently are sold primarily across 15 states through a network of 90 independent retail locations, 13 companyowned retail locations and through direct sales to owners of manufactured home communities. Our 13 companyowned retail locations, including 11 Heritage Housing stores and two Tiny House Outlet stores exclusively sell our homes. During 2019, approximately 48% of our manufactured homes were sold in Texas, followed by 8% in Georgia, 6% in Kansas, 5% in Oklahoma and 5% in Florida. During 2018, 56% of our manufactured homes were sold in Texas, followed by 13% in Georgia, 11% in Louisiana and 4% in Oklahoma. We plan to deepen our distribution channel by using a portion of the net proceeds from the IPO to expand our companyowned retail locations in new and existing markets. We offer three types of financing solutions to our customers. We provide floor plan financing for our independent retailers, which takes the form of a consignment arrangement between the retailer and us. We also provide consumer financing for our products which are sold to endusers through both independent and companyowned retail locations, and we provide financing solutions to manufactured housing community owners that buy our products for use in their manufactured housing communities. Our ability to offer competitive financing options at our retail locations provides us with several competitive advantages and allows us to capture sales which may not have otherwise occurred without our ability to offer consumer financing. Factors Affecting Our Performance We believe that the growth of our business and our future success depend on various opportunities, challenges, trends and other factors, including the following: · Consistent with our longterm strategy of conservatively deploying our capital to achieve [/INST] Negative. </s>

Collier Creek Holdings

2019-03-28

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. References to the “company,” “Collier Creek Holdings,” “our,” “us” or “we” refer to Collier Creek Holdings, except where the context requires otherwise. The following discussion and analysis of the company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Cautionary Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Annual Report including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Annual Report, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forward-looking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report should be read as being applicable to all forward-looking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors, including but not limited to, those detailed in our filings with the Securities and Exchange Commission. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on April 30, 2018 (inception) as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or geographic region for purposes of consummating a Business combination, we focus our search on the consumer goods industry and related sectors. The registration statement for our initial public offering was declared effective on October 4, 2018. On October 10, 2018, we consummated the initial public offering of 44,000,000 units, including the issuance of 4,000,000 units as a result of the underwriters’ partial exercise of their over-allotment option, at $10.00 per unit, generating gross proceeds of $440 million, and incurring offering costs of approximately $25.02 million, inclusive of $15.45 million in deferred legal fees and underwriting commissions. Each unit consists of one Class A ordinary share and one-third of one redeemable warrant. Each whole public shares entitles the holder to purchase one Class A ordinary share at an exercise price of $11.50 per share, subject to adjustment. Simultaneously with the closing of the initial public offering, we consummated the private placement of 7,200,000 warrants at a price of $1.50 per warrant to our sponsor, generating gross proceeds of $10.8 million. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. Upon the closing of the initial public offering and private placement, $440 million ($10.00 per unit) of the net proceeds of the initial public offering and the private placement were placed in a trust account and were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any open-ended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (c)(2), (c)(3) and (c)(4) of Rule 2a-7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a Business combination and (ii) the distribution of the trust account. Our management has broad discretion with respect to the specific application of the net proceeds of the initial public offering and the private placement, although substantially all of the net proceeds are intended to be applied toward identifying and consummating an initial Business combination. If we are unable to complete a Business combination within 24 months from the closing of the initial public offering, or October 10, 2020, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but no more than five business days thereafter, redeem 100% of the outstanding public shares which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any), subject to applicable law and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and our board of directors, proceed to commence a voluntary liquidation and thereby a formal dissolution of our company, subject in each case to its obligations to provide for claims of creditors and the requirements of applicable law. Results of Operations Our entire activity from April 30, 2018 (inception) through December 31, 2018, was in preparation for our initial public offering, and since, such offering, our activity has been limited to the search for a prospective initial business combination. We will not generate any operating revenues until the closing and completion of our initial business combination. For the period from April 30, 2018 (inception) through December 31, 2018, we had a net income of approximately $1.9 million, which consisted of approximately $2.0 million in investment income, offset by approximately $137,000 in general and administrative costs. Liquidity and Capital Resources As indicated in the accompanying financial statements, at December 31, 2018, we had approximately $945,000 in cash and working capital of approximately $1.1 million. Our liquidity needs prior to and for the initial public offering were satisfied through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the Founder Shares (as defined below), $155,000 in loans available from our sponsor under a promissory note (the “Note”) and the net proceeds from the consummation of the Private Placement. We fully repaid the Note on October 17, 2018, after the closing of the initial public offering. Related Party Transactions Founder Shares On May 2, 2018, we issued 2,875,000 Class B ordinary shares to our sponsor in exchange for a capital contribution of $25,000. On September 7, 2018, we effected a share capitalization resulting in the sponsor holding an aggregate of 10,937,500 founder shares. On September 10, 2018, the sponsor transferred 45,000, 45,000, 52,500 and 52,500 founder shares to each of Antonio F. Fernandez, Matthew M. Mannelly, William D. Toler and Craig D. Steeneck, respectively. On October 4, 2018, we effected a share capitalization resulting in an aggregate of 12,375,000 founder shares. On October 10, 2018, the underwriters partially exercised the over-allotment option, and an aggregate of 500,000 founder shares were subsequently surrendered to us by our sponsor for no consideration on October 19, 2018. Of the 11,875,000 shares outstanding as of December 31, 2018, our sponsor owned an aggregate of 11,680,000 Class B ordinary shares and the independent director owned an aggregate of 195,000 Class B ordinary shares. The founder shares will automatically convert into Class A ordinary shares upon the consummation of a Business combination, or earlier at the option of the holder, on a one-for-one basis. However, if additional Class A ordinary shares or any other equity-linked securities are issued or deemed issued in connection with the initial Business combination, the number of Class A ordinary shares issuable upon conversion of all founder shares will equal, in the aggregate, 20% of the total number of Class A ordinary shares outstanding after such conversion (after giving effect to any redemptions of Class A ordinary shares by public shareholders), including the total number of Class A ordinary shares issued or deemed issued, or issuable upon conversion or exercise of any equity-linked securities or rights issued or deemed issued, by us in connection with or in relation to the consummation of the initial business combination (including the forward purchase shares, but not the forward purchase warrants (both as defined below)), excluding any Class A ordinary shares or equity-linked securities exercisable for or convertible into Class A ordinary shares issued, or to be issued, to any seller in the initial business combination and any private placement warrants issued to the sponsor upon conversion of working capital loans, provided that such conversion of founder shares will never occur on a less than one-for-one basis. The holders of the founder shares agreed not to transfer, assign or sell any of their founder shares until the earlier to occur of: (i) one year after the completion of the initial business combination or (ii) the date on which we complete a liquidation, merger, share exchange or other similar transaction after the initial business combination that results in all of our shareholders having the right to exchange their Class A ordinary shares for cash, securities or other property (except to certain permitted transferees). Any permitted transferees will be subject to the same restrictions and other agreements of the Initial Shareholders with respect to any founder shares. Notwithstanding the foregoing, if the closing price of the Class A ordinary shares equals or exceeds $12.00 per share (as adjusted for share splits, share capitalizations, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the initial business combination, the founder shares will be released from the lock-up. Private Placement Simultaneously with the closing of the initial public offering, we consummated the private placement of 7,200,000 private placement warrants at a price of $1.50 per warrant to our sponsor, generating gross proceeds of $10.8 million. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. A portion of the proceeds from the sale of the private placement warrants were added to the proceeds from the initial public offering to be held in the trust account. If we do not complete a business combination within 24 months from the closing of the initial public offering, the private placement warrants will expire worthless. The private placement warrants are non-redeemable and exercisable on a cashless basis so long as they are held by the sponsor or its permitted transferees. Related Party Loans Under the Note, our sponsor loaned us $155,000 to be used for the payment of costs related to the initial public offering. The Note was non-interest bearing, unsecured and was due upon the closing of the initial public offering. We fully repaid the Note on October 17, 2018. In addition, in order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, loan us funds as may be required (the “Working Capital Loans”). If we complete a business combination, we would repay the Working Capital Loans out of the proceeds of the trust account released to us. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the Working Capital Loans but no proceeds held in the trust account would be used to repay the Working Capital Loans. Up to $1.5 million of such Working Capital Loans may be convertible into warrants of the post-business combination entity at a price of $1.50 per warrant at the option of the lender. The warrants would be identical to the private placement warrants. Except as set forth above, the terms of the Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. Administrative Service Fee We agreed, commencing on the effective date of the initial public offering through the earlier of our consummation of a business combination or our liquidation, to pay an affiliate of our sponsor a monthly fee of $10,000 for office space and secretarial and administrative services. We recorded an aggregate of approximately $27,000 in general and administrative expenses in connection with this administrative services agreement in the accompanying statement of operations during the period from April 30, 2018 (inception) through December 31, 2018. Forward Purchase Agreements On September 7, 2018, we entered into forward purchase agreements with the sponsor and our independent directors which provide for the purchase of an aggregate of 3,500,000 forward purchase shares, plus an aggregate of 1,166,666 redeemable forward purchase warrants to purchase one Class A ordinary share at $11.50 per share, for an aggregate purchase price of  $35,000,000, or $10.00 per Class A ordinary share, in a private placement to close concurrently with the closing of the initial business combination. The forward purchase warrants will have the same terms as the public warrants. These purchases will be made regardless of whether any Class A ordinary shares are redeemed by public shareholders. The forward purchase shares and forward purchase warrants will be issued only in connection with the closing of the initial business combination. The proceeds from the sale of forward purchase securities may be used as part of the consideration to the sellers in the initial business combination, expenses in connection with the initial business combination or for working capital in the post-transaction company. Contractual Obligations Registration Rights The holders of the founder shares, private placement warrants and warrants that may be issued upon conversion of working capital loans (and any Class A ordinary shares issuable upon the exercise of the private placement warrants and warrants that may be issued upon conversion of working capital loans) are entitled to registration rights pursuant to a registration rights agreement entered into on the effective date of the initial public offering. The holders of these securities are entitled to make up to three demands, excluding short form demands, that we register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the consummation of a business combination. We will bear the expenses incurred in connection with the filing of any such registration statements. Pursuant to the forward purchase agreements, we agreed to use our commercially reasonable best efforts (i) to file within 30 days after the closing of a business combination a registration statement with the SEC for a secondary offering of the forward purchase shares and the forward purchase warrants (and underlying Class A ordinary shares), (ii) to cause such registration statement to be declared effective promptly thereafter and (iii) to maintain the effectiveness of such registration statement until the earliest of  (A) the date on which the sponsor and all of the independent directors or their respective assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the forward purchase agreements provide these holders will have certain “piggy-back” registration rights to include their securities in other registration statements filed by us. Underwriting Agreement We granted the underwriters a 45-day option from the date of the prospectus relating to the initial public offering to purchase up to 6,000,000 additional units to cover over-allotments, if any, at the initial public offering price less the underwriting discounts and commissions. On October 10, 2018, the underwriters partially exercised this option in respect of 4,000,000 units, and, as agreed with the company, the underwriters waived their right to further exercise the over-allotment option. The underwriters were entitled to underwriting discounts of $0.20 per unit, or $8.8 million in the aggregate, paid upon the closing of the initial public offering. In addition, the underwriters were entitled to a deferred underwriting commission of $0.35 per unit, or $15.4 million in the aggregate. The deferred underwriting fee will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete a Business combination, subject to the terms of the underwriting agreement. Deferred Legal Fees We are obligated to pay deferred legal fees of $50,000 upon the consummation of an initial business combination for services performed in connection with the initial public offering. If no business combination is consummated, we will not be obligated to pay such fees. Critical Accounting Policies and Estimates This management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to fair value of financial instruments and accrued expenses. We base our estimates on historical experience, known trends and events and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe there have been no significant changes in our critical accounting policies as discussed in our final prospectus relating to our initial public offering and our Current Report on Form 8-K filed with the SEC on February 14, 2018 and February 22, 2018, respectively. Off-Balance Sheet Arrangements As of December 31, 2018, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We will qualify as an “emerging growth company” and under the JOBS Act will be allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As such, our financial statements may not be comparable to companies that comply with public company effective dates. Recent Accounting Pronouncements In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, Disclosure Update and Simplification, amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of shareholders' equity for interim financial statements. Under the amendments, an analysis of changes in each caption of shareholders' equity presented in the balance sheet must be provided in a note or separate statement. The analysis should present a reconciliation of the beginning balance to the ending balance of each period for which a statement of comprehensive income is required to be filed. We anticipate our first presentation of changes in shareholders' equity will be included in our Form 10-Q for the quarter ended March 31, 2019. Management does not believe that any other recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements All statements other than statements of historical fact included in this Annual Report including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Annual Report, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forwardlooking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report should be read as being applicable to all forwardlooking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forwardlooking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors, including but not limited to, those detailed in our filings with the Securities and Exchange Commission. All subsequent written or oral forwardlooking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on April 30, 2018 (inception) as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or geographic region for purposes of consummating a Business combination, we focus our search on the consumer goods industry and related sectors. The registration statement for our initial public offering was declared effective on October 4, 2018. On October 10, 2018, we consummated the initial public offering of 44,000,000 units, including the issuance of 4,000,000 units as a result of the underwriters’ partial exercise of their overallotment option, at $10.00 per unit, generating gross proceeds of $440 million, and incurring offering costs of approximately $25.02 million, inclusive of $15.45 million in deferred legal fees and underwriting commissions. Each unit consists of one Class A ordinary share and onethird of one redeemable warrant. Each whole public shares entitles the holder to purchase one Class A ordinary share at an exercise price of $11.50 per share, subject to adjustment. Simultaneously with the closing of the initial public offering, we consummated the private placement of 7,200,000 warrants at a price of $1.50 per warrant to our sponsor, generating gross proceeds of $10.8 million. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. Upon the closing of the initial public offering and private placement, $440 million ($10.00 per unit) of the net proceeds of the initial public offering and the private placement were placed in a trust account and were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any openended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (c)(2), (c)(3) and (c)(4) of Rule 2a7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a Business combination and (ii) the distribution of the trust account. Our management has broad discretion with respect to the specific application of the net proceeds of the initial public offering and the private placement, although substantially all of the net proceeds are intended to be applied toward identifying and consummating an initial Business combination. If we [/INST] Negative. </s>

Collier Creek Holdings

2020-03-12

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. References to the “company,” “Collier Creek Holdings,” “our,” “us” or “we” refer to Collier Creek Holdings, except where the context requires otherwise. The following discussion and analysis of the company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties. Cautionary Note Regarding Forward-Looking Statements All statements other than statements of historical fact included in this Annual Report including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Annual Report, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forward-looking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report should be read as being applicable to all forward-looking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forward-looking statements as a result of certain factors, including but not limited to, those detailed in our filings with the SEC. All subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on April 30, 2018 (inception) as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or geographic region for purposes of consummating a business combination, we focus our search on the consumer goods industry and related sectors. The registration statement for our initial public offering was declared effective on October 4, 2018. On October 10, 2018, we consummated the initial public offering of 44,000,000 units, including the issuance of 4,000,000 units as a result of the underwriters’ partial exercise of their over-allotment option, at $10.00 per unit, generating gross proceeds of $440 million, and incurring offering costs of approximately $25.02 million, inclusive of $15.45 million in deferred legal fees and underwriting commissions. Each Unit consists of one Class A ordinary share and one-third of one redeemable warrant. Each whole public warrant entitles the holder to purchase one Class A ordinary share at an exercise price of $11.50 per share, subject to adjustment. Simultaneously with the closing of the initial public offering, we consummated the private placement of 7,200,000 private placement warrants at a price of $1.50 per warrant to our sponsor, generating gross proceeds of $10.8 million. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. Upon the closing of the initial public offering and private placement, $440 million ($10.00 per unit) of the net proceeds of the initial public offering and the private placement were placed in the trust account and were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any open-ended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (c)(2), (c)(3) and (c)(4) of Rule 2a-7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a business combination and (ii) the distribution of funds in the trust account. Our management has broad discretion with respect to the specific application of the net proceeds of the initial public offering and the private placement, although substantially all of the net proceeds are intended to be applied toward identifying and consummating an initial business combination. If we are unable to complete a business combination within 24 months from the closing of the initial public offering, or October 10, 2020, we will (i) cease all operations except for the purpose of winding up, (ii) as promptly as reasonably possible but no more than five business days thereafter, redeem 100% of the outstanding public shares which redemption will completely extinguish public shareholders’ rights as shareholders (including the right to receive further liquidation distributions, if any), subject to applicable law and (iii) as promptly as reasonably possible following such redemption, subject to the approval of the remaining shareholders and our board of directors, proceed to commence a voluntary liquidation and thereby a formal dissolution of our company, subject in each case to its obligations to provide for claims of creditors and the requirements of applicable law. Results of Operations Our entire activity from April 30, 2018 (inception) through December 31, 2019, was in preparation for our initial public offering, and since such offering, our activity has been limited to the search for a prospective initial business combination. We will not generate any operating revenues until the closing and completion of our initial business combination. For the year ended December 31, 2019, we had net income of approximately $8.0 million, which consisted of approximately $9.0 million in investment income from the trust account, offset by approximately $998,000 in general and administrative expenses. For the period from April 30, 2018 (inception) through December 31, 2018, we had a net income of approximately $1.9 million, which consisted of approximately $2.0 million in investment income, offset by approximately $137,000 in general and administrative expenses. Going Concern Consideration The accompanying consolidated financial statements have been prepared assuming we will continue as a going concern, which contemplates, among other things, the realization of assets and satisfaction of liabilities in the normal course of business. As of December 31, 2019, we had approximately $585,000 in cash and working capital of approximately $119,000. In addition, in order to finance transaction costs in connection with a business combination, our sponsor or an affiliate of our sponsor, or certain of our officers and directors may, but are not obligated to, make Working Capital Loans to us. As of December 31, 2019, there were no amounts outstanding under any Working Capital Loan. Our liquidity needs prior to the initial public offering were satisfied through receipt of a $25,000 capital contribution from our sponsor in exchange for the issuance of the Founder Shares and $155,000 in loans available from our sponsor under a promissory note (the “Note”). We fully repaid the Note on October 17, 2018, after the closing of the initial public offering. Our liquidity needs for and following the initial public offering have been satisfied by the portion of the net proceeds from the private placement held outside the trust account. In connection with our assessment of going concern considerations in accordance with the Financial Accounting Standard Board’s (“FASB”) Accounting Standards Update 2014-15, “Disclosures of Uncertainties about an Entity’s Ability to Continue as a Going Concern,” management has determined that our liquidity position, the mandatory liquidation and subsequent dissolution raises substantial doubt about our ability to continue as a going concern. No adjustments have been made to the carrying amounts of assets or liabilities should we be required to liquidate and dissolve after October 10, 2020. Related Party Transactions Related Party Loans In order to finance transaction costs in connection with a business combination, the sponsor or an affiliate of the sponsor, or certain of our officers and directors may, but are not obligated to, make Working Capital Loans to us. If we complete a business combination, we would repay the Working Capital Loans out of the proceeds of the trust account released to us. In the event that a business combination does not close, we may use a portion of proceeds held outside the trust account to repay the Working Capital Loans but no proceeds held in the trust account would be used to repay the Working Capital Loans. Up to $1.5 million of such Working Capital Loans may be convertible into warrants of the post-business combination entity at a price of $1.50 per warrant at the option of the lender. The warrants would be identical to the private placement warrants. Except as set forth above, the terms of the Working Capital Loans, if any, have not been determined and no written agreements exist with respect to such loans. Administrative Service Fee We agreed, commencing on the effective date of the initial public offering through the earlier of our consummation of a business combination or our liquidation, to pay an affiliate of our sponsor a monthly fee of $10,000 for office space and secretarial and administrative services. We recorded an aggregate of $120,000 and $27,000 in general and administrative expenses in connection with this administrative services agreement in the accompanying statements of operations during the year ended December 31, 2019 and for the period from April 30, 2018 (inception) through December 31, 2018, respectively. As of December 31, 2019 and 2018, we have accrued approximately $147,000 and $27,000, respectively, for services in connection with such agreement on the accompanying balance sheets. Forward Purchase Agreements On September 7, 2018, we entered into forward purchase agreements with the sponsor and our independent directors which provide for the purchase of an aggregate of 3,500,000 forward purchase shares, plus an aggregate of 1,166,666 redeemable forward purchase warrants to purchase one Class A ordinary share at $11.50 per share, for an aggregate purchase price of  $35,000,000, or $10.00 per Class A ordinary share, in a private placement to close concurrently with the closing of the initial business combination. The forward purchase warrants will have the same terms as the public warrants. These purchases will be made regardless of whether any Class A ordinary shares are redeemed by public shareholders. The forward purchase shares and forward purchase warrants will be issued only in connection with the closing of the initial business combination. The proceeds from the sale of forward purchase securities may be used to fund part of the consideration to the sellers in the initial business combination, expenses in connection with the initial business combination or for working capital in the post-transaction company. Other Contractual Obligations Registration Rights The holders of the founder shares, private placement warrants and warrants that may be issued upon conversion of Working Capital Loans (and any Class A ordinary shares issuable upon the exercise of the private placement warrants and warrants that may be issued upon conversion of Working Capital Loans) are entitled to registration rights pursuant to a registration rights agreement entered into on the effective date of the initial public offering. The holders of these securities are entitled to make up to three demands, excluding short form demands, that we register such securities. In addition, the holders have certain “piggy-back” registration rights with respect to registration statements filed subsequent to the consummation of a business combination. We will bear the expenses incurred in connection with the filing of any such registration statements. Pursuant to the forward purchase agreements, we agreed to use our commercially reasonable best efforts (i) to file within 30 days after the closing of a business combination a registration statement with the SEC for a secondary offering of the forward purchase shares and the forward purchase warrants (and underlying Class A ordinary shares), (ii) to cause such registration statement to be declared effective promptly thereafter and (iii) to maintain the effectiveness of such registration statement until the earliest of  (A) the date on which the sponsor and all of the independent directors or their respective assignees cease to hold the securities covered thereby and (B) the date all of the securities covered thereby can be sold publicly without restriction or limitation under Rule 144 under the Securities Act. In addition, the forward purchase agreements provide these holders will have certain “piggy-back” registration rights to include their securities in other registration statements filed by us. Deferred Underwriting Fees Pursuant to our initial public offering, the underwriters were entitled to underwriting discounts of $0.20 per unit, or $8.8 million in the aggregate, paid upon the closing of the initial public offering. In addition, the underwriters were entitled to a deferred underwriting commission of $0.35 per unit, or $15.4 million in the aggregate. The deferred underwriting fee will become payable to the underwriters from the amounts held in the trust account solely in the event that we complete a business combination, subject to the terms of the underwriting agreement. Deferred Legal Fees We are obligated to pay deferred legal fees of $50,000 upon the consummation of an initial business combination for services performed in connection with the initial public offering. If no business combination is consummated, we will not be obligated to pay such fees. Critical Accounting Policies and Estimates This management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate our estimates and judgments, including those related to fair value of financial instruments and accrued expenses. We base our estimates on historical experience, known trends and events and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe there have been no significant changes in our critical accounting policies as discussed in our Annual Report on Form 10-K filed by us with the SEC on March 28, 2019. Off-Balance Sheet Arrangements As of December 31, 2019, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K and did not have any commitments or contractual obligations. JOBS Act On April 5, 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, relax certain reporting requirements for qualifying public companies. We will qualify as an “emerging growth company” and under the JOBS Act will be allowed to comply with new or revised accounting pronouncements based on the effective date for private (not publicly traded) companies. We are electing to delay the adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As such, our financial statements may not be comparable to companies that comply with public company effective dates. Recent Accounting Pronouncements Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on the Company’s financial statements.

<s>[INST] Cautionary Note Regarding ForwardLooking Statements All statements other than statements of historical fact included in this Annual Report including, without limitation, statements under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” regarding our financial position, business strategy and the plans and objectives of management for future operations, are forward looking statements. When used in this Annual Report, words such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions, as they relate to us or our management, identify forward looking statements. Such forward looking statements are based on the beliefs of management, as well as assumptions made by, and information currently available to, our management. No assurance can be given that results in any forwardlooking statement will be achieved and actual results could be affected by one or more factors, which could cause them to differ materially. The cautionary statements made in this Annual Report should be read as being applicable to all forwardlooking statements whenever they appear in this Annual Report. For these statements, we claim the protection of the safe harbor for forwardlooking statements contained in the Private Securities Litigation Reform Act. Actual results could differ materially from those contemplated by the forwardlooking statements as a result of certain factors, including but not limited to, those detailed in our filings with the SEC. All subsequent written or oral forwardlooking statements attributable to us or persons acting on our behalf are qualified in their entirety by this paragraph. Overview We are a blank check company incorporated on April 30, 2018 (inception) as a Cayman Islands exempted company for the purpose of effecting a merger, share exchange, asset acquisition, share purchase, reorganization or similar business combination with one or more businesses. Although we are not limited to a particular industry or geographic region for purposes of consummating a business combination, we focus our search on the consumer goods industry and related sectors. The registration statement for our initial public offering was declared effective on October 4, 2018. On October 10, 2018, we consummated the initial public offering of 44,000,000 units, including the issuance of 4,000,000 units as a result of the underwriters’ partial exercise of their overallotment option, at $10.00 per unit, generating gross proceeds of $440 million, and incurring offering costs of approximately $25.02 million, inclusive of $15.45 million in deferred legal fees and underwriting commissions. Each Unit consists of one Class A ordinary share and onethird of one redeemable warrant. Each whole public warrant entitles the holder to purchase one Class A ordinary share at an exercise price of $11.50 per share, subject to adjustment. Simultaneously with the closing of the initial public offering, we consummated the private placement of 7,200,000 private placement warrants at a price of $1.50 per warrant to our sponsor, generating gross proceeds of $10.8 million. Each private placement warrant is exercisable for one Class A ordinary share at a price of $11.50 per share. Upon the closing of the initial public offering and private placement, $440 million ($10.00 per unit) of the net proceeds of the initial public offering and the private placement were placed in the trust account and were invested in U.S. government securities, within the meaning set forth in Section 2(a)(16) of the Investment Company Act, with a maturity of 180 days or less or in any openended investment company that holds itself out as a money market fund selected by us meeting the conditions of paragraphs (c)(2), (c)(3) and (c)(4) of Rule 2a7 of the Investment Company Act, as determined by us, until the earlier of: (i) the completion of a business combination and (ii) the distribution of funds in the trust account. Our management has broad discretion with respect to the specific application of the net proceeds of the initial public offering and the private placement, although substantially all of the net proceeds are intended to be applied toward identifying and consummating an initial business combination. [/INST] Negative. </s>

Wealthbridge Acquisition Ltd

2019-04-01

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Certain information contained in the discussion and analysis set forth below includes forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. Overview We are a blank check company incorporated in the British Virgin Islands on May 2, 2018 and formed for the purpose of entering into a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar business combination with one or more businesses or entities. We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Units, our capital stock, debt or a combination of cash, stock and debt. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our Initial Public Offering, which was consummated on February 8, 2019. Results of Operations Our only activities from May 2, 2018 (inception) to December 31, 2018 were organizational activities and those necessary to consummate the Initial Public Offering, described below. Following the Initial Public Offering, we do not expect to generate any operating revenues until after the completion of our business combination. We expect to generate non-operating income in the form of interest income on cash and marketable securities held after the Initial Public Offering. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the period from May 2, 2018 (inception) through December 31, 2018, we had a net loss of $60,837, which consists of operating and formation costs. Liquidity and Capital Resources As of December 31, 2018, we had cash of $52,937. Until the consummation of the Initial Public Offering, our liquidity needs were satisfied through the receipt of $25,100 from our sale of the insider shares, advances and unsecured loans from our initial shareholders and their affiliates. On February 8, 2019, we consummated the Initial Public Offering of 5,000,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $50,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 247,500 Private Units to our Sponsor, generating gross proceeds of $2,475,000. On February 20, 2019, in connection with the underwriters’ exercise of their over-allotment option in full, we consummated the sale of an additional 750,000 Units at a price of $10.00 per Unit, generating total gross proceeds of $7,500,000. In addition, we also consummated the sale of an additional 22,500 Private Units at $10.00 per Private Unit, generating total gross proceeds of $225,000. Following the Initial Public Offering, the exercise of the over-allotment option and the sale of the Private Units, a total of $57,500,000 was placed in the trust account and, following the payment of certain transaction expenses, we had $661,112 of cash held outside of the trust account and available for working capital purposes. We incurred $4,415,225 in Initial Public Offering related costs, including $1,725,000 of underwriting fees, $2,012,500 of deferred underwriting fees and $677,725 of other costs. We intend to use substantially all of the funds held in the trust account to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our share capital is used in whole or in part as consideration to effect our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our initial business combination if the funds available to us outside of the trust account were insufficient to cover such expenses. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a business combination. In order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, our Sponsor or an affiliate of our Sponsor, or our officers and directors may, but are not obligated to, loan us funds as may be required. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Such loans would be evidenced by promissory notes. Up to $500,000 of notes may be convertible into Private Units, at a price of $10.00 per Unit. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business prior to our initial business combination. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. Moreover, we may need to obtain additional financing either to complete our business combination or because we become obligated to redeem a significant number of our public shares upon completion of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. Off-balance sheet financing arrangements We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of December 31, 2018. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities other than an agreement to pay our Sponsor a monthly fee of $10,000 for general and administrative services, including office space, utilities and administrative services to the Company. We began incurring these fees on February 5, 2019 and will continue to incur these fees monthly until the earlier of the completion of the business combination and the Company’s liquidation. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have not identified any critical accounting policies. Recent accounting pronouncements Management does not believe that any recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements.

<s>[INST] Overview We are a blank check company incorporated in the British Virgin Islands on May 2, 2018 and formed for the purpose of entering into a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar business combination with one or more businesses or entities. We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Units, our capital stock, debt or a combination of cash, stock and debt. We have neither engaged in any operations nor generated any revenues to date. Our entire activity since inception has been to prepare for our Initial Public Offering, which was consummated on February 8, 2019. Results of Operations Our only activities from May 2, 2018 (inception) to December 31, 2018 were organizational activities and those necessary to consummate the Initial Public Offering, described below. Following the Initial Public Offering, we do not expect to generate any operating revenues until after the completion of our business combination. We expect to generate nonoperating income in the form of interest income on cash and marketable securities held after the Initial Public Offering. We expect to incur increased expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the period from May 2, 2018 (inception) through December 31, 2018, we had a net loss of $60,837, which consists of operating and formation costs. Liquidity and Capital Resources As of December 31, 2018, we had cash of $52,937. Until the consummation of the Initial Public Offering, our liquidity needs were satisfied through the receipt of $25,100 from our sale of the insider shares, advances and unsecured loans from our initial shareholders and their affiliates. On February 8, 2019, we consummated the Initial Public Offering of 5,000,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $50,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 247,500 Private Units to our Sponsor, generating gross proceeds of $2,475,000. On February 20, 2019, in connection with the underwriters’ exercise of their overallotment option in full, we consummated the sale of an additional 750,000 Units at a price of $10.00 per Unit, generating total gross proceeds of $7,500,000. In addition, we also consummated the sale of an additional 22,500 Private Units at $10.00 per Private Unit, generating total gross proceeds of $225,000. Following the Initial Public Offering, the exercise of the overallotment option and the sale of the Private Units, a total of $57,500,000 was placed in the trust account and, following the payment of certain transaction expenses, we had $661,112 of cash held outside of the trust account and available for working capital purposes. We incurred $4,415,225 in Initial Public Offering related costs, including $1,725,000 of underwriting fees, $2,012,500 of deferred underwriting fees and $677,725 of other costs. We intend to use substantially all of the funds held in the trust account to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our share capital is used in whole or in part as consideration to effect our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating [/INST] Negative. </s>

Wealthbridge Acquisition Ltd

2020-03-20

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with our audited financial statements and the notes related thereto which are included in “Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Certain information contained in the discussion and analysis set forth below includes forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “Special Note Regarding Forward-Looking Statements,” “Item 1A. Risk Factors” and elsewhere in this Annual Report on Form 10-K. Overview We are a blank check company incorporated in the British Virgin Islands on May 2, 2018 and formed for the purpose of entering into a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar business combination with one or more businesses or entities. We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Units, our capital stock, debt or a combination of cash, stock and debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful. Proposed Business Combination On October 28, 2019, we entered into a share exchange agreement (as may be amended or supplemented from time to time, the “Share Exchange Agreement”) with Scienjoy, Lavacano Holdings Limited (“Lavacano”), WBY Entertainment Holdings Ltd. (“WBY,” together with Lavacano, the “Sellers”, and each “Seller”). Upon the closing of the transactions contemplated in the Share Exchange Agreement, we will acquire 100% of the issued and outstanding securities of Scienjoy, in exchange for approximately 16.4 million ordinary shares, of which 1.64 million ordinary shares are to be issued and held in escrow to satisfy any indemnification obligations of the Sellers. Additionally, the Sellers may be entitled to receive earnout shares as follows: (1) if Scienjoy’s net income before tax for the year ended December 31, 2019 is greater than or equal to either US$20,900,000 or RMB 140,000,000, the Sellers will be entitled to receive 3,000,000 ordinary shares; (2) if Scienjoy’s net income before tax for the year ended December 31, 2020 is greater than or equal to either US$28,300,000 or RMB 190,000,000, the Sellers will be entitled to receive 3,000,000 ordinary shares; and (3) if Scienjoy’s net income before tax for the year ended December 31, 2021 is greater than or equal to either US$35,000,000 or RMB 235,000,000, the Sellers will be entitled to receive 3,000,000 ordinary shares. Notwithstanding the net income before tax achieved by the post-transaction company for any period, the Sellers will receive (i) 3,000,000 earnout shares if the share price of the Company is higher than $15.00 for any sixty days in any period of ninety consecutive trading days during an twelve month period following the closing; (ii) 3,000,000 earnout shares if the share price of the Company is higher than $20.00 for any sixty days in any period of ninety consecutive trading days between the 13th month and 24th month following the Closing, and (iii) 3,000,000 earnout shares if the share price of the Company is higher than $25.00 for any sixty days in any period of ninety consecutive trading between the 25th month and 36th month following the Closing. On January 28, 2020, we issued a $575,000 Note to Scienjoy, pursuant to which such amount was deposited into our Trust Account in order to extend the amount of time we have available to complete a Business Combination from February 8, 2020 to May 8, 2020. The Note is non-interest bearing and is payable upon the closing of a Business Combination. In addition, the Note may be converted, at the lender’s discretion, into additional Private Units at a price of $10.00 per unit. The outbreak of the COVID-19 coronavirus has resulted in a widespread health crisis that has adversely affected the economies and financial markets worldwide. The extent to which COVID-19 impacts the Acquisition will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of COVID-19 and the actions to contain COVID-19 or treat its impact, among others. We may be unable to complete the Acquisition or another business combination if continued concerns relating to COVID-19 restrict travel and limit the ability to have meetings with potential investors, or if the target company’s personnel, vendors and services providers are unavailable to negotiate and consummate a transaction in a timely manner. Anticipated Accounting Treatment The Business Combination will be accounted for as a reverse merger in accordance with U.S. GAAP. Under this method of accounting, we will be treated as the “acquired” company for financial reporting purposes. This determination was primarily based on the holders of Scienjoy expecting to have a majority of the voting power of the post-combination company, Scienjoy senior management comprising substantially all of the senior management of the post-combination company, the relative size of Scienjoy compared to us, and Scienjoy operations comprising the ongoing operations of the post-combination company. Accordingly, for accounting purposes, the Business Combination will be treated as the equivalent of Scienjoy issuing stock for our net assets, accompanied by a recapitalization. Our net assets will be stated at historical cost, with no goodwill or other intangible assets recorded. Operations prior to the Business Combination will be those of Scienjoy. Results of Operations We have neither engaged in any operations nor generated any revenues to date. Our only activities from inception to December 31, 2019 were organizational activities and those necessary to prepare for the Initial Public Offering, described below, and, after our Initial Public Offering, identifying a target company for a Business Combination and activities in connection with the potential acquisition of Scienjoy. We do not expect to generate any operating revenues until after the completion of our Business Combination. We generate non-operating income in the form of interest income on marketable securities held in the Trust Account. We are incurring expenses as a result of being a public company (for legal, financial reporting, accounting and auditing compliance), as well as for due diligence expenses. For the year ended December 31, 2019, we had net income of $151,393, which consisted of interest earned on marketable securities held in the Trust Account of $1,085,110 and an unrealized gain on marketable securities held in the Trust Account of $3,028, offset by operating costs of $936,745. For the period from May 2, 2018 (inception) through December 31, 2018, we had a net loss of $60,837, which consisted of operating and formation costs. Liquidity and Capital Resources On February 8, 2019, we consummated the Initial Public Offering of 5,000,000 Units, at a price of $10.00 per Unit, generating gross proceeds of $50,000,000. Simultaneously with the closing of the Initial Public Offering, we consummated the sale of 247,500 Private Units to our Sponsor, generating gross proceeds of $2,475,000. On February 20, 2019, in connection with the underwriters’ exercise of their over-allotment option in full, we consummated the sale of an additional 750,000 Units at a price of $10.00 per Unit, generating total gross proceeds of $7,500,000. In addition, we also consummated the sale of an additional 22,500 Private Units at $10.00 per Private Unit, generating total gross proceeds of $225,000. Following the Initial Public Offering, the exercise of the over-allotment option and the sale of the Private Units, a total of $57,500,000 was placed in the Trust Account. We incurred $4,415,225 in Initial Public Offering related costs, including $1,725,000 of underwriting fees, $2,012,500 of deferred underwriting fees and $677,725 of other costs. For the year ended December 31, 2019, cash used in operating activities was $715,669. Net income of $151,393 was offset by interest earned on marketable securities held in the Trust Account of $1,085,110 and an unrealized gain on marketable securities held in the Trust Account of $3,028. Changes in operating assets and liabilities provided $221,076 of cash for operating activities. For the period ended December 31, 2018, cash used in operating activities was $60,837, which was comprised of the net loss for the period. At December 31, 2019, we had marketable securities held in the Trust Account of $58,588,138 (including approximately $1,088,000 of interest income and unrealized gains). We intend to use substantially all of the funds held in the trust account to acquire a target business or businesses and to pay our expenses relating thereto. To the extent that our share capital is used in whole or in part as consideration to effect our initial business combination, the remaining proceeds held in the trust account will be used as working capital to finance the operations of the target business. Such working capital funds could be used in a variety of ways including continuing or expanding the target business’ operations, for strategic acquisitions and for marketing, research and development of existing or new products. Such funds could also be used to repay any operating expenses or finders’ fees which we had incurred prior to the completion of our initial business combination if the funds available to us outside of the trust account were insufficient to cover such expenses. At December 31, 2019, we had cash of $11,610 held outside the Trust Account. We intend to use the funds held outside the Trust Account primarily to identify and evaluate target businesses, perform business due diligence on prospective target businesses, travel to and from the offices, plants or similar locations of prospective target businesses or their representatives or owners, review corporate documents and material agreements of prospective target businesses, and structure, negotiate and complete a business combination. In order to fund working capital deficiencies or finance transaction costs in connection with an initial business combination, our Sponsor or an affiliate of our Sponsor, or our officers and directors may, but are not obligated to loan us funds. If we complete our initial business combination, we would repay such loaned amounts. In the event that our initial business combination does not close, we may use a portion of the working capital held outside the trust account to repay such loaned amounts but no proceeds from our trust account would be used for such repayment. Such loans would be evidenced by promissory notes. Up to $500,000 of notes may be convertible into Private Units, at a price of $10.00 per Unit. We do not believe we will need to raise additional funds in order to meet the expenditures required for operating our business prior to our initial business combination. However, if our estimates of the costs of identifying a target business, undertaking in-depth due diligence and negotiating an initial business combination are less than the actual amount necessary to do so, we may have insufficient funds available to operate our business prior to our business combination. Moreover, we may need to obtain additional financing either to complete our business combination or because we become obligated to redeem a significant number of our public shares upon completion of our business combination, in which case we may issue additional securities or incur debt in connection with such business combination. If we are unable to complete our initial business combination because we do not have sufficient funds available to us, we will be forced to cease operations and liquidate the trust account. We have a promissory note with Kenn Nice Communications Limited, pursuant to which we can borrow up to an aggregate amount of $800,000. The promissory note is non-interest bearing, unsecured and due upon the consummation of a business combination. As of December 31, 2019, there was $465,641 outstanding under the promissory note. Off-balance sheet financing arrangements We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements as of December 31, 2019. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements. We have not entered into any off-balance sheet financing arrangements, established any special purpose entities, guaranteed any debt or commitments of other entities, or purchased any non-financial assets. Contractual obligations We do not have any long-term debt, capital lease obligations, operating lease obligations or long-term liabilities other than an agreement to pay our Sponsor a monthly fee of $10,000 for general and administrative services, including office space, utilities and administrative services to the Company. We began incurring these fees on February 5, 2019 and will continue to incur these fees monthly until the earlier of the completion of the business combination and the Company’s liquidation. The underwriters are entitled to a deferred fee of 3.50% of the gross proceeds of the Initial Public Offering, or $2,012,500. The deferred fee will be paid in cash upon the closing of a Business Combination from the amounts held in the Trust Account, subject to the terms of the underwriting agreement. In addition, we entered into an agreement with Chardan to provide financial advisory services to us in connection with the identification of and negotiation with potential targets, assistance with due diligence, marketing, financial analyses and investor relations. In the event a Business Combination is consummated, we shall pay Chardan an aggregate fee based on the Aggregate Value (as defined in the agreement) of the Business Combination immediately following the closing of the Business Combination in the form of newly issued shares. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and income and expenses during the periods reported. Actual results could materially differ from those estimates. We have not identified any critical accounting policies. Ordinary shares subject to redemption We account for our ordinary shares subject to possible conversion in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Ordinary shares subject to mandatory redemption are classified as a liability instrument and are measured at fair value. Conditionally redeemable ordinary shares (including ordinary shares that feature redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within our control) are classified as temporary equity. At all other times, ordinary shares are classified as shareholders’ equity. Our ordinary shares feature certain redemption rights that are considered to be outside of our control and subject to occurrence of uncertain future events. Accordingly, ordinary shares subject to possible redemption are presented at redemption value as temporary equity, outside of the shareholders’ equity section of our balance sheets. Net loss per ordinary share We apply the two-class method in calculating earnings per share. Ordinary shares subject to possible redemption which are not currently redeemable and are not redeemable at fair value, have been excluded from the calculation of basic net loss per ordinary share since such shares, if redeemed, only participate in their pro rata share of the Trust Account earnings. Our net income is adjusted for the portion of income that is attributable to ordinary shares subject to redemption, as these shares only participate in the earnings of the Trust Account and not our income or losses. Recent accounting pronouncements Management does not believe that any other recently issued, but not yet effective, accounting pronouncements, if currently adopted, would have a material effect on our financial statements.

<s>[INST] Overview We are a blank check company incorporated in the British Virgin Islands on May 2, 2018 and formed for the purpose of entering into a merger, share exchange, asset acquisition, share purchase, recapitalization, reorganization or similar business combination with one or more businesses or entities. We intend to effectuate our initial business combination using cash from the proceeds of the Initial Public Offering and the sale of the Private Units, our capital stock, debt or a combination of cash, stock and debt. We expect to continue to incur significant costs in the pursuit of our acquisition plans. We cannot assure you that our plans to complete a Business Combination will be successful. Proposed Business Combination On October 28, 2019, we entered into a share exchange agreement (as may be amended or supplemented from time to time, the “Share Exchange Agreement”) with Scienjoy, Lavacano Holdings Limited (“Lavacano”), WBY Entertainment Holdings Ltd. (“WBY,” together with Lavacano, the “Sellers”, and each “Seller”). Upon the closing of the transactions contemplated in the Share Exchange Agreement, we will acquire 100% of the issued and outstanding securities of Scienjoy, in exchange for approximately 16.4 million ordinary shares, of which 1.64 million ordinary shares are to be issued and held in escrow to satisfy any indemnification obligations of the Sellers. Additionally, the Sellers may be entitled to receive earnout shares as follows: (1) if Scienjoy’s net income before tax for the year ended December 31, 2019 is greater than or equal to either US$20,900,000 or RMB 140,000,000, the Sellers will be entitled to receive 3,000,000 ordinary shares; (2) if Scienjoy’s net income before tax for the year ended December 31, 2020 is greater than or equal to either US$28,300,000 or RMB 190,000,000, the Sellers will be entitled to receive 3,000,000 ordinary shares; and (3) if Scienjoy’s net income before tax for the year ended December 31, 2021 is greater than or equal to either US$35,000,000 or RMB 235,000,000, the Sellers will be entitled to receive 3,000,000 ordinary shares. Notwithstanding the net income before tax achieved by the posttransaction company for any period, the Sellers will receive (i) 3,000,000 earnout shares if the share price of the Company is higher than $15.00 for any sixty days in any period of ninety consecutive trading days during an twelve month period following the closing; (ii) 3,000,000 earnout shares if the share price of the Company is higher than $20.00 for any sixty days in any period of ninety consecutive trading days between the 13th month and 24th month following the Closing, and (iii) 3,000,000 earnout shares if the share price of the Company is higher than $25.00 for any sixty days in any period of ninety consecutive trading between the 25th month and 36th month following the Closing. On January 28, 2020, we issued a $575,000 Note to Scienjoy, pursuant to which such amount was deposited into our Trust Account in order to extend the amount of time we have available to complete a Business Combination from February 8, 2020 to May 8, 2020. The Note is noninterest bearing and is payable upon the closing of a Business Combination. In addition, the Note may be converted, at the lender’s discretion, into additional Private Units at a price of $10.00 per unit. The outbreak of the COVID19 coronavirus has resulted in a widespread health crisis that has adversely affected the economies and financial markets worldwide. [/INST] Positive. </s>